Derivatives ' Cayman Counterparty Considerations In Market Uncertainty

• Published date: 29 May 2020
• Author: David Lee and Dean Bennett
• Subject Matter: Finance and Banking, Corporate/Commercial Law, Insolvency/Bankruptcy/Re-structuring, Financial Services, Commodities/Derivatives/Stock Exchanges, Insolvency/Bankruptcy, Contracts and Commercial Law
• Law Firm: Appleby

Unprecedented swings in the financial markets in recent weeks and the ongoing uncertainty surrounding how long the COVID-19 pandemic may last has had, and continues to have, a significant impact on the global derivatives markets and their users. Buy side clients have found themselves left holding trades which are significantly "out of the money" and on the receiving end of unwanted calls for additional margin from their counterparties - in some cases placing further strains on liquidity. Banks and other sell side firms have been looking closely at the solvency of their counterparties and the terms of their derivative trading documentation, and have been left facing difficult decisions on how best to mitigate their exposure to financial losses.

Cayman funds and corporates are frequent users of over-the-counter (OTC) derivative products. In this briefing we consider the enforceability of common set-off clauses found in OTC derivative trading documentation and some key issues to be considered by derivative users looking to mitigate their financial losses when facing a Cayman counterparty in financial difficulty.

Set-Off Clauses

Where two parties have financial claims against each other, a set-off right allows the parties to deduct one liability from the other so that only a single balance payment is due. In the case of a termination and close-out scenario, set-off is a key loss mitigation tool which enables a non-defaulting party to reduce or eliminate entirely a liability it may owe to a defaulting counterparty.

Section 6(f) of the 2002 ISDA Master Agreement includes a bilateral set-off provision which provides that an Early Termination Amount payable to one party (the "Payee") by the other party (the "Payer"), in circumstances where, inter alia, there is a defaulting party, will, at the option of the non-defaulting party, be reduced by its set-off against any other amounts ("Other Amounts") payable by the Payee to the Payer (whether or not such Other Amounts arise under the ISDA Master Agreement). Unlike the 2002 ISDA Master Agreement, the 1992 ISDA Master Agreement does not contain a set-off clause as standard but parties are free to incorporate one into the Schedule and frequently do. Moreover, it is not uncommon for parties to modify and expand the scope of the set-off clause in their ISDA Master Agreements to bring in amounts owing to or by affiliates of the non-defaulting party (sometimes referred to as "multi-lateral", "cross-affiliate" or...