ISDA Publishes Standardized Clauses for Sustainability-Linked Derivatives
- The International Swaps and Derivatives Association's (ISDA) newly published ISDA SLD Clause Library contains standardized clauses and definitions for use in sustainability-linked derivatives.
- The standardized clauses are intended to offer market participants sufficient flexibility to cover a wide range of derivatives products linked to environmental, social and governance (ESG) goals, providing multiple variants, bracketed provisions and commentary to allow and encourage customization.
- Standardized terms include 1) identification of key performance indicators and related targets, 2) methodology for determining compliance with targets, 3) election of consequences of compliance or noncompliance, 4) dispute resolution and 5) various other terms.
The International Swaps and Derivatives Association (ISDA) has published a new ISDA SLD Clause Library (SLD Provisions) containing standardized clauses and definitions for use in sustainability-linked derivatives (SLDs). The SLD Provisions are intended to provide market participants with sufficient flexibility to cover a wide range of derivatives products linked to environmental, social and governance (ESG) goals. This Holland & Knight alert summarizes the key concepts of the SLD Provisions.
According to ISDA, the first SLD transaction was executed in August 2019.1 Since that time, in response to growing market interest in ESG in general and SLD transactions in particular, ISDA has published a number of papers covering different aspects of the subject, including in September 2021 a set of recommended best practices for drafting key performance indicators (KPIs) to track ESG goals related to SLD transactions.2 In April 2022, ISDA issued a survey soliciting responses from market participants to gather information about the then-current status of documentation of SLD transactions. The results of that survey were published in November 2022.3
ISDA's survey found that 69 respondents had already engaged in SLD transactions. In general, SLDs are typically structured as standard derivatives transactions (e.g., interest rate swaps, foreign exchange swaps, etc.) with an additional ESG element that impacts payment flows in some way. The ESG element is frequently tied to the achievement of specified KPIs related to compliance with the stated ESG goals. According to survey respondents, the majority of SLDs are structured as underlying interest rate swaps, followed by foreign exchange swaps and cross-currency swaps. Most of the respondents' SLD transactions involved KPI targets related to greenhouse gas emission reductions, although SLD transactions can cover the full range of ESG-related goals.
Against this background, ISDA has published the SLD Provisions to provide "a framework of standardized definitions and provisions to provide market participants with the flexibility to document bespoke SLDs using standardized components."
Identifying the Relevant KPIs and Targets
Pursuant to the SLD Provisions, each specific KPI and its relevant target, together with other specific SLD terms, is set forth in an annex (KPI Table) to be attached to the relevant confirmation. The SLD Provisions do not identify specific types of KPIs, allowing the parties to identify such terms as needed. However, ISDA does refer to the September 2021 ISDA paper "Sustainability-linked Derivatives: KPI Guidelines" (ISDA KPI Guidelines) in recommending that parties take into account the five principles identified therein: whether each KPI is "specific, measurable, verifiable, transparent and suitable."4
Similarly, the SLD Provisions refer to the ISDA KPI Guidelines with respect to the targets themselves, recommending that each target "should be specific" and should "be described by reference to percentages or specific amounts." In addition, ISDA suggests that each target "should make clear whether it involves an absolute or intensity-based change in the relevant metric(s) or a combination of both."
With respect to each KPI, the SLD Provisions anticipate that the parties will specify one or more "KPI Observation Periods," during which the relevant KPI will be observed for a specified party (KPI Reference Party), and a "KPI Achievement Score" will be determined. The KPI Achievement Score for each KPI Observation Period is the "value, percentage or score" reflecting the KPI Reference Party's performance during such KPI Observation Period.
In addition, the SLD Provisions include the designation by the parties of a third-party "Verification Agent." The parties may choose to designate a specific party as the Verification Agent or may agree to specific characteristics of a Verification Agent. According to the ISDA KPI Guidelines, an independent third-party verification agent "will assist in minimizing conflicts of interest and disputes" and "may help to address greenwashing risks."
For each KPI Observation Period, one party (typically the KPI Reference Party) will determine the KPI Achievement Score and assess it against the KPI target. Such party will then provide the Verification Agent with each KPI Achievement Score for independent verification, requesting that the Verification Agent prepare any required supporting documentation. The determining party will then deliver a completed "KPI Compliance Certificate" (in a form agreed to by the parties) confirming whether or not the the KPI target was satisfied. The parties will designate a date by which such certificate must be delivered in respect of each KPI Observation Period. Delivery of a KPI Compliance Certificate is intended to be irrevocable unless the parties otherwise agree.
