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25 March 2020
Market disruption, trading disruption, pricing disruption, settlement disruption and similar events
The outbreak of the novel coronavirus (COVID-19) has implications for derivatives contracts. For example, some companies are asserting that the reported disruptions in the global supply chain and travel restrictions constitute a force majeure, which is a legal basis for excusing non-performance and a right to terminate under contracts.(1) Below are certain issues that market participants may wish to consider when evaluating the potential impact of the COVID-19 outbreak on their outstanding derivatives contracts.
Force majeure clauses in contracts generally address circumstances beyond the contracting parties' control, which may render performance under a contract substantially difficult or impossible. Market participants should consider whether certain implications of the COVID-19 outbreak could constitute a force majeure or similar event of default or termination event under various derivatives contracts including International Swaps and Derivatives Association (ISDA) or other market standard master agreements. While the specific terms of agreements and relevant circumstances will ultimately determine parties' rights and obligations under such agreements, market participants should consider the following when evaluating their derivatives documentation.
Does the COVID-19 outbreak constitute a force majeure or similar event in the agreement?
Is the event related to the COVID-19 outbreak of a nature which would be captured under a general force majeure clause (such as Section 5(b)(ii) of the 2002 ISDA Master Agreement) or similar clause in the contract?
Could the event be covered under some other linked contract (eg, the loan agreement to which a hedging arrangement relates)? If so, how does this affect the derivatives contract and will the two contracts be affected differently?
Are there laws or regulations in an applicable jurisdiction that require the market participant to take or refrain from taking (or otherwise prevent it from taking) certain actions that may affect its rights or obligations under a derivatives or derivatives-linked contract? For example, US federal and state governments have broad constitutional authority to implement quarantines and other limitations that may curtail or substantially hinder a party's ability to fulfil contractual obligations. Section 361 of the Public Health Service Act permits the secretary of health and human services to take measures to prevent the entry and spread of communicable diseases from foreign countries into the United States and between states.(2) Additionally, earlier this month, Italy became the first European country to restrict movement throughout the entire country in order to contain the spread of COVID-19. Specifically, people are barred from entering or leaving Italy and travel within the country is severely limited, with certain exceptions for work, health or family emergencies. Violators of the ban could face penalties including jail time or fines.
Are there any applicable qualifiers to the force majeure or similar event clause?
Certain contracts may specify that a force majeure event exists only with respect to a party if such event could not reasonably have been foreseen or overcome by such party. For example, most market participants must have business disruption plans to reduce the risk of such events; failure to have such plans or effectively implement such plans for foreseeable events may weigh on whether the market participant has acted reasonably. Other contracts may require the party asserting that a force majeure event has occurred to demonstrate that:
The force majeure provision in the 2002 ISDA Master Agreement applies after giving effect to any other applicable provision, disruption fallback or remedy provided for in the applicable agreement and confirmation and applies only if the party could not, after using all reasonable efforts (but without any obligation to incur a material loss) overcome the relevant event. Parties will need to consider carefully any terms that are incorporated into the ISDA Master Agreement by reference, including definitional booklets such as the 2005 ISDA Commodity Definitions or the 2011 ISDA Equity Derivatives Definitions.
Could the event qualify as more than one default, termination or similar event and does the documentation address such ambiguity or plurality?
In some cases, an event related to COVID-19 could qualify as more than one event of default, termination or similar event and therefore potentially be subject to differing sets of rights or obligations. Market participants should review carefully any terms that address such ambiguity or plurality. For example, the 2002 ISDA Master Agreement provides that:
Whether an event constitutes a termination event or an event of default affects parties' rights to terminate the ISDA Agreement and obligations with respect thereto.
Are there any notice or other requirements with respect to the party asserting that a force majeure or similar event has occurred?
For example, a 'force majeure event' is a termination event under the 2002 ISDA Master Agreement and, while not a termination event under the 1992 ISDA Master Agreement, it may be included by parties as an additional termination event in the Schedule to the 1992 ISDA Master Agreement or by incorporation of the ISDA Illegality/Force Majeure Protocol. In such circumstances, each party must notify the other party of the force majeure event specifying its nature and any other information as the other party may reasonably require.
Some agreements may require notices or other documents to be delivered by courier. Market participants should consider whether travel restrictions or other public safety measures implemented as a result of the COVID-19 outbreak would make delivery by courier unfeasible or impossible, as well as alternative methods for delivery. Some derivatives agreements including ISDA master agreements require parties to deliver notices and other communications only through the means specified in such agreement. 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.
What are the consequences of asserting that a force majeure or similar event has occurred?
