Derivatives and Structured Products Alert

Transcription

1 Derivatives and Structured Products Alert March 16, 2010 Authors: Jonathan Lawrence Stephen H. Moller Anthony R.G. Nolan K&L Gates includes lawyers practicing out of 36 offices located in North America, Europe, Asia and the Middle East, and represents numerous GLOBAL 500, FORTUNE 100, and FTSE 100 corporations, in addition to growth and middle market companies, entrepreneurs, capital market participants and public sector entities. For more information, visit Shari ah-compliant Master Agreement Introduced for Hedging Islamic Finance Transactions On March 1, 2010 after many months of work, ISDA (the International Swaps and Derivatives Association) and IIFM (International Islamic Financial Market) jointly issued the first Shari ah-compliant master agreement for over-the-counter (OTC) derivatives. 1 Styled the ISDA / IIFM Ta Hawwut Master Agreement (ta hawwut signifies hedging in Arabic), the new template master agreement (the Ta Hawwut Agreement ) provides a framework for the expansion of derivatives activity in the Middle East, South Asia and many regions throughout the world where hedging is not currently standard practice due to ethical concerns. While based on the 2002 ISDA Master Agreement (the 2002 Master Agreement ) and with many terms familiar to participants in swap markets, the Ta Hawwut Agreement has been developed under the guidance and approval of the IIFM Shari ah Advisory Panel. The Ta Hawwut Agreement is therefore expected to be used as a reference for market participants where they or their customers need to hedge risks in line with Shari ah principles. This Alert will discuss the place of derivatives transactions within Shari ahcompliant finance principles, will discuss the types of transactions to which the Ta Hawwut Agreement could apply and will discuss some of the salient differences between the Ta Hawwut Agreement and the 2002 Master Agreement. Shari ah Principles Relevant to Hedging In structuring the Ta Hawwut Agreement, ISDA and IIFM have sought to provide a basis to hedge risks that are common in Shari ah-compliant transactions in a Shari ah-compliant way. There is a high correlation between Shari ah-compliant investing and socially responsible investing. Shari ah investment is constrained by restrictions on the way in which transactions can be carried out and the purposes for which they are entered into. In particular, Shari ah-compliant financial transactions may not involve riba (the charging of interest), gharar (unavoidable uncertainty) 1 ISDA represents participants in the privately negotiated derivatives industry. Its members include most of the world s major institutions that deal in privately negotiated derivatives, as well as many of the businesses, governmental entities and other end-users that rely on over-the-counter derivatives to manage efficiently the financial market risks inherent in their core economic activities. IIFM is a global standard setting body for the Islamic financial services industry. Its primary focus lies in the standardisation of Islamic products, documentation and related processes. IIFM was founded by the Central Banks of Bahrain, Indonesia and Sudan, Labuan Offshore Financial Services Authority (Malaysia), Islamic Development Bank (Saudi Arabia) and Ministry of Finance Brunei Darussalam. Besides the support of its founding members, IIFM is also supported by its permanent members the State Bank of Pakistan and Dubai International Financial Centre. IIFM is additionally supported by a number of regional and international financial institutions as well as other market participants.

