Financial sanctions on derivatives could constitute friendly fire
When considering sanctions, it is natural to think of the sanctioned party (the targeted entity) as the party that is punished. However, for financial sanctions it is important to bear in mind that the targeted entity is often not directly subject to the law of the country imposing the sanctions. Rather, a country imposing financial sanctions typically does so by prohibiting entities that are subject to its jurisdiction, such as banks and financial institutions (home firms), from doing business with the targeted entity. Thus the home firms are themselves directly subject to the sanctions, by being prohibited from doing business with the targeted entity. The fact that financial sanctions take effect through home entities creates the risk that the home entities, rather than the targeted entities, are the ones that take the greatest hit.
Recent financial sanctions have tended to involve prohibitions on new transactions and investments while allowing already agreed transactions to continue to be performed and existing investments to stay in place. This was the case for the financial sanctions that have been in place since 2014 following the Russian incursions into Crimea and eastern Ukraine, and subsequently strengthened following the Salisbury poisonings in 2018. However, western governments have made clear that sanctions that could be applied on a full invasion of Ukraine would be severe. The chair of the US Senate foreign relations committee has warned of the “mother of all sanctions”, while the UK Foreign Secretary has stated that no UK business or individual would be able to transact with the targets of sanctions. The possibility of sanctions that would make meeting payment obligations on existing derivatives illegal was noted in a white paper published by the International Swaps and Derivatives Association (ISDA) in 2019, and potentially this could be among the arsenal of possible sanctions being considered.
Effect of a prohibition of payments restriction on derivatives
Home firms dealing with Russian parties will commonly have their derivatives and foreign exchange transactions governed by the ISDA master agreement, which comes in two versions, one published in 1992 (the 1992 ISDA) and another published in 2002 (the 2002 ISDA). The differences between the 1992 ISDA and 2002 ISDA in part reflect lessons learned from the experience of the 1998 Russia default, in the course of which Russia prohibited its banks from making payments on non-deliverable forward foreign exchange derivatives. The 2002 ISDA is more commonly used with Russian counterparties, and, although there may be some long-standing relationships that are governed by the 1992 ISDA, our analysis focuses on the 2002 ISDA. The remainder of this section focuses on how the 2002 ISDA may operate if sanctions were imposed that prohibited a home firm from making payments to a sanctions target under existing derivative transactions.
If sanctions make it illegal for the home firm to meet its payment obligations to the targeted entity and the home firm then fails to pay when due, this, in the absence of any saving provision, would constitute an “Event of Default” under the 2002 ISDA, with the home firm as the Defaulting Party. The 2002 ISDA, however, does include a saving provision which allows the home firm to declare an ‘Illegality’ Termination Event and avoid an Event of Default.
Section 5(b)(i) of the 2002 ISDA provides that an Illegality occurs in respect to a party if “due to an event or circumstance … occurring after a Transaction is entered into, it becomes unlawful under any applicable law … for the Office through which such party (which will be the Affected Party) makes and receives payments or deliveries with respect to such Transaction to perform any absolute or contingent obligation to make a payment or delivery in respect of such Transaction, to receive a payment or delivery in respect of such Transaction or to comply with any other material provision of this Agreement relating to such Transaction…”. 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. If the Illegality continues for longer than a three day “waiting period”, either party may terminate the affected transactions. A home firm that is legally prohibited from making payment is the “Affected Party” (because it is the party whose payment obligations have become illegal), while the targeted entity is the “Non-affected Party”.
So far, so good: the home firm finds itself contractually obliged to make payments which are now illegal, but it has the ability to terminate these contractual obligations. Under Section 6(e) of the 2002 ISDA, the Non-affected Party is the “Determining Party” for the purpose of determining the Close-Out Amount to be exchanged between the parties in respect of the terminated transactions. The Close-out Amount represents the market value of all the derivative transactions governed by the relevant 2002 ISDA, boiled down into one net sum payable by one party to the other. It is paid by the party who is ‘out-of-the-money’ on a net basis regardless of whether that party is the Affected Party or Non-affected Party. Section 6(e) of the 2002 ISDA provides that the Close-out Amount is “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 realised under then prevailing circumstances (expressed as a negative number) in replacing, or in providing for the Determining Party the economic equivalent of [the] Terminated Transactions …”. Section 6(e)(ii)(3) provides that for an Illegality, the Determining Party (i.e. the targeted entity) is 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. The Determining Party must use commercially reasonable procedures to produce a commercially reasonable result.
