The emergence of the novel coronavirus (COVID-19) as a pandemic has caused
global stock markets to plummet, and has seen countries around the world
take measures to try to stop its spread, including the imposition of travel
restrictions, business cessation orders and national lockdowns. The effect
of these measures on businesses and the financial markets is causing
concern among market participants about the ability of their counterparties
to meet their payment and delivery obligations under derivatives
transactions, particularly in certain sectors, including travel, tourism,
events, retail and entertainment industries.
This article focuses on key considerations and potential effects of
COVID-19 in respect of derivatives transactions.
Derivatives transactions documented under the 2002 ISDA Master Agreement
will contain a force majeure clause which market participants may attempt
to invoke in the wake of the emergence of COVID-19. A “force majeure event”
will occur under the 2002 ISDA if the relevant office of a party is
prevented, either by way of it becoming impossible or impracticable, from
being able to make or receive a payment or delivery in respect of the
relevant derivatives transaction as a result of a “force majeure or act of
state.” Such event will trigger a termination event under the 2002 ISDA;
however, there is no generally applied definition of force majeure and each
event must be analysed on its individual facts.
It is uncertain whether the measures implemented as a result of COVID-19
will make it impossible or impracticable to effect cash-settled
transactions, which are generally performed by way of computerised payment
systems, unless such systems either could be accessed only on-site or are
required to be shut down. Contrary to this, during this time of national
lockdowns imposed in various jurisdictions, it is possible that physically
settled transactions would fall within the ambit of the force majeure
clause, as physical delivery of gold and other commodities would likely be
deemed impossible or, at the very least, impracticable. However, as set out
above, each scenario would be determined based on individual facts.
The 2002 ISDA force majeure clause will apply only after giving effect to
any other specific fallback provisions. When triggered, however, it will
automatically cause an eight-local-business-day waiting period for normal
payments or deliveries to be made. It is possible that a party could invoke
the force majeure clause when the other party seeks to designate an early
termination date due to a failure to pay or deliver, freezing any such
obligation until the expiry of the waiting period. Therefore, market
participants should take care to review their derivatives contracts to
assess whether any other specific fallback provisions could apply and what
events, if any, could be considered a force majeure event in the current
Market Disruption and Collateral Calls
In times of major market disruption and volatility, as is the case due to
the COVID-19 pandemic, it is inevitable one party to a derivatives
transaction may see its position weaken with respect to the underlying
transaction with its swap now “out of the money.” Derivatives contracts
often require that the party who is “out of the money” provide collateral
or post margin to cover its potential losses. In the coming days and weeks,
further market disruption could lead to additional collateral calls which
the relevant party may or may not be able to meet.
If these counterparties become unable to meet collateral demands, a
close-out right will arise in favour of the non-defaulting counterparty,
who will have the right to terminate all outstanding transactions and carry
out the valuations. As this can give rise to further liabilities,
counterparties should evaluate their margin obligations under their
derivatives transactions, and assess the availability of cash and other
collateral they could post in the event of a collateral call. Assessing
these matters early could prove crucial, as their counterparties may be
less willing to forgive delays in the current climate.
Unscheduled Holidays and Deliveries
The extension of the Lunar New Year holidays in China, as a result of
COVID-19, had an effect on derivatives contracts, as many actions required
to be taken were delayed. Unscheduled holidays can have a considerable
impact on contractual performance and market participants should therefore
assess their agreements to ascertain the possible effects of performance
being required on unscheduled public holidays and consequently on
calculation periods, valuations, settlements and payments.
In addition, unscheduled holidays could affect the delivery of notices
under derivatives contracts. Whilst the majority of notices under the 1992
or 2002 ISDA Master Agreement can be delivered by electronic means, this is
not permitted for notices of an event of default, termination or early
termination. Market participants should consider the impact governments’
restrictions on movement may have on physical delivery of notices.
Going forward, market participants should actively monitor their positions
(and re-mark those if necessary) under their derivatives contracts and keep
fully up-to-date with government measures taken in their relevant
jurisdictions. Please contact any of the authors of this briefing or your
regular McGuireWoods contact if you have questions or would like assistance
with the impact of COVID-19 on derivatives transactions.
McGuireWoods has published additional thought leadership related to how
companies across various industries can address crucial COVID-19-related
business and legal issues.