It has been an extraordinary few weeks as businesses face challenges presented by the COVID-19 outbreak. Companies are grappling with a multitude of issues — from the health and safety of employees to increased cyber security risks to financial and operational stability. Understandably, assessments of significant contractual and market exposures have been prioritized. Potential exposures under over-the-counter derivatives contracts should be included in those reviews. Many companies maintain active OTC derivatives portfolios to hedge commercial risk, whether interest rate, foreign exchange, commodity or other hedges. The OTC market has experienced large movements in reaction to COVID-19 and the related containment measures. Below we highlight key OTC considerations for companies in relation to COVID-19:
– Regulatory Reporting. Financial institutions and other market participants with statutory or delegated reporting obligations may be experiencing operational changes that make it difficult to timely report. Regulatory authorities are working to provide relief on reporting deadlines and scope. Companies should monitor these relief measures and communicate with derivatives counterparties to ensure reporting continuity.
– Margin Calls. Derivatives participants may experience a credit downgrade or may be out of the money on a trade or series of trades as a result of the COVID-19 market dislocation. In such cases, hedge counterparties may increase calls for margin and collateral posting both in frequency and amount. If a company is already suffering the economic impact of COVID-19 it may not have the liquidity needed to meet those counterparty demands. In extreme situations, failure to satisfy margin or collateral calls could result in the termination of all derivatives transactions.
– Pricing or Settlement Disruptions. Measures to contain or address COVID-19 and its impact on businesses could result in disruption events such as settlement system closures, trading limits or suspensions, lack of pricing publications or market closures. Companies should assess whether factors applicable to their trades would increase the likelihood of portfolio disruptions. Derivatives contracts typically provide for standard fallback mechanisms in the event of a disruption, including no-fault termination, but parties should confirm if the standard fallbacks have been modified in a confirmation or other documentation. Companies should understand their options in advance and plan for alternatives.
– Force Majeure and Impossibility. Derivatives contracts contemplate that unforeseen events beyond the parties’ control may occur that prevent full or partial performance. In the 2002 ISDA Master Agreement this concept appears in the “force majeure” termination event, and in the 1992 ISDA Master Agreement it is often adopted as an “impossibility” additional termination event. A careful analysis is required to determine whether contractual performance by either party might be excused on the basis of COVID-19 invoking a force majeure or impossibility clause, including as an “act of God”. The analysis would consider whether performance is not only impossible but impracticable, and will be largely fact specific taking into account the performance obligation and the COVID-19 circumstance being relied upon to claim excused non-performance (including business closures, shelter in place or quarantine practices, systems unavailability and market disruption events).
– Notices and Communications. Derivatives contracts provide multiple options for delivery of notices and other communications between parties. Often notices for more significant matters, such as default notices, must be made either in person or by overnight courier or certified mail. And certain contracts include deemed receipt clauses. In the event that such delivery services are delayed or suspended in light of COVID-19, parties would need to closely track delivery and receipt efforts and consider alternate methods. As companies experience office closures and move to remote working scenarios, changes in normal lines of communication should be shared with trade counterparties.
– Cross Defaults. The COVID-19 based market movements and containment measures may create situations where parties are in default under derivatives contracts. Often a default under a derivatives contract qualifies as a cross default to a company’s credit facility or other financial instrument, subject to certain dollar thresholds (if applicable). In a cross default situation, lenders and creditors under those other instruments would be entitled to seek immediate repayment of all indebtedness amounts. Should cross default rights be exercised in current market conditions, the implications could challenge the financial stability of a company and may even result in insolvency.
As COVID-19 continues to impact financial markets, companies should work with legal advisors to fully evaluate how outstanding trades and hedge relationships may be affected. Limitations imposed by Bail In and Resolution Stay measures should also be considered. The CFTC, ISDA, FIA and other bodies are providing guidance to market participants as issues arise[1] and companies should also check these resources regularly.
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The health, safety and well-being of our clients and colleagues are foremost in our minds as we continue to closely monitor the COVID-19 outbreak. Liskow & Lewis is fully operational. We have taken the necessary steps to ensure that our services continue uninterrupted while implementing procedures to protect our team members.
If we can answer questions about these OTC developments or assist with any other derivatives matters, please contact Nina Skinner.
[1] CFTC COVID-19 Updates: https://www.cftc.gov/coronavirus
ISDA COVID-19 Updates: https://www.isda.org/2020/03/13/covid-19-isda-update/
FIA COVID-19 Updates: https://www.fia.org/covid-19
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