This means that if, as a consequence of being unable to pay due to sanctions, a home firm terminates for Illegality, the targeted entity would determine the value of the terminated transactions and thus the Close-out Amount that now needs to be exchanged between the counterparties. If we consider the practical steps the targeted entity might take in order to do this, pitfalls start to appear. The fact that the targeted entity determines the value of the derivatives gives significant control to that party, and there are difficult questions to be considered as to the extent to which the overarching contractual obligation to use commercially reasonably procedures to produce a commercially reasonable result would operate as a fetter on the targeted entity. In order to show that it has used commercially reasonable procedures, the targeted entity might decide it needs external data in order to support its determination. The definition of Close-out Amount offers a few options as to what external data can be used. As noted above, Section 6(e)(ii)(3) requires any third party quotation to be a “mid-market quotation”. If the Russian targeted entity decides to seek a mid-market quotation, since it cannot do business with the non-Russian home firms, it has little option but to approach Russian firms. Unfortunately, despite its use in the 2002 ISDA, the term “mid-market quotation” does not have an accepted meaning. Quotes can be a bid quote or an offer quote, but there is no such thing as a mid-market quotation. Perhaps a reasonable interpretation would be to say that a mid-market quotation is the mean of the highest available bid quote and the lowest available offer quote. However, if the bulk of transaction executions occur closer to the bid than the offer, or vice versa, a dealer might reasonably determine the “mid-market quotation” according to where the bulk of the executions occur. Further, in the context of sanctions it is possible that a large disparity will develop between the prices in Moscow and those elsewhere. If a Russian dealer approached by the targeted entity for a quote decided that the mid-point in the non-Russian markets was the one to use, and this happened to produce a favourable result for the targeted entity, how could the home firm disagree? Equally if the dealer were to decide that the mid-point of the Russian markets was the one to use since that was the only market that the targeted entity had available to it, then, given that the price is the middle of the range at which the targeted entity might be able to trade, it would be far from straightforward for the home firm to successfully challenge this.
Where does this leave the home firm? The scenario above is just one example of a myriad of ways the determination of the Close-out Amount could play out, but ultimately the only grounds of challenge are on the basis that the targeted entity did not use commercially reasonable procedures or did not achieve a commercially reasonable result. The burden of proof is with the home firm. Taking the example above, they would need to prove either that approaching the Russian dealer for a mid-market quotation was not a commercially reasonable procedure or that the weight given to that quotation in determining the Close-out Amount did not produce a commercially reasonable result. This will be an uphill struggle.
For those transactions that are subject to the 1992 ISDA, the result is similar, but in one aspect materially worse: under the 1992 ISDA the determination of the amount to pay is, broadly speaking, based on the targeted entity’s cost of entering into replacement transactions. If the home firm is out of the money on its derivative transactions, it would be on the hook to pay the targeted entity’s replacement cost, however poor the price.
ISDA has published a guidance note on sanctions and derivatives that addresses this problem by proposing an Additional Termination Event specifically tailored to a sanctions scenario. The ISDA sanctions termination event reverses the position described above such that the home firm would value the derivative if it were terminated due to sanctions, and not the sanctioned entity. Despite this, we expect that relatively few parties will have incorporated such a term into their agreements, in part due to the difficulties of agreeing sanctions-related terms.
The significance for non-derivative transactions and for investments
Some other common financial transaction types are similarly vulnerable. The standard master agreement for repurchase transactions (repos), the Global Master Repurchase Agreement (the GMRA), does not deal with the possibility that a party might find it illegal to make payments. This means that a failure by a home firm to pay a targeted entity under a repo would be treated as an event of default under the GMRA. This will give a result that is in substance no different from that which would occur if the home firm failed to pay due to lack of financial resources. This would mean that the targeted entity would be free to sell all securities and collateral it has received, and demand that the home firm pay the targeted entity’s purchase cost of the securities that the home firm had received on the repos. Given the circumstances of the sanctions, the prices achieved by the targeted entity on sale are likely to be poor, while the targeted entity’s purchase cost for replacement securities may involve a premium. Both of these will increase the amounts that the home firm must pay the targeted entity. The master agreement for stock loans, the Global Master Stock Lending Agreement, takes the same approach as the GMRA and leads to the same result.
Similar considerations arise in the context of forced divestments. If home firms are obliged to disinvest from assets associated with a targeted entity, such as securities issued by the targeted entity or property held in the sanctioned country, the purchaser of the divested asset can only be a party that is not restricted by the sanctions, likely leading to only low offer prices being available. The party suffering the cost of the sanctions will be the home firm forced to sell at a poor price, and this might not be the only unintended effect of forced divestment. If we suppose that some Russian assets are subject to forced divestment, then non-Russian parties not directly subject to sanctions may have little appetite to buy assets that could be subject to further measures.
The appropriate scope of financial sanctions
It is important that financial sanctions are drafted with the market-standard contractual framework (such as the ISDA and GMRA) in mind. Ideally, outright prohibitions would be restricted to new financial transactions and acquisitions. Existing contractual protections, such as the close-out and netting provisions in the ISDA, should be preserved. Some financial contracts do contain termination rights for financial service providers at little cost, and home firms could be encouraged to terminate existing transactions where they have such rights. However, sanctions should not extend to a mandatory requirement to terminate existing transactions or otherwise refuse to perform on existing contractual obligations where this could result in a material economic loss for the home firm, or to force divestment where a home firm would be obliged to accept a material discount on sale.
This article is part of a Macfarlanes series on the potential legal consequences of the Russia/Ukraine conflict. For background and discussion of some of the options available to the UK Government as a matter of law and policy, please see the first part of the series: Russia/Ukraine conflict: what might the UK’s “unprecedented package of sanctions” look like?
We've also produced a podcast where we discuss the potential financial sanctions options available to the UK Government. Listen below: