ISDA-IIFM Ta'Hawwut Master Agreement described by K&L Gates

K&L Gates, an international law firm based in London, released a comprehensive summary of the new ISDA-IIFM Ta'Hawwut (hedging) Master Agreement. The full description is recommended reading because it raises a number of issues with the contract's implications based on the differences with a standard ISDA derivatives Master Agreement. I will put a few quotes here, but the full article, which was released March 16, 2010, is available from K&L Gates' website.

One point of note for ISDA Master Agreements generally (from Wikipedia) is:

The ISDA Master Agreement is a bilateral framework agreement. This means it contains general terms and conditions (such as provisions relating to payment netting, tax gross-up, tax representations, basic corporate representations, basic covenants, events of default and termination) but does not, by itself, include details of any specific derivatives transactions the parties may enter into. The ISDA Master Agreement is a pre-printed form which will not be amended itself (save for writing in the names of the parties on the front and signature pages). However, it also has a manually produced Schedule in which the parties are required to select certain options and may modify sections of the Master Agreement if desired. The Master Agreement would be modified to the extent the modification is mentioned in the Schedule.

The K&L Gates article describes the general need for Shari'ah-compliant derivatives:

"Although these [Shari'ah] restrictions may make a Shari'ah-compliant 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.

They provide an analogy to conventional derivatives to demonstrate that some can be viewed as speculation while others are legitimate needs for hedging. The ISDA-IIFM Master Agreement specifies that the derivatives transactions must be used for legitimate hedging activities only:

"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'ah-compliant as it is pure speculation not based on any ownership of an underlying asset."

The removal of interest in the contracts may change the incentives in cases where counterparties default:

"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."

K&L Gates describes the basis for the transaction which includes two wa'ad (promises), one is a promise to enter into a murabaha transaction on certain terms and the other is a promise to enter into a musawama, which is like a murabaha except that the cost to the seller does not have to be disclosed to the purchaser:

"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."

Finally, the Ta'Hawwut Master Agreement covers Shari'ah compliance. K&L Gates describes:

"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."

This reliance on the two parties to determine Shari'ah-compliance is both a strength and a weakness in my opinion. It allows for different Shari'ah standards to be incorporated for the underlying transactions and also for these standards to change over time (at least as far as they don't affect the Master Agreement. However, they also present a risk not unlike the Shari'ah risk that characterizes other products. In general, the transactions are governed by a secular law (in the Ta'Hawwut it allows the choice of New York or English law). A party should not have grounds to object to the transaction after the fact based on its Shari'ah-non-compliance. However, the TID v. Blom Bank case involving a wakala agreement adds another risk factor: that an Islamic bank will claim that it is, under its corporate charter or under another national law, unable to enter into contracts that are not Shari'ah-compliant. In the TID case, the courts cast doubt on the claim, but did not dismiss it altogether. This case should provide a good indication about whether institutions which are specifically prohibited from entering into non-compliant transactions can use this as a defense under the idea of ultra vives that could allow them to void a contract after it is signed even if the company's Shari'ah board approved the contract at the outset. It will be an important decision, and the judge who wrote the decision indicated that the ultra vives defense is unlikely to be allowed in the end when it required TID to pay the principal amount from the wakala to Blom Bank in order to be able to file an appeal.

The K&L Gates article covers many more issues than I could quote in this short blog post and I would recommend reading it in full.