Market Volatility: Close-out Disputes, Wrongful Termination and Assessing Loss

In our fourth and final post on the legal implications for investors of market volatility under English law governed transactions, we look at disputes involving close-outs, allegations of wrongful termination, and the assessment of loss in these scenarios.   

Close-out Disputes

In the ISDA context, close-out disputes typically involve a contested valuation of the amount owing to one party following the designation of an Early Termination Event under clause 6(a) or (b) of the ISDA Master Agreement. Some of the key issues for market participants to bear in mind when such disputes arise are as follows:

• Where one of the parties defaults and an event of default does not automatically occur (e.g. in the case of illegality, force majeure or tax events, or because Automatic Early Termination has not been specified in the Schedule), the non-defaulting party must take the significant step of designating an Early Termination Date.[1]
• In essence, the party that is ‘out of the money’ will become liable to make an Early Termination Payment.[2] The non-defaulting party must determine the netted close-out amount based on its valuation of the outstanding positions as soon as possible.[3]
• There is a difference in the way valuation occurs under the 1992 and 2002 ISDA Master Agreements. In summary, the 2002 Master Agreement replaced the earlier concepts of “Loss” and “Market Quotation” with a single and more flexible netted payment obligation, referred to as the “Close-out Amount”.[4] The concept of the “Close-out Amount” essentially values the price the non-defaulting, determining party would have to pay (or receive) to replace the existing positions.[5] For simplicity, we focus here on the “Close-out Amount” concept under the 2002 Master Agreement.
• The non-defaulting party must notify its defaulting counterparty of the designation of an Early Termination Date (unless Automatic Early Termination has been designated in the Schedule). 

Practical steps

Assuming an investor is the non-defaulting party, as soon as it becomes aware of a dispute and the potential need to calculate and serve notice of the Close-out Amount, there are various steps it should take. These include: 

• Conducting a full review of all Transactions governed by the ISDA Master Agreement in question, including to identify any illiquid or bespoke calculation issues that may arise in relation to individual Transactions.[6]
• Lining up its internal processes for approvals in advance, in both the commercial and legal functions.[6] This includes pre-briefing internally on ISDA valuation methodologies, the applicable timelines, and seeking any required advice from in-house or external counsel.
• Pre-planning for obtaining market quotations for replacement Transactions, for example by identifying brokers.
• Preparing to evidence the Close-out Amount calculation in other ways, such as via market data and any internal data sources (both being expressly envisaged by section 6(d) of the 2002 ISDA Master Agreement), and ensuring that such evidence can be properly documented.
• For any internal sources, care must be taken to ensure that any legal privilege issues have been addressed when documenting the Close-out Amount calculation, e.g. if lawyers have been advising internally on the same email chain. 

Once the Event of Default has occurred and the Close-out Amount falls to be calculated, the non-defaulting party should move swiftly to avoid any allegations of delay, waiver or acquiescence, and/or any challenges to its valuation that may result from having waited too long (e.g. if the market moves and evidence of the earlier prices is more difficult or impossible to obtain). 

Conversely, if an investor is the defaulting party and considers that the “Close-out Amount” has been wrongly calculated, it should put the dealer on notice of this as soon as possible, including by requesting any supporting evidence. An investor should also seek its own contemporaneous quotations to evidence any potential claims it may have to dispute the valuation.  

There is a detailed body of English and New York case law which informs an investor’s rights and obligations under the ISDA close-out valuation provisions.[7] Specialist advice should be sought from counsel on whether the valuation accords with the principles established in those cases.

Wrongful Termination 

A wrongful termination dispute is an ever-present risk, particularly for non-ISDA transactions where termination provisions are bespoke and not subject to a market standard regime. Such disputes arise where a party terminates the relevant transactions on the mistaken belief (and/or advice) that it has a valid right to terminate. If there was no valid termination right (either an express right in the contract, or at common law), then the terminating party will be liable for the losses suffered by the innocent party. This may include, for example, future losses in the form of expectation damages. Those future losses may be significant given the often large notional amounts involved. Of course, an innocent party is required to take reasonable steps to mitigate any losses.

While there are circumstances in which an ISDA-governed relationship may give rise to a claim for wrongful termination, they can be more difficult for the terminated party. Under an ISDA Master Agreement, if a party wrongfully designates an Early Termination Date in the mistaken belief that they are entitled to do so, the prevailing view is that this will typically not constitute a repudiation at common law.[8] This is because a repudiation will be found only where a party unequivocally acts as if it does not consider it is bound by the contract. Purporting to enforce an express termination right under a contract shows the opposite; i.e. it shows a willingness to be bound. 

As a practical point, an (innocent) party facing a potential wrongful termination by its counterparty should make it very clear in any correspondence or discussions that it (the innocent party) is not itself evincing an unwillingness to be bound by the contract, in case that innocent party itself inadvertently repudiates it. 

Losses and the counterfactual

If it can be proved that a close-out or termination was legally invalid, then when considering any potential proceedings, there are two key questions:

• What is the loss?
• What is the appropriate counterfactual? 

On the first point, the basic answer is the standard contractual measure of damages, namely the amount necessary to put the investor in the same position as if the contract had been performed.[9] Measures of loss may include future lost profits, the cost of replacement transactions, lost hedging costs, additional new funding costs incurred, and losses associated with any forced sale of security. Investors will appreciate that proving such losses typically involves layered degrees of complexity, and considerations swiftly move beyond the basic measure. Advice should be sought at an early stage. 

On the second point, an investor will need to consider what the appropriate counterfactual would have been. In other words, would the bank have been entitled to terminate anyway? For example, if the wrongful termination was due to an (allegedly) missed margin call, then consideration must be given to whether the bank could have issued a properly calculated (i.e. replacement) margin call on the day in question (or in the following days), and whether that payment could have been met by the investor. Market participants should put dealers to strict proof on this issue, and expert evidence is likely to be a necessary part of resolving the dispute.