ISDA Agreements and the effects of COVID-19
- June 19, 2020
Private Equity | Kennett Square, PA
Private Equity | Kraków
Chatham’s team of ISDA negotiators and regulatory advisors provide answers to questions about the status of ISDA agreements in view of the COVID-19 pandemic — including termination events, how the pandemic affects LIBOR transition, and covers CSAs.
Chatham’s team of ISDA negotiators and regulatory advisors provide answers to questions about the status of ISDA agreements with an eye towards the economic slowdown and market volatility caused by the COVID-19 pandemic. As these market conditions evolve, we will continue to update this document to reflect these changes. (Please contact our team if you have questions about your ISDA agreement.)
- Have governments passed any emergency legislation related to derivatives contracts? Are there any no-action letters or government relief specifically for end users?
- Can ISDA Agreements or Amendments be executed electronically? Are there any changes to the usual market practices in the current environment?
- Has the COVID-19 scenario impacted the market’s approach or timeline for LIBOR transition?
- How does the COVID-19 pandemic impact Brexit negotiations?
- We’re looking to close out some of our trading positions. Does the ISDA allow us to voluntarily terminate our trades?
- Does the ISDA let us defer swap payments, and if so, how do I start that process with my swap bank?
- Our lender is letting us defer some payments under the loan agreement. How does this affect our swap?
- We’re monitoring financial covenants closely under our loan agreement, given the uncertainty in the market. Are there any financial covenant requirements under the ISDA that could be impacted?
- What kind of notices do I have to deliver my counterparty under the ISDA and what kind of methods can I use to deliver those? Do any lockdown or stay at home orders affect this?
- Has Chatham seen changes in provisions or language in derivative agreements as a result of COVID-19? Is there any recommended language at this time?
Events of Default and Termination Events
- Are there any termination rights under the ISDA if there are government orders issued as a result of COVID-19?
- Does the COVID-19 pandemic constitute force majeure under the ISDA?
- If my counterparty is defaulting on their swap payment or loan payment, are there grace periods which apply before trades could be terminated?
- If my ISDA Agreement is terminated, are there impacts on other ISDAs or other contracts?
- Does the delay in payments under the swap caused by COVID-19-related operational issues, unexpected outages and market disruptions constitute an event of default under the ISDA?
- We have a Credit Support Annex in place with our counterparty. Given the market volatility, will we need to post additional collateral to our counterparty under our CSA?
- What remedies does the party have under the CSA if it fails to make a collateral call on time due to COVID-19 disruptions?
To date, the U.S. has directed most relief to large banks and other registered entities to temporarily relieve such market participants of certain requirements, and most end users will not be directly affected by such relief. Currently, the relief has been targeted towards requirements addressing elements of swap dealers’, FCMs’, introducing brokers’, SEFs’ DCMs’ and floor traders’ obligations around time stamping, recordkeeping, recording of oral communications, and filing and registration requirements. Additionally, individuals registering as associated persons have been permitted to delay the requirement to obtain a fingerprint card prior to being authorized as an AP. Finally, filing deadlines for Commodity Pool Operators’ Form CPO-PQR, Pool Annual Reports and Pool Periodic Account Statements have been extended.
There is no emergency legislation related to derivatives contracts passed in the EU at this time. Some member states (France, Belgium) passed legislation which recognizes COVID-19 as a force majeure event, but there are no other substantial reliefs granted by regulators in Europe. (Back to top)
What constitutes an electronic signature, and whether electronic signatures are valid for execution of documents such as derivatives contracts varies widely depending on jurisdiction and governing law of the ISDA Agreement, as well as any governing regulation in regarding electronic execution of various contracts. ISDA has also gathered and commissioned a considerable number of formal legal opinions regarding the validation of electronic signatures and consideration of e-contracts, and these collected opinions are available to all ISDA members on ISDA’s website.
Chatham generally sees ISDA Agreements for U.S. or European entities governed by either New York or English law (as the ISDA Agreement was initially drafted with enforceability under these two jurisdictions in mind). With regards to ISDA Agreements, Amendments, and associated documents, there are some regulations that may give guidance:
- New York law: (1) the Electronic Signatures and Records Act (ESRA), and (2) the Electronic Signatures in Global and National Commerce Act (ESIGN)
- English law: the Electronic Communications Act 2000
These jurisdictions maintain case law and regulatory guidance that generally provides for electronic signatures to have the same validity as “wet-ink” signatures. That includes recognition and acceptance of such electronic signatures into evidence for the purposes of litigation. Parties whose agreements are subject to those jurisdictions should be able to enter into their ISDA documentation electronically if their signature process complies with any specific requirements of these and any other applicable regulations (for example, verifying authority of a signatory party). Parties with agreements not subject to these two jurisdictions should review any regulations, resources, and opinions concerning their governing law in order to determine whether electronic execution of ISDA documents may be an option.
We are not aware of current significant changes to market practice with respect to executing ISDA Agreements or Amendments. Counterparties have shown willingness to accept electronic signatures or PDF copies of these documents, given many signatories are working remotely. Some counterparties, however, may still request a wet-ink signature. We would recommend parties discuss with their counsel and their swap counterparty to determine the current procedures that may apply in light of office staff working remotely. Parties should also recognize that electronic execution of their ISDA Agreements, Amendments, and associated documents does not allow for bypassing processes within the Agreements that may require non-electronic notices and communications. (Back to top)
In light of recent market events, many market participants have understandably shifted their focus to business continuity. However, on March 25, 2020, the FCA, Bank of England and the Working Group on Sterling Risk-Free Reference Rates reminded market participants to continue with their IBOR transition plans as well. While the FCA indicated that it would continue monitoring the situation, the FCA stated that its “central assumption that firms cannot rely on LIBOR being published after the end of 2021” has not changed. In light of this guidance, we strongly encouraged firms to continue with their LIBOR transition efforts to stay on track for the anticipated cessation of LIBOR at the end of 2021. (Back to top)
Formal negotiations on the future of the EU-UK relationship resumed mid-April after being on hold for a couple of weeks due to the COVID-19 crisis. The parties have agreed on a new timetable in order to make sufficient progress ahead of June when the decision on the continuation of the negotiations will be made and they both emphasized the intention to meet that deadline. However, the delay in reaching a significant agreement by June can’t be entirely ruled out given the continued focus of the member states and EU institutions on managing the COVID-19 situation. (Back to top)
Where there are outstanding transactions under an ISDA Master Agreement, there is no actual mechanism to voluntarily terminate the Agreement. However, it is possible that language may have been specifically negotiated either within the ISDA Schedule, or trade confirmation, which would change the standard termination provisions or otherwise may allow a party to voluntarily terminate their existing transactions. Given the bespoke nature of the Schedule and Confirmations, we would recommend reviewing these documents further to determine whether the termination process has been modified, and whether a voluntary termination provision may be included. (Back to top)
The ISDA Agreement does contemplate limited circumstances where payment deferral could be an option. The Agreement permits deferred swap payments as a result of triggering the Force Majeure Termination Event, outlined at Section 5(b)(ii) of the 2002 ISDA Master Agreement. While Force Majeure is not a Termination Event under the 1992 ISDA Master Agreement, the parties may include it as an Additional Termination Event in the Schedule to the 1992 ISDA Master Agreement or by incorporation of the ISDA Illegality/Force Majeure Protocol. Parties may look to the force majeure provision in the 2002 ISDA Master Agreement if they are unable to perform their obligations due to the occurrence of an act of god, state action, or similar event. Availability of this Termination Event is fact-driven and requires the parties to meet the high thresholds of impossibility or impracticability of performance. We encourage parties to consider their ability to perform on a case-by-case basis and to determine with counsel their options. If the Force Majeure Termination Event is triggered, the relevant payment or delivery obligations are deferred for up to eight Local Business Days (the “Waiting Period”) before impacted transactions can be terminated. Please note that this Waiting Period begins from the date of occurrence, not the date of a Force Majeure notice.
If a party has elected to defer payments due to triggering a Force Majeure Termination Event, a notice declaring a Force Majeure Termination Event must be given to the counterparty under Section 6(b)(i) and in accordance with notice requirements under the ISDA Master Agreement, Schedule, and/or confirmations. Section 12(a) in the ISDA Master Agreement sets forth the methods for notice; however, these standard provisions may be modified, supplemented, or overridden by the Schedule to the ISDA Master Agreement or by confirmation for a particular transaction.
