On Friday 20 February, ISDA circulated a final draft of the ISDA Close-out Amount Protocol (the "Protocol"). ISDA initially intended to publish the Protocol and open it for adherence on Monday 23 February 2009. However, that deadline has now passed and no further announcement has yet been made regarding publication.
The revised draft is in response to comments made by market participants on the pre-publication draft of 30 December 2008. We highlighted some key issues/concerns with the pre-publication draft in our alerter of 16 January 2009. We have repeated these comments in italics below, together with a note of the extent to which the concerns have been addressed by the revised draft.
Parties will need to carry out due diligence on all of their existing 1992 ISDA Master Agreements before adhering to the Protocol.
If both parties to a 1992 ISDA Master Agreement adhere, this will override any specific modifications that the parties may have made to the provisions which are replaced by the Protocol. Examples include changes to Paragraph 6 of the English law CSA (e.g. so that it applies if Termination Events occur) and modifications of the definition of "Exposure" in the CSA (e.g. to exclude certain transaction types such as FX). It is not possible to carve-out particular counterparties when adhering to the Protocol. Each party must therefore consider whether it would be appropriate for Close-out Amount to apply in respect of all its counterparties.
This will make adherence to the Protocol impractical for many institutions. Parties could instead look at their most active counterparties and bilaterally agree to incorporate the provisions of the Protocol into the ISDA Master Agreements with those counterparties.
The need to carry out comprehensive due diligence is unavoidable and it is still not possible to carve out particular counterparties when adhering. However, the amended Protocol now preserves any bespoke modifications made to definitional booklets or credit support provisions where those modifications do not conflict with the amendments made by the Protocol. This does not apply to amendments to the ISDA Master Agreement itself.
The changes in the Protocol go beyond those which are strictly necessary to achieve its aim of amending the payment measure on close-out of the ISDA Master Agreement.
The Annexes to the Protocol make amendments to the ISDA Definitions which are not limited to the position on close-out, but also change other terms of transactions. For example, Annex 2 alters the basis on which individual equity derivative transactions are closed out following a disruption event.
If such an event occurs, it will be necessary for adhering parties to ascertain whether or not each affected counterparty is an adhering party in order to see if the Protocol amendment applied.
The Protocol does not provide an opportunity for parties to switch off any of the Annexes, although if parties were bilaterally to agree to the Protocol this could be done. Parties are now able to switch off Annexes 1-9 (which make amendments to the ISDA Definitions). This is an "all or nothing" option and parties cannot switch off individual Annexes (unless they bilaterally agree to the Protocol).
A 1992 ISDA Master Agreement which has been modified by the Protocol will not be covered by the current ISDA netting opinions.
ISDA has said that it will commission updates to the opinions, but those institutions which are subject to regulatory requirements (e.g. regulated financial institutions or UK UCITS funds) may want to wait until the top-up opinions have been published before adhering.
The English netting opinion has been updated to refer to the Protocol as set out in the pre-publication draft of 30 December 2008. This will need to be further updated to refer to the Protocol as published. Opinions in relation to other jurisdictions are unchanged as yet.
The Protocol not only replaces Market Quotation with Close-out Amount; it also amends any 1992 ISDA Master Agreements which have Loss as the payment measure.
Parties who are comfortable with Loss but less happy with Close-out Amount need to bear this in mind.
Parties are now able to de-activate the Protocol in relation to any ISDA Master Agreements which specify Loss as the payment measure. Parties who consider Close-out Amount to be preferable to Loss should bear this in mind as de-activation by one party will bind the counterparty.
There are additional considerations where parties issue pre-master confirmations to the same counterparty both before and after adherence.
Would the Protocol require parties who have adhered to monitor their counterparty's adherence status every time a pre-master confirmation is issued? These concerns have not been addressed in the revised Protocol.
The Protocol raises additional considerations where investment managers adhere.
Should the Protocol apply to all clients? It is possible to carve out certain clients, but this requires either the included or the excluded clients to be listed in the adherence letter. This may have implications in relation to client confidentiality.
Parties are now entitled to refer to specific clients by way of an identifier to protect confidentiality. This will work where the manager is using these identifiers with all its counterparties.
How to deal with the status of clients which become clients after the manager has adhered.
The Protocol has been amended to clarify the situation where the manager adheres in relation to a client (or, presumably, in relation to "all clients from time to time") but that client is added to the umbrella ISDA Master Agreement after the date of the adherence.
The revised Protocol still does not address the circumstances where a manager adheres for specified clients and then acquires a new client. In such circumstances, the manager could serve an additional adherence letter in relation to that new client only.
How to adhere where the manager does not execute ISDA Master Agreements on behalf of clients – which is commonly the case with off-shore hedge funds and UCITS III funds, for example. This concern has not been addressed in the revised Protocol. Instead the asset manager would need to name or identify its clients and not include any to which this consideration applied.
The revised Protocol has addressed a number of the concerns we identified but not all of them. The need for due diligence has not completely diminished and in light of this the Protocol may still not be a practical solution for some market participants. The bilateral adoption of the Protocol is still an alternative approach.