In lieu of delivery of a KPI Compliance Certificate, the parties may agree that KPI compliance information posted to a public website by the KPI Reference Party will be sufficient to demonstrate the KPI Achievement Score.
In the event that the required party fails to deliver a KPI Compliance Certificate by the specified date, it will be deemed that the relevant KPI target was not met for the applicable KPI Observation Period. As currently written, such failure would expressly not constitute an Event of Default, Potential Event of Default or Termination Event under the related ISDA Master Agreement.
If elected by the parties, a party delivering a KPI Compliance Certificate will be deemed to have represented "that all applicable information that is furnished in such KPI Compliance Certificate is, as of the date of its delivery [to the best of its knowledge],5 true, accurate and complete in every material respect."
Impact of Compliance or Failure to Achieve Goals
The SLD Provisions provide a range of different cashflow implications (referred to as "Sustainability Consequences") that can be designated to occur whether the KPI Reference Party has met a specific KPI target or has failed to do so. The structure provides the parties with flexibility in drafting the terms of the specific Sustainability Consequences, allowing the parties to apply "different permutations of triggers and consequences."
The Sustainability Consequences identified in the SLD Provisions as being applicable to interest rate derivatives are as follows:
- Sustainability Amount Payment: This would require one party to make a payment (Sustainability Amount) to the other party or to a charitable organization. Payments to a charitable organization must be confirmed by delivery of written evidence.
- Fixed Rate Adjustment: Modification of the fixed rate of the underlying transaction.
- Fixed Amount Adjustment: Modification of the fixed amount payable in respect of the underlying transaction.
- Floating Rate Adjustment: Modification of the floating rate of the underlying transaction.
The Sustainability Consequences identified in the SLD Provisions as being applicable to foreign exchange and currency derivatives are as follows:
- FX Option Adjustment: modification of the underlying currency option transaction
- FX Forward Adjustment: modification of the underlying FX transaction
Any additional payment resulting from any Sustainability Consequence is referred to as a "Sustainability-linked Payment." The SLD Provisions provide two different alternatives for the parties to choose with respect to a party's failure to make a Sustainability-linked Payment. In "Variant 1," such failure constitutes an Additional Termination Event under the related ISDA Master Agreement. In "Variant 2," no Additional Termination Event is deemed to occur, but the failure constitutes a "Declassification Event," as described below under the heading "Impact of Adverse Sustainability Events." The parties would elect the relevant variant at the time of execution of the SLD transaction.
Impact of Adverse Sustainability Events
The SLD Provisions include optional terms to address the impact of "Adverse Sustainability Events" – essentially, negative ESG behavior by the KPI Reference Party. Adverse Sustainability Events are not defined in the SLD Provisions specifically, but are rather left to be negotiated and agreed upon between the parties. A party that becomes aware of the occurrence of an Adverse Sustainability Event is required to promptly notify the other party, providing reasonable detail. The SLD Provisions include two variations of the consequences of an Adverse Sustainability Event – if the parties choose to include the Adverse Sustainability Event concept in their transaction, they would agree upon one of the following two variants at the time of execution:
- Variant 1: No Sustainability Consequences will apply, regardless of whether the KPI trigger has been achieved during the relevant observation period or
- Variant 2: a Declassification Event (as described below) will occur
As drafted, the parties can agree that such consequences will either be permanent or in effect only while the related Adverse Sustainability Event is continuing.
The SLD Provisions include an optional provision addressing the consequences of Declassification Events. For these purposes, a "Declassification Event" is defined as the occurrence of any of the following:
- the failure by either party to pay all or part of any Sustainability-linked Payment
- the occurrence of an Adverse Sustainability Event
- the parties' failure to agree on a KPI Adjustment on or prior to the last day of the KPI Discussion Period (as such terms are described below)
- the termination, prepayment, repayment, redemption or otherwise the termination or maturity prior to its scheduled repayment, redemption, termination or maturity date of a Reference Sustainability Obligation (as described below)
- an amendment to the Reference Sustainability Obligation [resulting in the target(s) contained therein (materially) changing]
- the sustainability performance targets in the Reference Sustainability Obligation ceasing to apply to the relevant entity or
- the failure by the parties to resolve a KPI dispute within the required timeframe (as discussed below)
Upon the occurrence of a Declassification Event, the SLD Provisions require each party to "[take reasonable steps] to ensure that no further [external] announcement, publication or communication prepared by or on its behalf refers to the transaction as 'sustainability-linked' (howsoever described)." The parties may also elect to limit which Sustainability Consequences can occur following a Declassification Event and/or to revert to any amounts or percentages in effect as of the original trade date.