There may be other common law rights or remedies available to defer swap payments, including programs or deferrals which may be available or offered by swap counterparties given current market developments. There may also be further implications of any deferral from an accounting or operational perspective. Therefore, we ultimately recommend that you conduct this analysis with legal counsel and any other relevant advisors. (Back to top)
Given the current market developments, lenders have begun offering loan payment deferrals of differing length to impacted borrowers, many with associated hedge agreements in place. If clients are exploring these deferral options with their lenders, clients must consider the potential outlying effects of deferred loan payments on the parties’ hedging obligations.
First, parties will need to review and agree to new terms and financial details of any loan payment deferrals with their lenders (and potentially amend their loan documentation as needed to reflect the parties’ understanding). Parties may also want to review their existing loan documentation or loan modifications closely for payment dates and grace periods to avoid running afoul of any default mechanisms that may cause associated defaults in related swap agreements.
Second, as for amendments to swap agreements themselves, parties seem more diversified on this point. Parties may prefer to amend their hedging agreements as needed reflecting the new economic terms of their loans, with the potential of deferring of payment obligations under the swap. Or, other parties prefer to leave swap-agreements “as-is.” Whatever strategy borrowers and lenders pursue, we believe it is best practice to make clarification or changes to the current ISDA Agreement or trade confirmation in writing, as Section 9(b) provides that any amendment, modification or waiver to the ISDA Agreement must be in writing. (Back to top)
The ISDA Master Agreement does not contain any independent financial covenant requirements. However, there are several provisions which, if included in the ISDA Schedule, may be affected by a breach of the financial covenants in the underlying loan documents or may require a party to continue to maintain a particular financial status.
If a breach of covenants under a credit agreement results in an event of default, there may be consequences under several standard events in the ISDA Agreement. First, Cross Default (Section 5(a)(vi) of the ISDA Agreement) may apply if elected in the Schedule. If this event applies, a default by party in respect of debt obligations with either its swap counterparty or any third party (in an amount above the Threshold Amount specified) can result in an Event of Default under the ISDA. Second, a breach of covenants may also raise concerns under Credit Support Default (Section 5(a)(iii) of the ISDA Agreement) if loan documents have been listed as Credit Support Documents in the Schedule. A default under a Credit Support Document by a party, including defaults caused by a breach of the financial covenants in a Credit Support Document, could trigger a default under this subsection. There is no Threshold Amount applicable to Credit Support Default, so it is important to review any documents listed as Credit Support Documents further to determine the impact of any breach of covenants therein. Finally, some swap counterparties include a provision in the Schedule which incorporates covenants from credit agreements into the ISDA, often called “Incorporation of Loan Covenants” or “Incorporation by Reference of Terms of Credit Agreement.” If the covenants in the underlying credit agreement have been incorporated into the ISDA Agreement, a breach of those covenants could give rise to an Event of Default under the ISDA.
The Additional Termination Events listed in Part 1 of your Schedule, or other subparts of the Schedule, may also contain provisions which can be affected by a breach of financial covenants or a change in financial status. Examples include an Additional Termination Event that may restate a covenant contained within a credit agreement, or an Additional Termination Event or Additional Event of Default requiring a party to maintain a specific net worth or liquidity. A party could also be required to deliver certain financial documents to their counterparty under Part 3 of the Schedule, such as annual or quarterly financial statements or certifications. Finally, a party may be required to affirmatively provide notices to their swap counterparty of specific events under their ISDA, such as a breach of a specific representation upon an occurrence of the event, or upon request of their swap counterparty. We would recommend reviewing the specific Schedule further to determine if any of these provisions are included and what specific requirements must be met. (Back to top)
Under the 1992 and 2002 ISDAs, notices related to the ISDA or any Transaction thereunder must be delivered pursuant to the methods set forth in Section 12(a), unless otherwise modified by the Schedule. The current lockdown orders may make certain methods impossible, particularly in person delivery via courier. To the extent that certified or registered mail is still available to the recipient’s address, provided the sender confirms the notice was delivered or delivery was attempted, that would satisfy the requirements of Section 12(a). Similarly, notices other than those required under Section 5 or 6 under the 2002 ISDA may be delivered via email.
