Derivatives and
Structured Products Alert
March 16, 2010
Authors:
Jonathan Lawrence
jonathan.lawrence@klgates.com
+44.20.7360.8242
Stephen H. Moller
stephen.moller@klgates.com
+44.20.7360.8212
Anthony R.G. Nolan
anthony.nolan@klgates.com
+1.212.536.4843
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
www.klgates.com.
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.
Derivatives and Structured Products Alert
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, 2010
2
Derivatives and Structured Products Alert
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. 2004 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, 2010
3
Derivatives and Structured Products Alert
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, 2010
4
Derivatives and Structured Products Alert
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, 2010
5
Derivatives and Structured Products Alert
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?
•
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, +971.4.401.9820,
paul.decordova@klgates.com
Jonathan Lawrence, +44.20.7360.8242,
jonathan.lawrence@klgates.com
Stephen H. Moller, +44.20.7360.8212,
stephen.moller@klgates.com
Anthony R.G. Nolan, +1.212.536.4843,
anthony.nolan@klgates.com
Basis risk concerns: It may remain to be seen
how the Ta’Hawwut Agreement will coexist
with other forms to the extent that counterparties
March 16, 2010
6
Derivatives and Structured Products Alert
Anchorage Austin Beijing Berlin Boston Charlotte Chicago Dallas Dubai Fort Worth Frankfurt Harrisburg Hong Kong London
Los Angeles Miami Moscow Newark New York Orange County Palo Alto Paris Pittsburgh Portland Raleigh Research Triangle Park
San Diego San Francisco Seattle Shanghai Singapore Spokane/Coeur d’Alene Taipei Tokyo Warsaw Washington, D.C.
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 www.klgates.com.
K&L Gates comprises multiple affiliated entities: a limited liability partnership with the full name K&L Gates LLP qualified in Delaware and
maintaining offices throughout the United States, in Berlin and Frankfurt, Germany, in Beijing (K&L Gates LLP Beijing Representative Office), in
Dubai, U.A.E., in Shanghai (K&L Gates LLP Shanghai Representative Office), in Tokyo, and in Singapore; a limited liability partnership (also named
K&L Gates LLP) incorporated in England and maintaining offices in London and Paris; a Taiwan general partnership (K&L Gates) maintaining an
office in Taipei; a Hong Kong general partnership (K&L Gates, Solicitors) maintaining an office in Hong Kong; a Polish limited partnership (K&L
Gates Jamka sp. k.) maintaining an office in Warsaw; and a Delaware limited liability company (K&L Gates Holdings, LLC) maintaining an office in
Moscow. K&L Gates maintains appropriate registrations in the jurisdictions in which its offices are located. A list of the partners or members in each
entity is available for inspection at any K&L Gates office.
K&L Gates has offices in: Anchorage, Austin, Beijing, Berlin, Boston, Charlotte, Chicago, Dallas, Dubai, Fort Worth, Frankfurt, Harrisburg, Hong
Kong, London, Los Angeles, Miami, Moscow, Newark, New York, Orange County, Palo Alto, Paris, Pittsburgh, Portland, Raleigh, Research Triangle
Park, San Diego, San Francisco, Seattle, Shanghai, Singapore, Spokane/Coeur d’Alene, Taipei, Tokyo, Warsaw, and Washington, D.C.
This publication is for informational purposes and does not contain or convey legal advice. The information herein should not be used or relied upon
in regard to any particular facts or circumstances without first consulting a lawyer.
©2010 K&L Gates LLP. All Rights Reserved.
March 16, 2010
7