Mukund Arora is a second-year student at Symbiosis Law School, Pune.
The Russian invasion of Ukraine in the early hours of 24th February called for the biggest war in a European Country since World War II. As an inevitable disruption in the financial markets followed, the impact triggered all-time-high energy prices and global inflation fears. The Russian ruble lost half its value by March 7 and MSCI's Russia index crashed by 38%. The US administration promptly retaliated with a comprehensive sanction program targeting individual wealth, exports, the Russian central bank’s reserves, and exclusion from financial systems. JP Morgan estimated a shrink of 35 percent in the second quarter of 2022 and 7 percent for the entire year for Russia’s economy.
To maximize the effects of sanction programs, entities largely focused on global markets are targeted. This, in consequence, has a penetrating effect on the derivatives market. The Over-the-Counter derivatives are essentially governed by an International Swaps and Derivatives Association (ISDA) Master Agreement, which expansively covers the terms between the parties. Given that these contracts are traded on a cross-border basis, they are susceptible to jurisdictional compliance challenges, which are often affected by the political and economic dynamics. This article seeks to assess the application of sanctions on derivatives and ISDA’s termination provisions in this regard.
The sanctioning authority or country usually has no jurisdiction over the sanctioned country, which means that the sanctioned entity is not directly subject to the law of the country imposing the sanctions. Therefore, the sanctioning country instead sanctions another country by prohibiting entities in its jurisdiction from entering into business with the target entity. The fact that sanctions originate from the home country also implies that the sanctioning entity also carries the risk of effects of the sanction, along with the target entity. Thus, the home companies, banks, and funds are the first subject to sanctions with an intent to cause damage to the target.
Before the latest conflict, the US Office of Foreign Asset Control (OFAC) in April 2021 issued Executive Order 14024 ("EO 14024"), "Blocking Property with Respect to Specified Harmful Foreign Activities of the Government of the Russian Federation". This order authorizes sanctions against persons designated by OFAC and is still effective today. The order declared that all of the designated persons' property and interests in property that are or come within the United States or that are or come within the possession or control of any US person are blocked, and US citizens are prohibited from doing business with these institutions unless authorized by OFAC.
In response to the current conflict, OFAC further issued directives under this order on February 22, 2022. Directive 1A “Prohibitions Related to Certain Sovereign Debt of the Russian Federation” makes no reference to derivatives transactions but prohibits participation in the "secondary market" in sovereign debt issued after March 1, 2022, which covers derivatives. Directive 4 lists entities including the Russian Central Bank, National Wealth Fund, or Ministry of Finance, and thus transactions these entities are party to also come under the scope of sanctions. In fact, even credit default swaps (CDS) that reference Russian debts will also be covered under Directive 3 “Prohibitions Related to New Debt and Equity of Certain Russia-related Entities”. It states “All transactions in, provision of financing for, and other dealings in new debt of longer than 14 days maturity or new equity where such new debt or new equity is issued…”. A reference to "transactions … or other dealings in" suggests that a CDS referencing the new relevant debt may be prohibited.
ISDA Master Agreement and Termination Clauses
According to the latest data from the Bank of International Settlements, the derivatives notional amount outstanding by the end of the second half of 2021 was $598.4 Trillion with a gross market value being $14.4 Trillion. These figures emphasize how disruption to the operation of these contracts can have effects extending to markets condition as a whole.
The OTC derivatives operate through the 2002 ISDA Master Agreement, giving the transaction a robust and legally enforceable structure. It comprises (i) the standard agreement (the ISDA Master) which governs the general contractual relationship between the parties, (ii) the Schedule used by the parties to negotiate terms in the standard agreement or to provide for new or additional provisions, and (iii) the Confirmation which sets out the economic and financial terms of the individual transaction is entered into and which may incorporate by reference one or more standard ISDA Definitions booklets. Broadly, these terms include interpretation, obligations of the parties, agreements, termination events, early termination, and jurisdiction. Additionally, these derivatives are also subject to the ISDA Credit Support Annex. The Credit Support Annex to the ISDA Master agreement facilitates parties to exchange bilateral margins on a daily basis to cover the net mark-to-market credit exposure across their entire trading relationship.
The termination events listed in the master agreement refer to circumstances where it is illegal or impossible for parties to carry out the transaction. On the other hand, events of default refer to situations where the risk of non-performance is so high that the basis of the relationship between the parties is declared to have ceased, such as bankruptcy, credit support default, failure to deliver, etc. It enables the non-defaulting party to crystallize its position by closing out and taking enforcement proceedings to recover the full amount due before the defaulting party commences winding up or administration proceedings. The primary difference is that while events of default are the result of a party’s fault or actions, termination events are triggered without the involvement or cognizance of the parties.