If no stated method of notification is possible, courts in both New York and England have allowed for alternative methods of notification. Such alternatives would not apply if the methods of notification set forth in Section 12(a) are merely inconvenient or burdensome. Further, if an alternate method is used, it is imperative that actual notice of receipt by an authorized representative of the counterparty is received. (Back to top)
Chatham has not seen many significant changes or new provisions in ISDA Agreements at this time. We have seen clients ask bank counterparties for fax and/or email information in Part 4(a) of the Schedule for delivering notices. Also, in negotiating the 2002 ISDA Master Agreement, we have seen a reluctance in banks agreeing to disapply the Force Majeure Termination Event, where clients had previously sought and obtained this modification in earlier negotiations with the same counterparty.
Market participants may consider reaching out to counterparties now in order to facilitate updating notice information, for example, by requesting fax or email details not included in the documentation or amending the documentation to include alternative, non in-person methods for delivery.
If clients are currently negotiating ISDA Agreements and have specific concerns they would like addressed in those agreements, we recommend they work further with their advisors and legal counsel to discuss any proposed language to be added in order to address these concerns. (Back to top)
Events of Default and Termination Events
Neither the 1992 or 2002 ISDA Master Agreement contemplates a termination right specifically capturing government action as the result of COVID-19. The 2002 ISDA Master Agreement does include a Termination Event with respect to Force Majeure. Parties should be aware that the 1992 ISDA Master Agreement does not normally provide for a Force Majeure Termination Event, though this type of event may be included by way of provisions within the Schedule.
Generally speaking, the Force Majeure Termination Event addresses a situation in which a force majeure event (potentially including acts of god, ecological disaster, or state action) has impeded or made impossible a party’s ability to make or receive payments or otherwise comply with obligations and material provisions of their Agreement and associated Credit Support Documents (if any). If such an event occurs, the Affected Party may be afforded potential relief in the form of an eight Local Business Day waiting period and deferral of currently due payments, and ultimately, if no resolution of non-performance takes place, the right to terminate their transactions under the Agreement following such waiting period.
The 2002 ISDA Master does not explicitly define what constitutes force majeure and declines to offer much in way of interpretation, though does include “state action” as an explicit trigger (albeit refraining from any further definition as well). Another important consideration is determining whether the established event actually causes impossibility or impracticality of performance after a party’s reasonable efforts; difficulty of performance, even as the result of economic difficulty, is not likely to qualify as a sufficient force majeure event for the purposes of the Termination Event. However, without further defining this event within a specific ISDA Agreement, determination of whether a certain event constitutes a Force Majeure Termination Event is a question of legal interpretation that parties should evaluate alongside counsel.
Finally, both the 1992 and 2002 ISDA Master Agreements include an Illegality Termination Event, which could be triggered if a change in law makes it illegal to continue to perform under a specific transaction. Chatham is not aware of any current existing or proposed legislation in relation to COVID-19 which should impact end-users’ existing derivatives contracts in this manner. Similar to the Force Majeure Termination Event, any determination of whether a certain event constitutes an Illegality Termination Event is a question of legal interpretation that parties should evaluate alongside counsel. (Back to top)
Although only a court could give clear guidance, it is likely that the question of whether the COVID pandemic and its associated restrictions constitute a Force Majeure Event under the ISDA would be fact and circumstance specific for the party invoking it. The 2002 ISDA Master Agreement defines Force Majeure in general terms (Force Majeure is commonly understood as “acts of god”) and also includes acts of state. If the pandemic would be considered such an event, there would still be a question of whether or not such event materially prevented the party from performing its obligations under the agreement using “all reasonable efforts” (which will not require such party to incur a loss other than immaterial, incidental expenses). This could vary significantly based on the party’s business, finances, and operational capacities. (Back to top)
Yes, however, the length of the grace period depends on the version of the ISDA Agreement which is governing the transactions.
With respect to swap payments, if your counterparty has failed to make (i) normal payments or (ii) payments of interest on defaulted payments, following notice of such payment failure, there is a grace period of three Local Business Days under a 1992 ISDA and one Local Business Day under a 2002 ISDA Agreement. If no notice is given, however, the grace period never starts.
