Market Volatility and Collateral Valuation Disputes: Investors' Rights, Remedies and Potential Claims

This is our third post concerning the legal implications for investors of market volatility under English law governed transactions. This week, we look at collateral valuation disputes in volatile markets. 

ISDA - Credit support annexes 

For most professional market participants, where collateral valuation disputes arise, they are likely to do so under facilities governed by an ISDA Master Agreement with an agreed credit support annex. For ISDA facilities, as discussed in our first post, the most common types of credit support documents are the 1995 Credit Support Annex ("CSA") or 2016 CSA (Variation Margin) Annex ("CSA VM"). Unless otherwise defined, capitalised terms in this post take their meaning from those respective CSAs. 

Under either form of CSA, one party is the designated Valuation Agent. Typically, that is the bank or institutional broker-dealer. Under the CSAs, collateral valuation disputes generally take one of two different forms. 

Dispute 1 - Valuation of open positions impacting collateral demand 

First, the Valuation Agent is required to calculate the Exposure on a given Valuation Date. This requires a calculation of the parties' respective exposures under the open positions, as if all open positions had been terminated on that day. In short, this is an overall calculation of which party is ‘in the money’. If a party is in the money, this leads to a calculation of how much Eligible Credit Support is payable to that party as collateral (effectively either the Delivery Amount or Return Amount obligation under paragraph 2 of the CSA).  

This calculation of Exposure therefore affords the Valuation Agent a critical discretion: it must value the “estimates at mid-market” for the open positions (see paragraph 10 definitions of Exposure). Circumstances where this type of dispute may arise include where the Valuation Agent:

• Makes a valuation that significantly favours its net position on the open trades, by selecting quotations that do not properly represent the mid-market price. This risk may be particularly acute in volatile markets and/or where the positions to be valued are illiquid (e.g. in the case of exotic structured products).   
• Seeks to increase its overnight liquidity in times of market volatility by overvaluing its own Exposure, thereby demanding levels of collateral to which it is not properly entitled. This exploits a lack of reference assets for mark-to-market valuations.
• In the reverse scenario, repeatedly undervalues the counterparty's Exposure, if the latter is the party in the money (thereby reducing the amount of collateral that may be returned to the counterparty under a section 2(b) Return Amount demand). 

Dispute 2 - Valuation of the Delivery or Return Amounts 

Second, under both CSAs, the Exposure calculation feeds into a separate, further calculation, namely, the core calculation of the Delivery Amount or Return Amount of collateral. This involves the calculation of Value under paragraphs 2(a) or (b). The following points should be noted: 

• As foreshadowed above, there is a clear qualitative difference between situations where the disputed valuation relates to collateral that is liquid or illiquid. If the collateral is liquid, then at least in principle, the price of the reference asset should be objectively verifiable from contemporaneous market data (even if determining the price may in practice be less straightforward in highly volatile markets).  
• If the collateral is illiquid, however, there may be wider scope to challenge the collateral-taker’s valuation. This is due to the fact that there may be a range of reasonable market valuations of the collateral, but a counterparty may attempt to exploit this by valuing it below the floor of that acceptable market range. 

Practical step - reservation of rights

As a practical step in any live dispute, if a collateral call is based on a dubious valuation, the investor should send a letter or email disputing the valuation and reserving its rights. Care should be taken to avoid any such letter (or email) from being construed as a repudiation of the transaction by the investor, and express wording to prevent this from occurring should be included.[1] Such a letter or email should ensure that there is an evidentiary record to demonstrate that the counterparty has been put clearly on notice of its contractual obligations as the Valuation Agent. 

Practical step - plan for CSA disputes 

For both CSAs, there is a mandatory dispute resolution regime which the parties must follow in live disputes, unless otherwise agreed. Failure to comply with this regime may have significant consequences for investors, as doing so briefly suspends collateral Delivery and Return obligations.[2] Disputes under the CSA regime must typically be raised within 24 hours, leaving little time to make decisions on next steps. Market participants should instruct their lawyers ahead of time to prepare template documentation which may be finalized and sent quickly should a CSA dispute arise. 

English case law on Valuation Agent obligations

Market participants will also need to bear in mind the content of a Valuation Agent’s obligations, including with respect to its CSA and CSA (VM) paragraph 9(b) duty to act in “good faith and in a commercially reasonable manner”. In summary, this is a mixed subjective (good faith) and objective (commercially reasonable manner) test.[3]

The case law indicates that the English courts will evaluate the substantive methodology used by the counterparty, including any pricing inputs for the trades and applicable practices in the relevant market.[4] Accordingly, expert valuation evidence will usually be required to prove that the counterparty’s valuation falls short of this standard. 

Market participants considering claims based on wrongful collateral valuations by a Valuation Agent will need to assess carefully what (if any) losses have been suffered. If losses are identified, then challenges to adverse valuations are likely to focus on the Valuation Agent’s breach of its express objective obligation to act in a commercially reasonable manner. 

In our final post next week, we examine close-out disputes, claims for wrongful termination, and some of the key factors that courts take into account when assessing loss in these cases.