The ever increasing restrictions on movement and forced physical closures of businesses as a result of COVID-19 are a serious challenge to businesses. Understanding the risks in each part of your business is key to ensuring continuity in times of severe disruption like this.
COVID-19: issues for treasurers - derivatives and hedging
Derivatives and hedging
Key questions for treasury functions:
- Do I have access to the terms and conditions which govern my derivatives?
- Managing cash-flows:
- What are the payment terms?
- What happens if I don't pay?
- Can I defer or restructure my payments?
- Early termination triggers:
- Can my counterparty terminate early?
- Logistics and business continuity:
- Are we in a force majeure scenario?
Our briefing covers these issues for over-the-counter (OTC) derivatives transactions which are executed using either a 1992 Master Agreement or 2002 Master Agreement in the form published by the International Swaps and Derivatives Association (ISDA).
Managing cash flows
What are the payment terms?
Normally payment obligations are linked to some form of business day concept. Business days are generally defined as days on which commercial banks and foreign exchange markets settle payments, and are open for general business. As long as banks and foreign exchange markets are open, payment obligations will become due on their specified dates.
Can I defer or restructure my payments?
Any restructuring of payments will need to be carefully considered and discussed with the relevant counterparty and may come at a cost. Typically, contracts will not contain specific contractual provisions to deal with an amendment of the payment schedule or payment terms. Amendments are down to parties' ability and willingness to negotiate.
Bank and other financial institutions often enter into back-to-back arrangements and therefore changes to payment terms and schedules are likely to require the consequential amendment of the financial institution's own back-to-back arrangements. This can add to the costs as the financial institution will seek to pass these on.
Special situation 1
Mandatory hedging in the context of loan facilities
The commercial terms of these derivatives transactions will be aligned with the commercial terms of the loan facilities to hedge certain risks arising in connection with the loan facilities (commonly interest rate risk). If the commercial terms are amended for either the facility or the hedge (but not the other) then that mismatch could be problematic and may have economic and accounting consequences. While unlikely, in extremis it could give rise to legal issues such as the transaction no longer qualifying as a hedge for the purpose of the loan facilities, which could give rise to a default of the loan facilities.
Any restructuring of the hedge terms will need to be done in accordance with the terms of the facility agreement. In some cases, negotiations with the derivative counterparty can trip the "negotiations with creditors" event of default in the facility agreement.
Early termination triggers
Can my counterparty terminate early?
Unlike loan facility agreements, the 1992 and 2002 ISDA Master Agreements typically do not contain material adverse change termination rights or financial covenants which could result in breaches and early termination rights. Put somewhat simplistically, as long as the parties perform, and no insolvency occurs, parties are unlikely to have rights to terminate all derivatives transactions between them purely as a result of COVID-19 and the current economic situation.
Parties should however carefully check any bespoke terms added to their 1992 or 2002 ISDA Master Agreement to ensure that they do not contain such termination rights or covenants.
Special situation 2
Bespoke transactions such as idiosyncratic risk management or funding transactions
OTC derivative transactions can be highly bespoke. Individual transactions can include early unwind triggers if, for example, a share price falls below certain levels, trading is disrupted, hedging becomes impossible or corporate credit deteriorates. In these circumstances, counterparties may be able to terminate individual transactions; however, the overall trading relationship should remain unaffected. These transactions and their impact need to be considered on a case by case basis.
Special situation 3
Alternative funds, pension schemes and SPVs
ISDA Master Agreements for non-corporates (such as alternatives funds, pension schemes and SPVs) will often include non-standard termination rights. For example, ISDA Master Agreements for alternatives funds may include NAV-trigger termination rights and other bespoke provisions which may be triggered due to the broader macro-economic impact of COVID-19. Parties should carefully check any bespoke terms added to their 1992 or 2002 ISDA Master Agreements.
Special situation 4
Mandatory hedges in the context of loan facilities
If the derivative transactions have been entered into in connection with wider financing arrangements (for example, interest rate swaps which form part of leveraged acquisitions) then these wider arrangements need to be considered. Usually the relevant intercreditor agreement will govern termination scenarios.
Logistics and business continuity
Are we in a force majeure scenario?
- The 1992 ISDA Master Agreement does not contain a standard force majeure provision. Parties should however carefully check any bespoke terms added to their 1992 ISDA Master Agreement.
- In contrast the 2002 ISDA Master Agreement does contain a standard force majeure termination event.
The provision in the 2002 ISDA Master Agreement is nuanced and needs to be considered on a case by case basis. In general terms, the bar for a force majeure occurring is set extremely high. The provisions would only be triggered if as a result of a force majeure or act of state, the office through which a party makes/receives payments is 'prevented' from making a payment, or it becomes 'impossible or impracticable' to perform, receive or comply. The force majeure or act of state needs to be beyond the control of such office or party, and such office or party could not, after using all reasonable efforts, overcome such prevention, impossibility or impracticability. Wide-ranging business continuity measures and remote working capabilities across the economy in the UK will have significantly reduced the likelihood of a force majeure event, at least, in the UK.