The current COVID-19 pandemic has already impacted many derivatives transactions. This note sets out a checklist of key legal issues market participants may need to consider in relation to OTC derivatives contracts.
The current COVID-19 pandemic has already led to huge disruption in financial markets, larger collateral swings and impacted many derivatives transactions. It would therefore be prudent for counterparties to derivatives transactions to review their contractual documentation to determine if there are any consequences of the current disruption. This note sets out a practical checklist of key legal issues market participants may need to consider in relation to their OTC derivatives contracts.
1. Contractual terms
Counterparties will need to consider carefully the relevant contractual provisions in its derivatives documentation in light of the COVID-19 pandemic. The following areas should be assessed:
A) Market disruption
If there are unscheduled holidays or market disruption, this could impact on the ability to make payments as well as valuations that are based upon market price sources (for example, in relation to an equity derivative). If such sources are not published or trading in the underlying asset is suspended or there are unscheduled holidays, this could affect calculations of mark-to-market, option value and settlement amounts. Counterparties should consider the product specific provisions that might apply, for example the Market Disruption Events under the 2002 ISDA Equity Derivatives Definitions
B) Illegality and Force majeure events
(i) The events of the last few months have led to a number of questions as to the circumstances in which a force majeure event or illegality event may occur and the impact this will have on OTC derivatives transactions generally and more particularly how this relates to collateral posting obligations.
(ii) Under the Force Majeure Termination Event in Section 5(b)(ii) of the 2002 ISDA Master Agreement, counterparties can suspend performance for a period of time and then ultimately terminate. Although the 1992 ISDA Master Agreement does not contain a force majeure provision, counterparties should check whether they have agreed to include in the Schedule the optional impossibility provision or a force majeure provision that is identical to Section 5(b)(ii) of the 2002 ISDA Master Agreement or whether this is incorporated by reference in specific product terms.
(iii) Whilst Illegality is more straightforward to determine, whether the COVID-19 pandemic is a force majeure event is a fact specific determination and depends upon the asset class. It is a high hurdle to overcome as the event itself must make performance impossible or impractical, so a cash shortfall as a result of market conditions due to the COVID-19 is unlikely to be a force majeure event.
(iv) In relation to collateral posting, the effect will depend on the type of OTC derivatives contract entered into and it is important to understand the different consequences. For instance, the answer is likely to be different under an English law ISDA Credit Support Annex, where the force majeure or illegality termination event provided for in a 2002 ISDA Master Agreement will also apply to the English law ISDA Credit Support Annex, as compared to the position under an English law ISDA Credit Support Deed or New York law ISDA Credit Support Annex, which create a security interest and may not have the same treatment.
(v) Where an Illegality or Force Majeure Event Termination Event is triggered, it creates a waiting period of three Local Business Days (in the case of an Illegality) or eight Local Business Days (in the case of a Force Majeure Event). Unlike a termination following an Event of Default or certain other termination events, in the case of both an Illegality and Force Majeure Event, the Transactions are valued upon termination at mid-market.
C) Cross Defaults
Even if the force majeure provision is unlikely to be triggered and there is not an additional termination event, a review of the cross default provisions of the derivatives contract should be undertaken as there could be a default under a linked financing agreement such as the loan agreement hedged by the derivative. Section 5(a)(vi) of both the 1992 and 2002 ISDA Master Agreement is an elective Event of Default that provides for cross-default if there is default on "Specified Indebtedness" above a "Threshold Amount."
D) Additional Termination Events
Counterparties should consider whether any terms of their derivatives documentation contains additional termination events which may be triggered in the current environment, especially in circumstances where there is a credit deterioration of one party as a result of Covid-19. Examples of typical Additional Termination Events include:
(i) A material adverse effect event. Although the 2002 and 1992 ISDA Master Agreements do not have a material adverse effect clause (MAE clause), this may have been included in the Schedule or Confirmation which would allow for termination of the ISDA Agreement or a suspension of payment. If there is a MAE clause, it is important to understand whether it is triggered by reference to objective standards or whether there is some degree of discretion that one or more party may use in declaring that a material adverse effect has occurred.
(ii) A rating trigger. In the event that either one or both parties are downgraded below a certain ratings threshold by one or more ratings agency, this may give the non-affected party the right to terminate the contractual arrangement early. Depending on the terms of the contract, this can sometimes be cured by posting collateral (or additional collateral) or providing a guarantee with a specified time limit.
