On February 27, 2009, ISDA published its Close-out Amount protocol (the “Protocol”). The Protocol provides participants in the derivatives market a streamlined way to amend the 1992 ISDA Master Agreement so that termination payments are determined according to the Close-out Amount method used in the ISDA 2002 Master Agreement, rather than the ISDA 1992 Master Agreement’s Market Quotation or Loss methods. Under the Protocol, a participant can amend multiple master agreements with only one signed document, precluding the need for a bilateral amendment with each counterparty.

The desire to move to the Close-out Amount method for determining termination payments is by no means universal. Some participants continue to prefer Market Quotation or the more subjective Loss method. Described in simple terms, Market Quotation is an objective approach that uses quotes from sources external to the party making the determination. The Loss method is more flexible, with a party choosing any approach to determine its loss or gain resulting from termination of transactions, subject only to standards of reasonableness and good faith. The Close-out Amount method is somewhere in between, giving the determining party flexibility to choose its approach, but holding it to a standard of commercial reasonableness.

Each participant can make its own decision as to whether it wants to amend its master agreements that are in the form of the 1992 ISDA Master Agreement to incorporate the Close-out Amount method and, if so, whether it will sign onto the Protocol. The participant who wants to substitute Close-out Amount for some but not all of its counterparties may have to enter into bilateral amendments—either to effect the substitution for particular agreements (if it does not sign onto the Protocol) or to nullify the effect of the Protocol where it wants to retain its current approach (if it does sign onto the Protocol).

Following is a brief description of the Protocol’s salient provisions and related issues that may assist a participant in deciding whether to sign onto the Protocol.

Substantive Provisions of the Protocol

1. The Protocol has the effect of amending a master agreement to substitute Close-out Amount as the method for determining termination payments if  

  • the master agreement is in the form of a 1992 ISDA Master Agreement that has been signed by two parties (including where one party has signed as agent for third parties) or a 1992 ISDA Master Agreement deemed entered into by the terms of a confirmation;  
  • both parties to the agreement have signed onto the Protocol; and  
  • neither the master agreement nor any credit support document requires the consent of a third party to effect amendments to the master agreement.

2. Even if all three conditions noted above are fulfilled, the Protocol will not override modifications to a 1992 ISDA Master Agreement agreed to bilaterally if those modifications  

  • were incorporated into a confirmation (other than certain changes that are ISDA standard formulation); or  
  • were made in the schedule to the master agreement but do not apply explicitly to all transactions under the master agreement.  

3. A party that signs onto the Protocol may elect to retain the Loss method, to the extent it is applicable, under  

  • 1992 ISDA Master Agreements for which the Loss method applies to some or all transactions terminated as a result of ISDA standard events of default or termination events; and  
  • 1992 ISDA Master Agreement provisions for which the Loss method applies to some or all transactions terminated as a result of an additional event of default or additional termination event, but only if the event of default or termination event requires that all transactions be terminated.  

4. For consistency, the use of Market Quotation in determining the amount of collateral required under any ISDA form of credit support document (including the Credit Support Annex) is replaced with a determination based on Close-out Amount method.  

5. “First Method” under the 1992 Master Agreement is eliminated.  

6. A party that signs onto the Protocol may elect whether to make consistency changes to the general ISDA definitions booklets and the ISDA definitions booklets for FX, equity, equity option, bond option, credit and commodity transactions. The election is an all or nothing choice. A party that wishes to retain the Loss method or wants to move to the Close-out Amount method for only some counterparties may have to enter into supplementary bilateral amendments, whether or not it has elected to incorporate the consistency changes, to ensure that the definitions booklets are consistent with all its master agreements.  

Procedural Provisions of the Protocol  

1. To sign onto the Protocol, both a manually executed and a conformed copy of an “adherence letter” (the form of which is an exhibit to the Protocol) must be delivered to ISDA by e-mail as a PDF document.  

2. In completing the adherence letter, a party selects whether it wants to replace Loss with Close-out Amount. Failure to make a selection is deemed an election to replace. In addition, the party selects whether the changes to the ISDA definitions booklets are applicable. Failure to make a selection is deemed an election to incorporate the changes.  

3. The Protocol amends a master agreement between two parties as of the date on which the second to sign onto the Protocol has delivered its adherence letter.  

4. Where a master agreement is signed by an agent on behalf of its clients, the Protocol is effective with respect to clients that were parties to the agreement on the effective date described above and with respect to clients who are added to the agreement after that date (as long as ISDA permits the addition of parties to the Protocol at that time).

5. A party who has signed onto the Protocol has a limited right to withdraw from the Protocol. The party must submit a revocation notice during the period between October 1 and December 31 of any year, with the revocation taking effect on December 31. The revocation will be effective except with respect to  

  • any agreement amended by the Protocol prior to the effectiveness of the revocation; and  
  • any agreement entered into after effectiveness of the revocation, but for which both parties signed onto the Protocol prior to effectiveness of the revocation.  

6. ISDA can provide 30-day notice that no further parties may sign onto the Protocol.  

7. Parties can modify the effect of the Protocol through bilateral agreement. Any such provision must refer specifically to section 4(c) of the Protocol.  

Additional Issues

1. Does the party want to use Close-out Amount? Are there any counterparties for which Close-out Amount does not make sense? Although Market Quotation is a more objective method for determining termination payments, it may be more burdensome to implement. Loss gives the determining party maximum flexibility. Which of the three methods is preferable may depend in part upon a party’s view of the likelihood of its own default as compared to the likelihood of the counterparty’s default. Concern regarding dealer default has taken a higher priority after Bear Stearns and Lehman Brothers’ demise.  

2. Will the same decision apply for all clients of an agent that is party to a master agreement? If not, the agent will have to decide whether it is more efficient to sign onto the Protocol and enter into bilateral agreements to nullify its effect where Close-out Amount is not preferred, or to apply Close-out Amount through a bilateral amendment for each relevant client and counterparty.  

3. Under the Protocol, a participant represents that the Protocol will not adversely impact obligations owed by it or a third party in connection with a credit support arrangement. A participant should review its credit support documents before making the representation.  

4. If a party chooses to revoke, it should check whether the counterparty to any master agreement entered into after the date of revocation had signed onto the Protocol prior to that date. If so, the new master agreement will have to include a provision explicitly nullifying the Protocol.  

5. A party that has signed onto the Protocol should ensure that all internal records regarding a particular master agreement reflect whether the agreement has been amended by the Protocol.  

Conclusion  

A derivatives market participant should make certain it is comfortable with all aspects of the Protocol before signing on. To the extent any provisions are not satisfactory, the participant will have to decide whether to approach its counterparties (both existing and future) to modify the effect of the Protocol on a bilateral basis. Once the participant signs onto the Protocol, terms of the Protocol become part of any master agreement to which it applies, even though the agreement does not reference the Protocol explicitly.