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.
Force Majeure
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 climate.
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.
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