(iii) In addition, there may be bespoke termination events such as NAV triggers or specific financial covenants.
E) Product Specific Provisions
Derivatives contracts will in most instances incorporate by reference certain specific product terms which relate the nature of the derivative being entered into, for example by way of definitions booklets produced by ISDA. Consideration should be given as to whether the effects of the Covid-19 pandemic will, either directly or indirectly, impact particular transactions which reference these product terms and whether these product terms themselves work in the current environment. Examples of areas where problems may arise include:
(i) Unscheduled holidays. As outlined in paragraph 1(a) above, this may alter the date on which payments, deliveries and valuations are due to take place. This may in turn cause calculation periods to be adjusted. It may also limit the ability to serve notices.
(ii) Volatility. Extreme volatility in rates may cause large swings in prices and rates leading to trading suspensions and other unforeseen issues in how a particular product is due to perform.
(iii) Governmental interventions. Governments have provided major interventions in the markets to ward off the economic impact of Covid-19. Depending on the jurisdictions involved, this may impact the ability of parties to take actions under their derivatives documentation, for example in relation to credit events or to exercise termination rights.
F) Notice Provisions
(i) Attention should be paid to ensuring that any notices are provided in line with the notice obligations in the contractual documentation.
(ii) Different types of notice may require different methods for service. For example, under the 2002 ISDA Master Agreement, notices given in respect of any event of default or termination, including close-out notices, cannot be given by electronic messaging service or email. Where notices cannot be given electronically because of any lockdowns or closures, consideration will need to be given as to how to effect delivery and this will to a large extent depend on the governing law of the contract. If it is not possible to use any of the methods of delivery contemplated in Section 12(a) of the 1992 or 2002 ISDA Master Agreement, it may be that a court might imply a term permitting an alternative method to be used but this will depend on the governing law of the contract.
(iii) Where collateral calls are dealt with by a different function within an organisation from the department responsible for documentation, there can often be mismatches between the contractual requirements and the operational reality. Whilst in the normal course this is of less practical importance, in a more stressed environment this will be looked at more closely, especially in circumstances where a counterparty might be seeking to exercise rights to terminate as a result of a failure to post collateral.
G) Resolution of Disputes
Market standard derivatives documentation generally contains dispute resolution provisions, although a review should be conducted to make sure they are followed in the eventual event of a dispute, including any bespoke modifications or elections made to the standard terms. In addition to the terms contained in the relevant collateral arrangements, counterparties should also be live to any additional overarching dispute mechanics that they have agreed to be bound by as a result of regulatory initiatives or terms of business, for example those contained in the ISDA 2013 EMIR Portfolio Reconciliation, Dispute Resolution and Disclosure Protocol.
2. Impact of the current disruption on collateral
A) Unexpected market movements can lead to increased margin calls under OTC derivatives contracts, causing liquidity problems for counterparties who may be unable to meet the increased collateral demands. Where collateral is required to be posted in respect of an OTC derivatives contract, if the collateral is not posted in a timely manner in accordance with the relevant contractual documentation, this may cause payment and delivery failures, which in turn may lead to events of default and termination of transactions.
B) Whilst many participants in the OTC derivatives market will be subject to the obligation to post variation margin (reflecting the daily mark-to-market value of outstanding contracts and being the collateral collected by a counterparty to cover its current and potential future exposure), participants that are more systemically important also are required to post initial margin, being the collateral collected by a counterparty to protect itself against expected losses that could stem from movements in the market value of the derivatives position occurring between:
(i) the latest exchange of variation margin covering the exposure related to such market value of OTC derivatives contracts (i.e. the latest time when such market value of OTC derivatives contracts was calculated), before the default of either party; and
(ii) the time that the OTC derivatives contracts are replaced or the corresponding risk is hedged.
Collateral collected as initial margin must be segregated from the other proprietary assets of the collecting counterparty, posting counterparty or third-party holder or custodian, as relevant. The requirement to post initial margin is still being phased in, with only the most active OTC derivatives participants already subject to the requirements.
C) There are, however, a large number of counterparties for whom the obligation to post initial margin was due to commence in September 2020 resulting in a large amount of complex operational and contractual arrangements needing to be put in place in a short time period. Due to the current COVID 19 pandemic, the Basel Committee on Banking Supervision (BCBS) and International Organisation of Securities Commissions (IOSCO) have recently announced the deferral of the implementation of each of Phases 5 and 6 of the margin requirements by one year. This is certainly welcome relief, as market participants and trade associations have been calling for these implementation dates to be pushed back because of concerns that it would be very challenging to meet the documentation and operational requirements required for Phase 5 in particular in the current environment.
The BCBS and IOSCO have proposed that:
(i) Phase 5 covered entities (entities with an aggregate average notional amount (AANA) of non-centrally cleared derivatives greater then EUR 50 billion) will be subject to the margin requirements from 1 September 2021; and
(ii) Phase 6 covered entities (entities with an AANA of non-centrally cleared derivatives equal to or lower than EUR 50 billion but greater than EUR8 billion) will be subject to the requirements from 1 September 2022.
This revised timeline will now need to be reflected in the margin frameworks in relevant jurisdictions although has been broadly welcomed by regulators at a national level.
D) In relation to OTC derivatives contracts where there is already an obligation to exchange initial margin, a counterparty should review the models that it uses to calculate the amount of initial margin required to ensure that it is still appropriate in light of current market conditions.
E) The following contractual terms should also be considered in collateral documentation in light of the COVID-19 pandemic:
(i) Valuation disputes over collateral and outstanding transactions
Counterparties should review the types of transactions and collateral that are subject to the relevant OTC derivatives contracts and also determine the amount of discretion given to the valuation agent to make determinations. Care should be taken to record accurately the basis on which valuations are made and, where possible, retain records of this in the case of future disputes. In particular, care will be needed in order to determine the applicable business days. If a jurisdiction in which a counterparty is located declares an unscheduled bank holiday due to the COVID-19 pandemic, resulting in the closure of commercial banks, this will impact when transactions can be valued and collateral transfers can be settled given that, typically, commercial banks in the relevant jurisdiction need to be open for business.
(ii) Eligibility of collateral
The fast moving pace of the COVID-19 pandemic has caused some collateral to cease to be eligible for the purposes of posting under an OTC derivatives collateral arrangement and some collateral to be subject to bigger valuation haircuts than otherwise would be the case for more normal market conditions. As the situation develops further, this will be a dynamic situation and so counterparties should monitor this closely to avoid potential defaults. Where there is a requirement to post cash, due diligence should be undertaken to understand whether there is a zero floor on the rate used to calculate interest on the posted amount or whether negative interest will also apply. This is particularly the case for currencies where governments have reduced interest rates to support national economies in light of the pandemic.
(iii) Defaults and failure to comply with collateral posting obligations
Finally, where there are defaults or other failures to comply with obligations under collateral documentation, counterparties should be familiar with the legal and operational processes that are required to enforce or otherwise appropriate collateral and how this interacts with the obligations to pay amounts due under the close-out provisions of the relevant contract. Considerations that need to be taken into account include the valuation of collateral upon a default, the location of the collateral, interaction with any third parties such as custodians and, with security collateral arrangements, exercising rights of control over relevant accounts.
3. Location of documentation and templates
A) Whilst great progress has been made in recent years in ensuring that arrangements for OTC derivatives transactions are properly documented, it is helpful in times of market stress to ensure that documentation is fully available and complete. Account also should be taken of ancillary documentation (such as terms of business) and terms that are incorporated by reference into the main contracts (such as ISDA protocols) to ensure that a complete picture of rights and obligations is available. We also advise that template notices are prepared in advance so that, in the case of a default or other event, it is possible to exercise rights in a timely manner, especially in circumstances where markets are likely to be moving very quickly such that quick control and valuation of collateral will be critical.
B) As derivatives documentation can be heavily negotiated it is worth checking whether all entities in the same corporate group have the same terms in their derivatives contracts, even when trading with the same dealer.
4. Electronic execution
In light of the recent imposition of lockdowns in some jurisdictions, there has been increasing use of electronic execution. Although it will depend on the governing law of the contract, broadly most ISDA documentation should be capable of being executed electronically. With regards cross border transactions, it will be important to check that there are no statutory restrictions in terms of the local law of the counterparty or anything prohibiting electronic execution in the counterparty’s own constitutional documents or any notarisation requirements.
Market participants should carefully review their relevant derivatives transaction documentation, including any Confirmations, Schedules, definitions and credit support documents in order to obtain a complete picture of any elections or modifications made and relevant requirements so that they are in an informed position in case they need to take any action quickly in the event of further market volatility and increased margin calls in the current environment.