2 or maysir (gambling or speculation). 2 These restrictions have led to a number of amendments in the Ta Hawwut Agreement compared to the 2002 Master Agreement. Although these restrictions may make a Shari ahcompliant derivative seem like a contradiction in terms, OTC derivative transactions are not necessarily repugnant to Islamic finance principles if carefully drafted and appropriately limited in purpose. Islamic finance, just like conventional finance, has a need for hedging against unexpected changes in exchange rates and commodity prices. Surprisingly, hedges are also needed in some transactions against changes in interest rates, despite the prohibition on interest in Islamic finance, because Shari ah-compliant transactions often use published interest rates as a benchmark for pricing Islamic financial products. For example, although LIBOR rates would not be employed directly in an Islamic finance transaction, they may used as a guide for determining the premium payable on a finance lease arrangement ( Ijara ) between a bank and Islamic end-user. Similarly, the prohibition on gambling and uncertainty would not prevent the use of a derivative transaction to hedge other risks associated with the ownership of a financial asset. One analogy is of an Islamic participant being (a) a conventional investor who holds a bond and buys credit default protection on that bond versus (b) an investor who buys a credit default swap on a bond he does not own. The latter position is not Shari ahcompliant as it is pure speculation not based on any ownership of an underlying asset. 2 Riba means excess in the sense of interest, i.e., the addition of a premium that is paid to a lender in return for waiting for his money, that premium being a predetermined amount in excess of capital. Riba is strictly prohibited in Islamic finance and investment transactions. Any agreement that includes riba is invalid from the Shari ah viewpoint, irrespective of the parties agreeing to such a contract. Gharar means to deceive, cheat, delude, entice, and overall uncertainty. This principle means the avoidance of any element of uncertainty in a contract that is otherwise preventable or avoidable. Maysir means gambling or speculation. This affects the purpose of ta hawwut or hedging transactions to the extent that the hedge must be strictly linked to underlying transactions and cannot be a transaction that has the sole purpose of making money from money. Consequences of Removing Interest Provisions As expected, the Ta Hawwut Agreement rigorously eliminates provisions for payment of interest. However, it is not clear how the time value of money is addressed in situations contemplated by the Ta Hawwut Agreement where amounts may be deferred. Deferral of payments may occur in two circumstances. First, there is normal delay in obtaining payment of termination amounts and unpaid amounts as well as deferrals during the waiting period for force majeure. Second, delay occasioned by deferral of performance of future agreements is contemplated in, for example, the setoff provision. In the second case, the parties can structure the payment price or delivery amount, but it seems that in the first case the payee may lose the value of use of the money during the period it is tied up. The absence of interest may also affect the behavior of parties in a default situation. A defaulting party may potentially raise legal objections and elongate the process knowing that default interest is no disincentive. Equally, a non-defaulting party may prefer to continue with a transaction under a mechanism that has a premium attached rather than be left with a liquidated amount which carries no interest. These issues related to the removal of interest will need further examination by parties and in-house counsel to determine whether the economics of a transaction will be distorted on early termination or otherwise. Types of Shari ah-compliant Transactions in which the Ta Hawwut Agreement may be Used The Ta Hawwut Agreement expressly contemplates that parties would enter into underlying Shari ahcompliant transactions that may include murabaha transactions. Murabaha refers to a deferred payment arrangement used to provide trade or acquisition finance. In a murabaha transaction, the financier buys an asset from the supplier and sells it to the customer at a premium, typically payable in installments. The premium is generally based on a benchmark rate, such as LIBOR, plus a margin, thus giving rise to the need to hedge March 16,

