ISDA Master Agreement: Salient features

(This post offers salient features of ISDA, covering some of the points most important to the parties to the agreement for OTC derivatives transactions internationally.)

The ISDA Master Agreement is an internationally agreed document published by the International Swaps and Derivatives Association, Inc. (“ISDA”) which is used to provide certain legal and credit protection for parties who enter into over-the-counter or “OTC” derivatives transactions.

The ISDA document is the most commonly used master service agreement for OTC derivatives transactions internationally. It is part of a framework of documents, designed to enable OTC derivatives to be documented fully and flexibly.  Two main versions are still commonly used in the market: the 1992 ISDA Master Agreement (Multicurrency – Cross Border) and the 2002 ISDA Master Agreement.

For the learners, the ISDA Master Agreement may appear daunting with its long text (28 pages in the 2002 version) and multiple defined terms and cross-references. However, it is an important document that sets out the general contractual relationship between the parties involved. Here below, we cover some of the points most important to the parties to the agreement for OTC derivatives transactions internationally.

The ISDA Master Agreement is an umbrella agreement that sets out the overarching terms between the parties who want to trade OTC derivatives. OTC (Over the counter) derivatives are mainly used for hedging purposes, (can also be used for speculation). For example, an entity may wish to protect itself against adverse movements in medium or long-term interest rates by entering into an interest rate swap to “lock in” a fixed interest rate for a fixed period.

The framework of a master agreement consists of the schedule (the “Schedule”), and the documents and other confirming evidence (each a “Confirmation”) exchanged between the parties or otherwise effective for confirming or evidencing those Transactions. The Master Agreement and the Schedule are together referred to as “Master Agreement” in 2002 ISDA.

The master agreement is a document agreed to between two parties that sets out standard terms that apply to all the transactions entered into between those parties. The Agreement is split into 14 Sections which outline the contractual relationship between the parties. It includes standard terms that detail what happens if a default occurs to one of the parties e.g. bankruptcy and how OTC derivative transactions are terminated or “closed out” following a default.  There are 8 standard Events of Default and 5 standard Termination Events under the 2002 ISDA Master Agreement covering various default situations that could apply to one or both parties.  However, in close-out situations, the Bankruptcy Event of Default will be the one most commonly triggered.

 In the Agreement text, there is a Schedule that allows parties to add to or amend the standard terms. The Schedule is what negotiators negotiate.  It typically takes at least 3 months to negotiate the Schedule but this can be shorter or longer depending on the complexity of the provisions concerned and the responsiveness of the parties.

When parties enter into individual Transactions a Confirmation will be prepared (either on paper or electronically) detailing the terms of that specific trade. Each Confirmation will reference the ISDA Master Agreement.  All the trades are then covered by the terms of the Agreement.

The terms defined in Section 14 and elsewhere in this Master Agreement will have the meanings therein specified for Master Agreement. For example, the following words have the meaning specified below;

Inconsistency: In the event of any inconsistency between the provisions of the Schedule and the other provisions of the Master Agreement, the Schedule will prevail. In the event of any inconsistency between the provisions of any Confirmation and Master Agreement, then such confirmation will prevail for the relevant Transaction.

Single Agreement: All Transactions are entered into in reliance on the fact that the Master Agreement and all Confirmations form a single agreement between the parties (collectively referred to as “Agreement”), and the parties would not otherwise enter into any Transactions.

General Conditions:

(i) Each party will make each payment or delivery specified in each Confirmation to be made by it, subject to the other provisions of the Agreement.

(ii) Payments under the Agreement will be made on the due date for value on that date in the place of the account specified in the relevant Confirmation or otherwise under the Agreement, in freely transferable funds and the manner customary for payments in the required currency. Where settlement is by delivery (that is, other than by payment), such delivery will be made for receipt on the due date in the manner customary for the relevant obligation unless otherwise specified in the relevant Confirmation or elsewhere in the Agreement.

(iii) Each obligation of each party under Section 2(a)(i) is subject to;

(1) The condition precedent that no Event of Default or Potential Event of Default concerning the other party has occurred and is continuing,

 (2) the condition precedent that no Early Termination Date in respect of the relevant Transaction has occurred or been effectively designated and each other condition specified in the Agreement to be a condition precedent for this Section 2(a)(iii).

Netting:

It is important to note that the ISDA Master Agreement is a netting agreement and all Transactions depend upon each other.  Therefore a default under one Transaction counts as a default under all Transactions.  In Section 1(c) of the Agreement, the single agreement concept is outlined and is vital because it is the basis of close-out netting.  The intention is that if an ‘Event of Default’ occurs, all Transactions are terminated without exception.  The close-out netting concept stops a liquidator from “cherry-picking” i.e. choosing to make payments on Transactions that are profitable to his bankrupt client and refusing to do so, on unprofitable ones.

Change of Account: Either party may change its account for receiving a payment or delivery by giving notice to the other party at least five Local Business Days before the Scheduled Settlement Date for the payment or delivery to which such change applies unless such other party gives timely notice of a reasonable objection to such change.

It is possible to enter into OTC derivative trades without a signed ISDA Master Agreement and often when this happens the Confirmation will include an undertaking between the parties that an ISDA Master Agreement will be negotiated and signed within a 30, 60, or 90-day period. In the meantime, a “vanilla” ISDA (the ISDA Form without schedule) is deemed to apply.  However, without the Schedule and assuming that the Confirmation does not outline extensive choices relating to the ISDA Master Agreement, the parties are not entirely protected.

Netting of Payments: If on any date amounts would otherwise be payable;

 (i) in the same currency; and

(ii) In respect of the same Transaction,

by each party to the other, then, on such date, each party’s obligation to make payment of any such amount will be automatically satisfied and discharged, and, if the aggregate amount that would otherwise have been payable by one party exceeds the aggregate amount that would otherwise have been payable by the other party, replaced by an obligation upon the party by which the larger aggregate amount would have been payable to pay to the other party the excess of the larger aggregate amount over the smaller aggregate amount.

The parties may elect in respect of two or more Transactions that a net amount and payment obligation will be determined in respect of all amounts payable on the same date in the same currency in respect of those Transactions, regardless of whether such amounts are payable in respect of the same Transaction. The election may be made in the Schedule or any Confirmation by specifying that “Multiple Transaction Payment Netting” applies to the Transactions identified as being subject to the election (in which case, clause (ii) above will not apply to such Transactions). If Multiple Transaction Payment Netting applies to Transactions, it will apply to those Transactions with effect from the starting date specified in the Schedule or such Confirmation, or, if a starting date is not specified in the Schedule or such Confirmation, the starting date otherwise agreed by the parties in writing. This election may be made separately for different groups of Transactions and will apply separately to each pairing of Offices through which the parties make and receive payments or deliveries.

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