The termination provisions are constituted under Section 5(b) of the ISDA Master Agreement. They are listed as-
Tax Event upon Merger
Credit event upon Merger
Therefore, when sanctions make it illegal for the home company to fulfill its payment obligations to the target entity, it would constitute an Event of Default in absence of any other saving provision under the Master Agreement. However, “Illegality” is instead invoked under the termination events as a saving clause to avoid an Event of Default. Section 5(c)(i) of the 2002 ISDA provides that if the Illegality event makes payments illegal, a consequent failure to pay is not considered an Event of Default. In this context, the home firm is the “Affected Party” since it is unable to meet its obligations and the target entity is the “Non-Affected Party.”
Section 6(e) stipulates that the Non-Affected Party is the “Determining Party” to decide the Close-Out Amount to be exchanged between the parties in respect of the terminated transactions. Section 14 defines close out amount as “the amount of the losses or costs of the Determining Party that are or would be incurred under then prevailing circumstances (expressed as a positive number) or gains of the Determining Party that are or would be realized under then prevailing circumstances (expressed as a negative number) in replacing, or in providing for the Determining Party the economic equivalent of the terminated transaction...”
Therefore, in the case of sanctions, the target entity is the determining party and is empowered by the ISDA to determine the close-out amount. The calculation methodology to determine to close-out amount is further provisioned in Section 6(e)(ii) which required the determining party to use ‘mid-market values’ for the terminated transactions, and when seeking quotes from third parties to ask for “mid-market quotations”, in either case without regard to the creditworthiness of the Determining Party. This gives the target entity a great control in valuing the derivatives, and it has to demonstrate usage of commercially reasonable procedures to make the determination. However, the term “mid-market quotations” has not been defined in the agreement and can be subject to interpretation. The home firm can only challenge the valuation by proving that the determining entity did not use commercially reasonable procedures in the process.
ISDA Whitepaper and Guidance Note
In December 2019, ISDA published a whitepaper on the potential effects of sanctions on derivatives. The whitepaper provided comprehensive proposed solutions with respect to the sanctions. Among other recommendations, it proposed that sanction orders must clearly set out whether they prohibit derivatives transactions by a non-sanctioned party with the target entity. It recommended that the rights and obligations of the parties be clarified, and any grandfathering periods and the impact of any lifecycle events be set out. Interestingly, it also proposed that the ability to enter into and perform obligations under reference transactions with respect to the target entity should not be curbed as a part of sanctions. This proposition is logical since a reference transaction only constitutes a transaction by two non-sanctioned entities which refer to a sanctioned entity, its benchmark interest rates, payment obligations, etc. It is not a transaction with the target entity.
The whitepaper also sought that targeting particular financial instruments should only affect those derivatives contracts that are clearly expressed to be within the scope of the sanctions. For the sanctioned entity, ISDA proposed a reasonable wind-down period of not less than 30 days to manage credit and market risks. Additionally, it recommended that in case of illegality or an event of default, non-sanctioned entity exercise their rights to terminate transactions and fulfill any contractual conditions to any such termination. Contrary to the status quo, the whitepaper sought to empower the non-sanctioned party to determine the relevant net settlement amount under the close-out provisions.
In December 2020, ISDA also published a guidance note for Addressing Sanctions Issues in ISDA Documentation. It emphasized the need for parties to consider the inclusion of a specific Additional Termination Event (ATE) to unambiguously counter sanctions issues, principally concerning termination events, payment and delivery obligations, termination payments, and the transfer or novation of transactions following a sanctions-related termination event. It suggests an addition owing to certain circumstances where the performance of obligations may not be illegal but continuing the trading relationship would be impractical, such as when a party’s employees are prohibited from performing the function or when the market infrastructure is made inaccessible. Additionally, a sanction program may allow a wind-down period during which the performance of obligations remains lawful but the trading documentation may not provide a party with the unilateral ability to terminate the transactions prior to the end of such period.
Often, termination for illegality comes with certain contractual preconditions such as notice requirements, waiting periods, or obligations to attempt to transfer obligations to another office. The parties may find such compliances impractical or undesirable and therefore rely on the ATE. The ATE may also provide for termination in case other sanctions-related clauses provided for in the agreement have been breached. Lastly, an ATE allows either party to terminate the transaction in case obligations become illegal to perform and the other party whose obligations are unaffected by the change in law determines the relevant termination payment at its side of the market. This can be done to balance the interests of both parties and extends beyond sanction-related events. All of these clauses seek to provide solutions to these economic uncertainties and harm to non-sanctioned parties in derivatives transactions.
The financial sanctions on Russia pose an evolving situation with high-stakes for certain entities. Termination procedures aim to provide effective ways out in exigency, and the ISDA guidance note and whitepaper offer an approach for assessing counterparty risks. The use of Additional Termination Events could increase confidence that necessary protections are in place where the clear effect of sanctions on agreements cannot be evaluated. Scope of sanctions and rights and obligations of the parties must be clarified while executing sanction orders, and home firms must not be strictly required to terminate existing transactions or prohibited to perform contractual obligations where it could result in a substantial financial loss for them.