
We wish to highlight an important point for any party unfortunate enough to face a close-out in an ISDA (International Swaps and Derivatives Association) transaction. In the course of acting for parties in that position as their banking litigators, we have identified an apparently common practice among investment banks, by which they obtain a short-term directional bet on the market at the potential expense of the defaulting counterparty. This leads to inflation of the amounts demanded in the close-out if the bank loses money on those trades.
Picture the fictional scene. You are counterparty to a derivatives contract with ‘bank A.’ The market has gone against you and the trade is under water. Perhaps you were sent margin calls you could not meet. Whatever the reason, ‘bank A’ has issued a notice of event of default in which it notifies you of the early termination date. As non-defaulting party, ‘bank A’ will be determining the close-out amount due on termination on that future date. Close-out protocols vary a little between the 1992 and 2002 master agreements, but for present purposes they can be treated as identical. Under either, the early termination date has to be at least 20 days after service of the notice of event of default.
Ordinarily, ‘bank A’ will have hedged the risk of your transaction when it entered into it with you. ‘Bank A’ should largely be protected by that hedge against market risk in the period between declaring default and closing out. Indeed, the master agreements provide that the non-defaulting party may include hedging costs in the close-out valuation. Nothing controversial there.
Now, imagine you are a little fortunate as your market position improves somewhat in the period before termination (but not enough to cure the position). When the early termination date arrives, that is reflected in a better close-out valuation for your trade than would have been the case on the date when notice of default was served. However, ‘bank A’ includes larger than expected claims for hedging costs in its valuation. It is, as ever, unrealistic to expect great transparency. Details of trades and pricing may be absent or thin, and supporting materials are unlikely to be volunteered.
Close-out chicanery
But, with the fortitude of a sensible defaulting party (and tenacious advisors), you probe ‘bank A’ about the valuation. You press for the detailed calculations behind the headline figures, and for evidence supporting them. Skill and persistence eventually uncovers that large sums are demanded for the losses incurred on new ‘hedging’ transactions entered into around the date of service of notice of default (so three weeks or so before the valuation).
There is an expectation that any losses can be claimed as hedging costs
What are these transactions? Well, these turn out to be new trades ‘bank A’ entered into in the same direction as it sees your trade, so in the opposite direction to its original hedge. Just as you have made some relative gains since the default notice was served, so these trades lost money for ‘bank A.’ Therefore ‘bank A’ says that it is entitled to claim the losses on the new trades as costs of adjusting its hedging.
There are two questions which arise. The first is a legal one – are the costs of such ‘counterhedges’ entered into around service of the notice of event of default costs which can be lawfully claimed from the defaulting party in the close-out amount due under the ISDA framework? After considered legal analysis, my view is that they are not.
The second question is practical. Why would ‘bank A’ enter into these new ‘counterhedges,’ especially when they cancelled out the prior hedge which was its protection against market risk? One reason might be it perceives credit risk on your leg of the trade, although in our view that does not provide the basis for a lawful claim under the ISDA valuation mechanism.
The more cynical view is that if there is an expectation that any losses can be claimed as hedging costs, there is no reason not to place a directional bet. In our experience of how close-outs work, ‘bank A’ is unlikely to be economically irrational enough to volunteer to give credit for any such trade which made money – they would simply become unconnected rewarding trades.
In reality, this is not a fictional scenario. I have witnessed a number of investment banks executing this strategy in close-outs where they have attempted to demand very significant losses on such ‘counterhedges’ under the cloak of generalised ‘hedging costs.’