If your counterparty has made the contractual defense that the downstream effects of the COVID-19 pandemic is the reason for their failure to pay, in transactions governed by a 2002 ISDA Agreement, there is a waiting period of eight Local Business Days following the occurrence of a force majeure event. This Termination Event is not included in the 1992 ISDA Agreement, so unless the parties negotiated a similar provision in their Schedule or Confirmation, there may be no termination right available for a force majeure or impossibility event.
With respect to loan payments, a payment default could potentially impact the ISDA Agreement if certain Events of Default, such as Cross-Default, are elected to apply in the Schedule. The ISDA Agreements do not provide for any grace periods beyond what is permitted under the associated loan documents. Additionally, under a 2002 ISDA Agreement, the Events of Default which permit a party to terminate swap transactions may override any Force Majeure waiting period (with certain exceptions). (Back to top)
Yes. If your ISDA Agreement is terminated it can trigger defaults in other derivatives and securities agreements separate from the terminated ISDA Agreement, and dependent on any default provisions contained in those separate agreements. The impacted agreements can be between the parties to the terminated ISDA Agreement, as well as any Credit Support Providers and any Specified Entities listed in the terminated ISDA Agreement.
If the parties are hedging a loan, many commercial loan agreements contain cross-default provisions which may include hedging obligations or include other default events related to a failure to pay under a hedge agreement. If maintaining a hedge agreement is a requirement under the associated loan, it’s possible termination of the hedge agreement could trigger a default under the loan agreement, as well. (Back to top)
Standard non-payment constitutes an Event of Default under the 2002 ISDA Master Agreement, subject to a one-business-day grace period after the notice of non-payment is given by a non-defaulting party. When such Event of Default occurs, then the non-defaulting party can then stop making any payments to the party in default and then has the right to designate an early termination date. That said, if failure to pay or deliver occurs as a result of COVID-19-related complications, then the party to the contract shall first establish whether the Force Majeure standard could apply to such event and, in addition, what sort of grace periods and related remedial mechanisms are included in the affected contracts. Under the 2002 ISDA Master Agreement, non-payment that occurs as a result of Force Majeure would trigger a waiting period of eight local business days and if such non-payment continues then the non-affected party could terminate the affected transaction. Additionally, in the financing-linked hedging, one needs to examine very carefully what is an interplay between the Force Majeure and grace/remedy provisions in the loan agreement and ISDA Agreement. (Back to top)
Market volatility alone is unlikely to impact collateral requirements under the CSA. Of course, changes in mark-to-market valuation due to this volatility may require more frequent posting of collateral and/or larger collateral calls. However, it is unlikely that market conditions alone would be sufficient to cause a dealer to require an Independent Amount for a new transaction or to trigger a springing Independent Amount, absent material adverse events or a marked deterioration in credit quality. (Back to top)
Such failure does not result in any negative consequences unless the collateral is required to be transferred under a regulatory Variation Margin CSA. In such case the party that failed to send a demand for collateral would be in breach of its regulatory obligation to implement risk mitigation techniques under the relevant rules (e.g. EMIR and/or Dodd-Frank). If, however, such failure results from the inability to do so due to COVID-19 related circumstances, then it could be reasonably ascertained as beyond that party’s control. (Back to top)
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Chatham Hedging Advisors, LLC (CHA) is a subsidiary of Chatham Financial Corp. and provides hedge advisory, accounting and execution services related to swap transactions in the United States. CHA is registered with the Commodity Futures Trading Commission (CFTC) as a commodity trading advisor and is a member of the National Futures Association (NFA); however, neither the CFTC nor the NFA have passed upon the merits of participating in any advisory services offered by CHA. For further information, please visit chathamfinancial.com/legal-notices.
Transactions in over-the-counter derivatives (or “swaps”) have significant risks, including, but not limited to, substantial risk of loss. You should consult your own business, legal, tax and accounting advisers with respect to proposed swap transaction and you should refrain from entering into any swap transaction unless you have fully understood the terms and risks of the transaction, including the extent of your potential risk of loss. This material has been prepared by a sales or trading employee or agent of Chatham Hedging Advisors and could be deemed a solicitation for entering into a derivatives transaction. This material is not a research report prepared by Chatham Hedging Advisors. If you are not an experienced user of the derivatives markets, capable of making independent trading decisions, then you should not rely solely on this communication in making trading decisions. All rights reserved.20-159