Review of KPIs
The SLD Provisions incorporate an optional mechanism for the parties to review the applicable KPIs and their targets on a periodic basis and upon the occurrence of certain specified events and to engage in discussion and negotiation toward updating such terms. (Such review and discussion process is called a "KPI Discussion.") As drafted, these provisions include nine separate "KPI Review Events," each of which would trigger a KPI Discussion. The published events include an option for a mandatory annual review date, as well as review upon the occurrence of other potential events relating to suitability, changes in methodology, inability to determine or verify a KPI Achievement Score, and others. The parties may include their own events as well. The commentary notes that KPI Review Events should be "tailored to the needs of the parties (for example, given any internal requirements around committee approvals, greenwashing/ESG policies, etc.)." ISDA further notes that "SLDs are used in a fast-changing scientific and regulatory landscape, and an annual review may therefore be helpful to ensure that targets remain appropriate at all times."
One or both parties may be designated as the "KPI Review Determining Party" for purposes of determining whether a KPI Review Event has occurred. Such determination is required to be made in good faith, using commercially reasonable procedures to produce a commercially reasonable result. In that regard, the SLD Provisions include a list of sources that may be taken into account in reaching such determination, including media reports, regulatory announcements, disclosures and other materials.
The SLD Provisions provide the following alternate procedures upon the occurrence of a KPI Review Event:
- Variant 1: The KPI Review Determining Party has the option to initiate a KPI Discussion with the other party to determine whether any modifications can be made to the applicable KPI or its target (any such modifications are called "KPI Adjustments"). The parties may also agree that any designated annual review date would automatically trigger a KPI Discussion.
- Variant 2: The parties will automatically engage in a KPI Discussion.
If a KPI Review is initiated, the parties are required to discuss KPI Adjustments in good faith during a designated "KPI Discussion Period." If they are able to reach an agreement during the KPI Discussion Period, the KPI Adjustments will become effective. In order to address possible concerns about "greenwashing," the SLD Provisions include optional provisions prohibiting the parties from adjusting any KPI or target to make it easier to achieve. ISDA's commentary on this point suggests that "a KPI Review Event should not generally be used to weaken either party's sustainability commitment," though they do recognize that there may be certain circumstances (such as a merger) that could justify changes to the "sustainability profile" of a party.
Unless otherwise agreed to by the parties, the occurrence of a KPI Review Event would not constitute an Event of Default, Potential Event of Default or Termination Event, but no Sustainability Consequence would apply during the KPI Discussion Period.
In the event that the parties are not able to reach an agreement on KPI Adjustments during the KPI Discussion Period, the SLD Provisions specify that a Declassification Event will occur at the end of the KPI Discussion Period.
In situations where the KPI Reference Party has entered into a separate agreement (referred to as a "Reference Sustainability Obligation") pursuant to which it has committed to achieve certain sustainability performance targets, the SLD Provisions include a set of terms allowing the parties to refer to the Reference Sustainability Obligation in lieu of including a table of KPIs and related targets. The SLD Provisions effectively allow the parties to incorporate the KPIs and targets from the Reference Sustainability Obligation and provide a framework for the parties to indicate the relevant Sustainability Consequence applicable to each such KPI. ISDA's commentary notes that the provisions "have been drafted with the aim of facilitating tracking provisions relating to details of KPIs and delivery of KPI Compliance Certificates."
The SLD Provisions include terms allowing the parties to coordinate KPI Review Events and Declassification Events between the SLD transaction and the Reference Sustainability Obligation and to determine the significance of such events. ISDA notes that this coordination may be particularly relevant when the SLD transaction is hedging the Reference Sustainability Obligation.
Similarly, the SLD Provisions provide a list of various events that can occur with respect to the Reference Sustainability Obligation and allow the parties to determine the treatment of such events under the SLD transaction. As drafted, this provision includes such events as termination, prepayment, amendment or disapplication of underlying sustainability performance targets. However, ISDA notes that the included list is not intended to be exhaustive and advises parties to "check the Reference Sustainability Obligation to ensure that this language is adequate."
In the event that a party disputes the validity of a KPI Compliance Certificate, the SLD Provisions include a set of terms to manage the process of resolving such disputes. Initially, the SLD Provisions require a disputing party to notify the other party and the Verification Agent within a specified period of time prior to the occurrence of the related Sustainability-linked Payment or other change in economic terms. As noted by ISDA, this requirement is meant "to minimize the need for potential repayments of Sustainability-linked Payments."
