Shariah-compliant master agreement introduced for hedging Islamic finance deals (page 1 of 2)

By Jonathan Lawrence, Stephen H. Moller and Anthony R.G. Nolan, K&L Gates

While based on the 2002 ISDA Master Agreement (the "2002 Master Agreement") and with many terms familiar to participants in swap markets, the Form has been developed under the guidance and approval of the IIFM Shariah Advisory Panel. The Form is therefore expected to be used as a reference for market participants where they or their customers need to hedge risks in line with Shariah principles.

Principal differences between the 2002 Master Agreement and the Form

The Form 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 (DFT): The Form 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 Shariah compliance.

Close-out Mechanism: While in many respects the early termination provisions of the Form 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.

Shariah Compliance Provisions: The Form includes many references that appear intended to ensure compliance with Shariah principles. These include references to Shariah 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 authorised (e.g., the footnote in the definition of "specified obligation," new language at the end of the definition of "specified transactions").

The Form 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 Form 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 Form. 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 Form 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.