The COVID-19 crisis and induced lockdown measures taken by numerous governments are starting to have a significant impact on the global economy. The full economic effects will only be known in the months to come. However, in the wake of rapidly declining portfolio values, financial institutions will be prompted to consider whether they should enforce margin calls (or, in some cases, termination rights), whilst investors explore the extent to which they can legally challenge call requests or termination elections in light of the current economic climate.
We set out below practical steps to consider in this context.
Margin based products are widely used by financial institutions. They are a form of financing backed by a portfolio of market traded assets such as shares or bonds which is extended to borrowers for the purpose of financing investments. A central component of this form of lending is that the ability to borrow funds is determined by the value of the assets in the portfolio, with the capacity to loan and credit limit based on the borrower’s financial position. If the value of the security for the loan falls below the agreed loan to value ratios, the lender can make a margin call, which requires the borrower to pay to make up the difference. If borrowers cannot make good on the shortfall, lenders are entitled to liquidate or close-out their positions. In some circumstances a lender might have a right to terminate the transaction immediately if the value of collateral falls below a certain value (so that the borrower might not even have the opportunity to post more collateral to keep the trade alive).
Legal disputes typically arise from whether lenders have complied with contractual provisions in respect of margin calls (or terminations), as well as looking to whether they have subsequently taken the correct steps to liquidate and/or value the positions.
Practical steps to consider
Whilst it will no doubt be important to react quickly as the value of collateral rapidly decreases, below are practical steps to consider to mitigate the risk of a legal challenge:
Check the contractual terms carefully for how the portfolio is to be valued, the trigger events and any exclusions for things like material changes in market conditions.
Ensure all calculations are in strict compliance with the contractual terms and maintain a full documentary record of the calculations, including evidence of the market values used. This is particularly important where firm (executable) quotations are required.
Ensure strict compliance with notice provisions in the contract, including business days, form of notice, method of service and any addresses for service It may be appropriate to provide notice in various forms (in addition to the contractually prescribed form) to ensure the notices are brought to the attention of the counterparty as soon as possible. An improperly served notice is likely to be invalid.
Maintain a documentary record of all discussions and decisions in relation to the portfolio and all communications with the counterparty. Give consideration to conducting any negotiations on a without prejudice basis. In such unprecedented times, documenting reasons for decisions that are taken can provide a helpful contemporaneous documentary record in instances which require a party to act reasonably or in good faith.
Financial institutions should take care when entering discussions with counterparties to be clear as to any terms on which the counterparty is to be given the opportunity to provide the required margin before closing out a position. If the financial institution intends to retain an existing right to close out a position immediately then it is prudent to expressly reserve such right in any discussions or correspondence with the counterparty.
When dealing with international counterparties, give consideration to the impact of measures announced by various governments to defer obligations of borrowers.
Ensure any trades undertaken are in accordance with the authorisation provided by the counterparty and in line with the regulatory status of the counterparty.