Once a party has given notice of a dispute, the SLD Provisions require payment of any undisputed portion of the relevant Sustainability-linked Payment or the making of any undisputed portion of any adjustment of economic terms. The parties are then required to consult with each other in an attempt to resolve the dispute. The SLD Provisions include three alternative consequences in the event that the parties are unable to resolve the dispute within some specified time period. The three variants (one of which must be selected at the time of execution of the SLD transaction) are as follows:
- "Variant 1: the Verification Agent will determine whether the fact or figure subject to the dispute, as stated in the KPI Compliance Certificate or KPI Supporting Documentation, is correct within [●] Business Days of the KPI Dispute Notice Delivery Date.
- Variant 2: [no Sustainability Consequence will apply in respect of the affected KPI Compliance Determination Date][the relevant Sustainability Consequence Trigger(s) will be deemed to occur and each relevant Sustainability Consequence will apply].
- Variant 3: a Declassification Event will occur on such day."
If it is determined that any KPI Compliance Certificate or any KPI Supporting Documentation included any false, inaccurate or misleading information and any payment or adjustment was made in reliance on such information, the SLD Provisions include terms specifying the return of such payments (or applicable portion thereof) or readjustment of economic terms (or applicable portion thereof) within a specified time period. If a party becomes aware of any false, inaccurate or misleading information in a KPI Compliance Certificate or any KPI Supporting Documentation, that party is required to provide notice to the other party within a specified time period.
In addition to the transactional terms described above, the SLD Provisions include 1) terms relating to disclosure and confidentiality, and 2) additional representations and acknowledgments to be made by the parties.
Disclosure and Confidentiality
The SLD Provisions include two optional clauses for the parties to choose from with respect to the right to disclose the existence of the SLD transaction and the underlying KPIs and targets. The two variants are as follows:
- Variant 1: One or both parties (and affiliates if elected) may disclose the existence of the SLD transaction and, if elected by the parties, the details of the underlying KPIs and targets, to any third party including, without limitation, "placement of advertisements in financial and other newspapers and journals for marketing purposes."
- Variant 2: Each party is generally required to treat the existence of the SLD transaction and the details of the underlying KPIs and targets as strictly confidential and, unless such terms become publicly available or the other party consents, may disclose such terms only pursuant to a specific list of exceptions. As drafted, itemized exceptions include required legal or regulatory disclosure and disclosure to certain offices or affiliates, professional advisors, transferees, or potential transferees or trade repositories.
Representations and Acknowledgments
As drafted, the SLD Provisions include two additional acknowledgments that the parties may require in connection with each SLD transaction. They relate to responsibility for the KPIs and targets and are as follows:
"The parties acknowledge and agree that (i) [Party A][Party B] is solely responsible for ensuring that the KPI Targets are [, at all times during the term of the Transaction,] appropriate for its business and consistent with its policies, including those related to greenwashing and (ii) [Party A][Party B] gives no representation to the other party or any third party as to the suitability of the KPI Targets for any purpose. "
The SLD Provisions also include two additional representations to be made by one or both parties as follows:
"[Each party][Party A][Party B] represents that (i) there is not pending or, to its knowledge, threatened against it [or a KPI Reference Party] any [material] action, suit or proceeding at law or in equity or before any court, tribunal, governmental body, agency or official or any arbitrator that relates to its sustainability profile or its ability to achieve the KPI Targets and (ii) it [and each KPI Reference Party] is not subject to any Adverse Sustainability Event. "
The parties may elect to treat breach of any of the above-referenced acknowledgements or representations in one of two ways. In the first variant, the parties may elect to have any such breach treated as an Additional Termination Event under the related ISDA Master Agreement, with the breaching party as the sole Affected Party and the specific SLD transaction as the sole Affected Transaction. Alternatively, the parties may elect to not have any such breach treated as an Additional Termination Event, but solely treat such a breach as a Declassification Event.
The sustainability-linked derivatives market is still developing, and transactions are typically executed on a bespoke basis. The SLD Provisions provide an initial set of standardized terms and clauses, while also providing a wide range of flexibility for market participants. By addressing basic concepts such as compliance verification, dispute resolution, periodic review of targets and other core issues, these terms create a framework that can be used in an array of SLD transactions. Given the fluid nature of the SLD market, market participants are also encouraged throughout the SLD Provisions to tailor the basic terms to suit their specific needs. It is important to note that all of the provisions described above are subject to negotiation by the parties to any particular SLD transaction.
For more information on the SLD Provisions or other derivatives or ESG-related matters, please contact the authors.
1 ISDA: "The Way Forward For Sustainability-linked Derivatives" (November 2022).
3 ISDA: "The Way Forward For Sustainability-linked Derivatives" (November 2022).
5 In each instance of language excerpted herein from the SLD Provisions, brackets are included in the original text to reflect optional provisions that may be elected by the parties.
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