3 fluctuations in such benchmark. The financier must acquire title to the asset in question, taking some commercial risk in relation to it. When one party undertakes to enter into a transaction in the future at the election of the other party, that undertaking is a wa ad. The Ta Hawwut Agreement contemplates two distinct sets of wa ad : the wa ad to enter into designated future transactions ( DFT ) between the parties to the Ta Hawwut Agreement; this wa ad will usually be contained in the DFT terms confirmation entered into at the time the parties agree the specific terms to apply to the specific DFT, and the wa ad to enter into musawama under section 2(e) of the Ta Hawwut Agreement in the event of an early termination date. A musawama is a sale contract in which a commodity is traded without the cost price of the object being known to the purchaser. Is the Ta Hawwut Agreement itself Shari ah-compliant? The Ta Hawwut Agreement is intended to be Shari ah-compliant. However, the standard representation by each party to the Ta Hawwut Agreement at section 3(h) as to Shari ah compliance is caveated by the words: Insofar as [a party] wishes or is required for any reason to enter into transactions. which. are.. Shari ahcompliant. it has made its own investigation into and satisfied itself as to the Shari ah compliance of this Agreement (including the obtaining of a declaration, pronouncement, opinion or other attestation of the Shari ah adviser, board or panel relevant to it where required). Therefore a party is only obliged to confirm that the transaction is Shari ah-compliant as far as it wishes or is required to do so. This may lead to further discussions between the parties as to each other s stance on such issues. If a non-islamic party is concerned, then it could attempt to exclude this representation. Due to the varied interpretations of Shari ah law, users may also want to involve their Shari ah advisers in approving the Ta Hawwut Agreement. There are disclaimers throughout the Ta Hawwut Agreement that there is no guarantee of Shari ah compliance for any amendments or additions to the Ta Hawwut Agreement or related underlying transaction documents. Parties must obtain their own opinions from scholars if this is a concern. Areas where concerns could arise may include the transactions themselves that are being hedged as well as events of default under section 5(a)(v) (default under specified transaction) and 5(a)(vi) (cross-default), as those provisions, by their terms, may relate to transactions that are not Shari ahcompliant. It is important to note that, regardless of the Shari ah compliance of the Ta Hawwut Agreement or any transactions thereunder, the Ta Hawwut Agreement provides for the election of New York law or the law of England and Wales as the governing secular law for the Ta Hawwut Agreement, as is the case with the 2002 Master Agreement. Section 1(d) provides that any reference to law or laws in the Ta Hawwut Agreement does not include reference to principles of the Shari ah. It also provides that determinations of unlawfulness or illegality are made without reference to Shari ah law. This means that termination events under section 5(b)(i) (illegality) or section 5(b)(iii)(2) (tax event change of tax law) will be determined without regard to Shari ah law principles. The approach of relying on the law of a country as the governing law of a contract intended to be Shari ah-compliant was confirmed by the English Court of Appeal in the case of Beximco Pharmaceuticals Ltd and others v Shamil Bank of Bahrain E.C EWCA Cir 19. In that case, the clause provided Subject to the principles of the Glorious Shari ah, this Agreement shall be governed by and construed in accordance with the laws of England. The court found that the general reference to Islamic Shari ah rules afforded no reference to, or identification of, those aspects of Shari ah law that were intended to be incorporated into the contract. The reference was contrary to the choice of English law as the law of the contract and rendered the clause self-contradictory and therefore meaningless. The application of Shari ah principles to finance contracts was a matter of controversy even amongst Shari ah scholars. It was highly March 16,

4 improbable that the parties intended an English court to determine any dispute as to the nature or application of such principles. The approach suggested by the case is that, under English law, it is for each party to satisfy themselves that the substantive terms of the underlying contract comply with Shari ah principles. This English court approach prevents parties introducing Shari ah principles to avoid the contract. However, it places even further importance on parties who require Shari ah-compliance ensuring that the Ta Hawwut Agreement and related transactions are blessed by Shari ah advisers to their satisfaction. If there are aspects that need to be amended, then there will need to be changes to the template Ta Hawwut Agreement before it is entered into. Principal Differences Between the 2002 Master Agreement and the Ta Hawwut Agreement The Ta Hawwut Agreement is heavily based on the 2002 Master Agreement and follows a similar layout and style. Important provisions such as the liability for indemnified taxes, events of default, termination events, governing law, cross-transaction payment netting and set-off are similar to those in the 2002 Master Agreement. However, there are some significant differences. Transactions and Defined Future Transactions. The Ta Hawwut Agreement includes not just completed transactions but also undertakings to enter into DFT. It appears that the separation of completed transactions and DFT agreements may be intended to create a mechanism to effectuate hedging, where it is helpful to separate the legs of underlying hedged