Such consequences may include relief for one or both parties from the obligation to perform under the agreement for a certain period of time or for as long as the force majeure event exists, or the right of a party to terminate the agreement. Section 5(d) of the 2002 ISDA Master Agreement provides that on the occurrence and during the continuance of a force majeure event, payments and deliveries are deferred until the earlier of:
Section 6(b)(iv)(2) further provides that if the force majeure event still exists following the expiration of the waiting period, either party may, by not more than 20 days' notice, designate an early termination date on which all or some affected transactions will terminate, provided that such party must specify which transactions it wishes to terminate if terminating less than all transactions.
Parties should consider the effect of any unscheduled holidays on their derivatives transactions. For example, the extension of the Lunar New Year holiday from 24 January 2020 to 2 February 2020 (inclusive) affected valuations, settlements and other actions required to be made or taken on such dates.(3) In general, market participants should evaluate the terms of their various derivatives contracts, including equity, commodity, interest and foreign exchange derivatives contracts, in order to determine whether market, banking or payment system closure in any applicable jurisdictions (as a result of an unscheduled holiday) would affect valuation, settlement or payment dates including accrual periods for payment of interest.
Market participants should consider whether events relating to COVID-19 trigger any relevant definitions relating to market, trading, pricing, liquidity and settlement disruptions. If an event that would otherwise constitute a force majeure event in the 2002 ISDA Master Agreement also constitutes a disruption event under the 2005 ISDA Commodity Definitions or the 1998 ISDA Foreign Exchange Market (FX) and Currency Option Definitions, the relevant disruption fallbacks would apply rather than the force majeure provisions. Market participants are therefore encouraged to prioritise review of any terms in their derivatives agreements addressing disruption and similar events and to note that such terms will differ based on product type, the ISDA and other definitions included in the documentation and the elections chosen by the parties in the relevant documentation. Market participants should also consider the implications of such disruptions that may not be addressed in relevant documentation, as well as potential alternatives for pricing, payment or settlement that could be considered in the event of disruption.
Review of equity derivatives documentation should include an evaluation of whether events relating to COVID-19 could result in delayed or substitute valuation, pricing or settlement mechanics. To illustrate, with respect to the 2002 ISDA Equity Derivatives Definitions, events relating to COVID-19 could constitute a failure to open or market disruption event. The latter occurs as a result of three possible classes of event: trading disruption, exchange disruption or early closing. Trading disruption refers to a suspension or limitation of trading in shares (or, in some cases, a proportion of shares in an index) or in related listed derivatives. For example, fluctuations in share prices on an exchange listed in mainland China, Italy or other relevant jurisdiction as a result of the COVID-19 beyond the limits set by such exchange outbreak could result in the suspension or limitation of trading in such shares. With respect to the 2011 ISDA Equity Derivatives Definitions, the COVID-19 outbreak could result in a pricing disruption, settlement disruption, extraordinary event or additional disruption event. The share prices example provided earlier in this paragraph could constitute a pricing disruption under the 2011 ISDA Equity Derivatives Definitions. If a disruption occurs, applicable disruption fallbacks will apply as an alternative for determining settlement rates or an alternative basis for settling transactions.
In addition, with respect to equity derivatives generally, market participants should make sure to review the terms of any master confirmation agreements.
Commodity and other derivatives
For commodity derivatives transactions, market participants should review relevant documentation in order to evaluate whether COVID-19 could affect payment or valuation dates, or pricing, including with respect to unscheduled holidays as discussed above. Note that the 2005 ISDA Commodity Definitions include a no fault termination disruption fallback. If no fault termination is specified in a relevant transaction confirmation, affected transactions will be terminated as if a force majeure event and early termination date had occurred on the day the no fault termination became the applicable disruption fallback.
FX and currency option transactions
With respect to FX and currency options transactions, events relating to COVID-19 could constitute disruption events as defined in the 1998 ISDA FX and Currency Option Definitions. Market participants should carefully review transaction confirmations to understand the disruption events that apply with respect to outstanding transactions. For example, the 1998 ISDA FX and Currency Option Definitions include a material change in circumstance disruption event; if applicable, this disruption could provide a catch-all ability for parties to terminate transactions if an event not specified in the definitions and beyond the control of the parties makes it impossible for a party to:
The 1998 ISDA FX and Currency Option Definitions also include a no fault termination disruption fallback.
For further information on this topic please contact Donna M Parisi, Geoffrey B Goldman, Azam H Aziz or Naffie Lamin at Shearman & Sterling LLP by telephone (+1 212 848 4000) or email (firstname.lastname@example.org, email@example.com, firstname.lastname@example.org or email@example.com). The Shearman & Sterling LLP website can be accessed at www.shearman.com.
(1) China National Offshore Oil Corp, one of the world's largest buyers of liquefied natural gas, invoked force majeure and told some suppliers that it would not take delivery of shipments because of difficulties caused by COVID-19. See here.
(2) 42 US Code Section 264.
(3) The ISDA has released market guidance on the impact of the Lunar New Year holiday extension on interest rate, equity, foreign exchange and commodity derivatives contracts at the following website. See here.
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