• Friday, February 23, 2024
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COVID-19 and its implications on contractual arrangements in the OTC derivatives market

OTC derivatives market

Since the COVID-19 coronavirus was first reported in Wuhan, China, in December last year, countries around the world have imposed travel bans, quarantined citizens and isolated the infected in an attempt to stop the spread of the virus. The outbreak has developed into a global threat and the World Health Organisation declared that the outbreak constitutes a pandemic.

Business organisations have reported substantial business and operational disruptions, including closures of offices, factories and ports, disruptions to supply and distribution channels, shortage of labour and reduced demand. Businesses are, therefore, assessing their contractual relationships to ascertain if they are able to perform their contractual obligations and if they are not able to, to determine what options are available to them in the circumstances.

For participants in the Over-The-Counter (OTC) derivatives market, COVID-19 raises some considerations that market participants should take into account as they develop risk management strategies and adapt to ongoing developments. This alert addresses one key area: Implications of COVID-19 for Force Majeure Under the 2002 ISDA Master Agreement.

The 2002 ISDA Master Agreement updates the 1992 ISDA Master Agreement and is used to document derivatives transactions between parties in different jurisdictions and/or derivatives transactions involving different currencies.

Derivatives are financial contracts with values dependent on or derived from underlying assets or group of assets. Derivatives can be used to hedge a position (to eliminate risk), speculate on the directional movement of an underlying asset (to profit from risk), or give leverage to holdings. Their value comes from the fluctuations of the values/prices of the underlying asset which are mostly caused by market conditionsThe common forms of Derivatives are Futures, Swaps and Options.

There are broad market disruption fallbacks which have been included in OTC derivatives contracts by asset class-specific definitions. It is also instructive to note the eight local business day waiting period in the 2002 ISDA Master Agreement before termination notices can be issued

Implications of COVID-19 for force majeure under the 2002 ISDA Master agreement.

The concept of force majeure (FM) in contracts is widely applied in common law jurisdictions such as Nigeria and is used because of the limited remedies otherwise available to the parties when the contract becomes impossible, difficult or onerous to perform due to events outside the affected party’s control. Under the 2002 ISDA Master Agreement, a FM constitutes a Termination Event (as defined in the 2002 ISDA Master Agreement), which will apply only after giving effect to any disruption fallback or other remedy applicable via any relevant definitions in the transaction confirmation. The FM event must have arisen due to an event that is not an action taken by the party and the party must not be able to overcome the impossibility using any reasonable efforts.

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It is important to note that the term “force majeure event” is not defined in the 2002 ISDA Master Agreement and will be a matter of common law in each jurisdiction. What constitutes a force majeure event must be interpreted under the governing law of the relevant ISDA Master Agreement.

The FM provision in Clause 5(b)(ii) of the 2002 ISDA Master Agreement is triggered if, on any day, a FM or act of state prevents the specific trading office of the counterparty or the counterparty itself from performing, or if performance becomes impossible or impracticable, beyond the control of such office or party, as long as the circumstance may not be overcome by the affected party using all reasonable efforts.

The FM event in the 2002 ISDA Master Agreement effectively establishes two tests for an event: (i) the impossibility test; and (ii) the impracticability test.

Assessing the impossibility test and impracticability test

For the Impossibility Test, a key consideration here is whether the actions taken to fight COVID-19 would make it impossible for parties to perform their obligations. It is generally believed that “impossibility” is essentially a high threshold to satisfy. For such a threshold to be met, it will take an event or measure like a total shut down of all payment and settlement systems for an extended period, which would make performance under the 2002 ISDA Master Agreement impossible. This is, however, very unlikely given the grave implications that will have on any economy and considering the fact that financial institutions are still operating, even if remotely, using electronic platforms for non-physically settled transactions.

With respect to the Impracticability Test, it is perhaps a lower threshold to satisfy. As an example, physically settled transactions may be affected by a business office closure due to the COVID-19 pandemic, which could make settlement impractical. This will not be the case for non-physically settled transactions that rely on electronic processing.

Other considerations

There are broad market disruption fallbacks which have been included in OTC derivatives contracts by asset class-specific definitions. It is also instructive to note the eight (8) local business day waiting period in the 2002 ISDA Master Agreement before termination notices can be issued. Both provisions make for a very high threshold before a FM event occurs. It is, therefore, unlikely that actions occasioned by COVID-19 would result in a FM event. However, depending on the circumstances, the delivery of physical commodities is more likely to be impacted and a FM could be triggered.

It is imperative for parties who are having trouble with performing their obligations under the 2002 ISDA Master Agreement to note that terminating a derivative transaction due to a FM event will not entitle either of the parties to resale from the 2002 ISDA Master Agreement. Clause 6 (Early Termination; Close out Netting) of the 2002 ISDA Master Agreement is instructive in this regard. Clause 6(e) sets out in detail, the process for determining an amount payable by one party to the other after such an early termination. Some of the considerations that will impact the calculation include whether the FM event affects one party or both parties, the values of any payments or deliveries that became due but were not fulfilled prior to the date of termination and a valuation, by one or both parties, of the cost of entering into a replacement transaction under then prevailing circumstances, determined in accordance with section 6 of the 2002 ISDA Master Agreement. Parties will need to consider the concept of Netting and whether the provisions on netting are enforceable in jurisdictions that are yet to legislate on netting – like Nigeria.

With respect to certain notices like termination notices, such notices must be issued in line with the provisions of the 2002 ISDA Master Agreement. Such termination notices may require delivery in person, via courier or registered mail, and are typically effective upon receipt. Counterparties may consider amending their agreements to address those issues during these times.

In addition, it is advisable for market participants to monitor receipt of notices that may have adverse consequences and adopt measures ahead of time that may put them in a position to react accordingly.

Finally, the market volatility created by the pandemic in certain markets will have implications for the value of trades referencing affected assets. However, it remains to be seen if events since the advent of the pandemic will eventually result in performance becoming impossible. This seems very unlikely at this time.


Chukwudi Ofili is a lawyer and an Associate Partner at Detail Commercial Solicitors in Lagos. He can be reached at [email protected] or [email protected].