transactions for purposes of Shari ah compliance. The inclusion of future transactions impacts many sections of the Ta Hawwut Agreement. For example, the events of default and termination events have been modified to account for nonperformance of future obligations (with a shorter grace period for failure to enter into a future transaction than for other non-payment events of default) and for illegality/force majeure affecting a party s ability to enter into future transactions; and the set-off provision is modified to provide for deferral of set-off where amounts are to be paid in future under future transactions. Another example is that the right to transfer payment entitlements under section 7 is expanded to include the right to receive the purchase price under a musawama. It also may affect netting, as discussed below. Close-out Mechanism. While in many respects the early termination provisions of the Ta Hawwut Agreement are similar to those in section 6 of the 2002 Master Agreement, the close out settlement mechanics relating to the calculation of the settlement amount differ considerably between the two forms. The inclusion of future transactions also has significant consequences for the termination mechanism in sections 6(d) and 6(e), because, while the 2002 Master Agreement concept of a close out amount is included (in simplified form) for fully delivered transactions, the termination amount of non-fully delivered transactions or DFT is valued by determination of a Relevant Index, which essentially uses a methodology that is very similar to the market quotation methodology in the 1992 ISDA Master Agreement. Consequently, there is no single net sum payable under the Ta Hawwut Agreement if it covers both fully delivered transactions and undertakings for future agreements or transactions under which delivery remains to be performed. Additionally, the termination provisions require a market valuation of the Designated Assets under section 6(f)(v) as determined by the exercising party acting in good faith and in a commercially reasonable manner. This adds a level of uncertainty to the termination mechanics. In entering into the Ta Hawwut Agreement, each party issues an undertaking to enter into a contract in the future for the sale of assets following the designation of an early termination date. The party to whom the Relevant Index Amount is due may exercise the wa ad given in its favor and sell preagreed assets in exchange for the cost price of such assets and the Relevant Index Amount. If, in breach of the wa ad it has issued, a party fails to purchase the assets under a musawama, liquidated damages are determined and payable. March 16,

5 Shari ah Compliance Provisions. The Ta Hawwut Agreement includes many references that appear intended to ensure compliance with Shari ah principles. These include references to Shari ah law compliance, elimination of references to provisions for payment of interest (e.g., elimination of interest and compensation provisions of section 9(h) of the 2002 Master Agreement and replacement with no interest payable as well as elimination of related definitions such as applicable close out rate and applicable deferral rate ); change of the term specified indebtedness to specified obligation albeit with no change to the substance; and references in various places to confirmation that provisions that may contemplate non-islamic financing do not necessarily mean such are authorized (e.g., the footnote in the definition of specified obligation, new language at the end of the definition of specified transactions ). References to taking into account the creditworthiness of a party in the context of obtaining quotations are also removed throughout. The Ta Hawwut Agreement also contains some clarifying changes from the 2002 Master Agreement. For example, the new section 3(i) includes a non-reliance provision that is normally included in the schedule, so one will have to consider whether to turn it off for particular cases rather than considering whether to turn it on, as is generally done. Section 3(g) clarifies the no agency provision of the 2002 Master Agreement. Another example is section 6(b)(ii), in which the concept of transfer of the contract to another office to avoid a termination event is changed to redesignation of the contract as being one of another office. There is the inclusion of an arbitration provision at section 13(c). In section 6(e), some provisions of the 2002 Agreement (such as adjustment for bankruptcy, adjustment for illegality/force majeure, pre-estimate, mid-market quotations) have been retained but moved. Issues of Note The Ta Hawwut Agreement raises points of ambiguity on which advice will be required: Netting of transactions and Relevant Index Amounts under DFT: Parties may elect to have cross-transaction payment netting apply. However, netting of future transactions is not covered (except in a footnote that contemplates that parties may provide for similar netting in those agreements). There is no provision in the Ta Hawwut Agreement that purports to make it a cross-product master netting agreement. There may be enforceability issues in the bankruptcy of a party with respect to the netting of amounts under existing transactions versus amounts in respect of future transactions, particularly to the extent that future transactions may contemplate delivery of assets rather than payment of money. This will also be affected by whether and to what extent netting is enforceable as a matter of bankruptcy law in jurisdictions of parties to the Ta Hawwut Agreement. It is important that parties consider netting in the relevant jurisdictions, particularly when netting a cash claim against an obligation to deliver an asset. Redesignation to avoid termination event: The replacement of transfer with redesignation in section 6(b)(ii) may create ambiguity as to whether redesignation of rights and obligations implies the ability of the affected party to change substantive rights in connection with changing the obligor office. Simplification of close-out amount: The Ta Hawwut Agreement replaces the definition of close out amount that appears in the 2002 Master Agreement with a very brief definition, and with many elements of the definition that relate to good faith and commercial reasonableness inserted in the operative text relating to the close out amount and the determination of the Relevant Index. The change should be studied with care, because it appears to make this area very subjective. The relation of the close-out amount calculation to the automatic acceleration of specified payments in section 6(d)(i) of the Ta Hawwut Agreement may also create ambiguity to the extent it may be read to imply that the specified March 16,

6 payments are separate from the close-out amount. Determination of close-out amount where there are two affected parties or burdened parties: Like the 2002 Master Agreement, section 6(e)(ii) of the Ta Hawwut Agreement provides that, in certain cases, both parties calculate a close out amount and that the close out amount be calculated based on those calculations. Unlike in the 2002 Master Agreement, section 6(e)(ii) does not include a mechanism to split the difference between both calculations. This is probably an oversight, because a corresponding provision in section 6(f)(iii) for determination of the Relevant Index and Relevant Index Amount relating to future transaction agreements or non-fully delivered transactions does include that language. Removal of credit-worthiness in determining quotations: The 2002 Master Agreement generally requires that mid-market quotes and some others may take into account the creditworthiness of the requesting party. Not so in the Ta Hawwut Agreement. This could distort the economics of a transaction on early termination or otherwise. No Shari ah advisory board approval for transactions: The introductory paragraph to the Ta Hawwut Agreement states the limits of formal religious approval. Since section 5(a)(v) (default under specified transaction) and section 5(a)(vi) (cross-default) may relate to transactions that are not Shari ah-compliant, it may be necessary to consider carefully any issues in obtaining this approval for particular transactions. Similar issues may arise with regard to hedging activities of dealer counterparties. Would parties have to wall off their transactions under the Ta Hawwut Agreement from others? Would a party s own Shari ah advisers require modification of those terms? Basis risk concerns: It may remain to be seen how the Ta Hawwut Agreement will coexist with other forms to the extent that counterparties may hedge exposure thereunder by entering into master agreements with differing terms. For example, the unique close out methodology may expose counterparties to risk of loss to the extent that hedging transactions would be closed out using a different methodology. The Future The Ta Hawwut Agreement is a step forward in demystifying the Islamic finance and investment market by using an accepted market document as the basis for a new standard. However, its use will need to be monitored and issues will arise in its application which will need to be carefully considered. It could be a pathfinder for further standardized documentation in the Islamic finance market. The lack of such documentation to this point has been one of the impediments to the market s further development. While it raises issues that market participants will consider carefully, ISDA and IIFM are working with sovereign players in the Islamic finance market - including the UAE and Malaysia - to amend domestic legal frameworks governing closing out and netting. In order for the efforts in development of standard documentation for transactions in Islamic derivatives to be optimized, legal and regulatory changes are needed across Islamic jurisdictions, in particular in relation to insolvency, collateral and conflict of law issues. In the event that you have questions concerning the Ta Hawwut Agreement or this Alert, please contact one of the K&L Gates partners named below. Paul De Cordova, , paul.decordova@klgates.com Jonathan Lawrence, , jonathan.lawrence@klgates.com Stephen H. Moller, , stephen.moller@klgates.com Anthony R.G. Nolan, , anthony.nolan@klgates.com March 16,

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