banking and finance
BY Kelle Gagné
South Africa: Coronavirus (COVID-19) | illegal and impossible performances under derivatives transactions – contractual provisions and South African common law
Some reports claim that as many as one third of people around the world are subject to some degree of lockdown to stem the coronavirus (COVID-19) rate of infection. As a result, businesses everywhere are facing unprecedented circumstances that most of us would agree could never have been imagined, and certainly not anticipated, in negotiating a contract. Many such businesses are likely looking at their contractual obligations and evaluating whether they are able to perform the obligations. Although parties will not have anticipated the lockdowns, the 2002 ISDA Master Agreement (the “ISDA Master”) contains two “termination events” pursuant to which one or both parties may have a right to terminate transactions that it cannot perform due to lockdown. In addition, South African common law recognises an exception to the contractual principal of pacta sunt servanda – that parties are bound to keep their agreements – where supervening events make it impossible for a party to perform its obligations under an agreement.
Firstly, under section 5(b)(i) of the ISDA Master, a party can terminate a transaction due to an “illegality” if, after giving effect to any other remedy or provision provided in the transaction confirmation (incorporating the relevant definitions published by the International Swaps and Derivatives Association, Inc. (“ISDA”) or the ISDA Master) it is illegal for such party to make, deliver or receive payments or deliveries, or comply with any obligations, relating to the transaction. The illegality needs to arise due to an event that is not an action taken by the party itself, and the applicable law must affect the office through which the party normally makes, delivers or receives payment or delivery, or complies with obligations, of the relevant transaction.
In the current environment, it is unlikely that the parties would find themselves in an illegality situation in relation to payments or delivery of dematerialised securities (at least in South Africa, as payments and deliveries through the banks, the JSE and settlement systems are working as usual), but in respect of deliveries or compliance with other obligations it could be that due to a jurisdiction’s “lockdown rules” a particular delivery or performance is temporarily illegal. Of course, the parties would also be free to agree that performance of the obligation will take place once the illegality no longer exists, if, as is the case with the lockdown, it will likely be temporary.
Secondly, under section 5(b)(ii), a party can terminate a transaction due to a “force majeure event” if, after giving effect to any other remedy or provision provided in the transaction confirmation (incorporating the relevant definitions published by ISDA) or the ISDA Master, it becomes impossible or impracticable using reasonable effort for such party to make, deliver or receive payments or deliveries, or comply with any obligations, relating to the transaction due to a force majeure or an act of state (intended to cover actions by sovereign states that do not constitute an illegality, eg an act by a foreign sovereign state). The force majeure event must have arisen due to an event that is not an action taken by the party and the party must not be able to overcome the impossibility using any reasonable efforts.
If the illegality or force majeure event continues to exist after expiry of the stipulated waiting period (generally three local business days or eight local business days, respectively), either party may terminate those transactions that are affected. An exception, however, is that if the obligation that cannot be performed is an obligation of a party’s “credit support provider”, such as a guarantor, then only the other party can terminate after expiry of the waiting period.
Similar to a force majeure event, the South African common law exception relating to supervening impossibility may apply to a contractual obligation if the performance by a party (i) has become objectively impossible, (ii) due to no fault of the non-performing party, and (iii) as a result of an unavoidable and unforeseen event. That party may then be released from its obligation to perform and the contract will, as a general rule, be terminated. Given, however, that possible impossibility of performance has been contracted for by the parties in the force majeure event, the exception of supervening impossibility will likely only be useful if the parties disapplied the force majeure event clause when negotiating their ISDA Master.
A party that is experiencing difficulty in performing should note that terminating a derivative transaction due to illegality or a force majeure event will not entitle either of the parties to simply walk away from the transaction. In fact, terminating a transaction may ultimately prove to be a costly proposition. Section 6(e) of the ISDA Master sets out a detailed process for determining an amount payable by one party to the other. Factors that will figure into the calculation include whether the illegality or force majeure event affects both parties or only one party, the values of any payments or deliveries that became due but were not fulfilled prior to the date of termination and a valuation, by one or both parties, of the cost of entering into a replacement transaction under then prevailing circumstances, determined in accordance with section 6 of the ISDA Master.
Whether or not a particular act or performance is illegal is likely to be fairly clear. On the other hand, the term “force majeure event” is not defined in the ISDA Master and will be a matter of common law in each jurisdiction. What constitutes a force majeure event must be interpreted under the governing law of the relevant ISDA Master. At a high level, however, under the common law jurisdictions a force majeure event will require the proclaiming party to show it was (a) objectively prevented, hindered or delayed from performing its contractual obligations by the force majeure event, (b) the event and the party’s inability to perform under the contract were beyond its control, and (c) there were no steps the party could have reasonably taken to avoid the event or its consequences. In relation to the prevention, hindrance or delay, it is usually a requirement that the party must show it was physically prevented from performing or complying. It is not sufficient only that performance or compliance has become more expensive than expected, that the risk being hedged no longer exists or that a hedge is no longer useful in a party’s current circumstances. For a discussion of what constitutes force majeure under South African law, click here.
Parties should also note that there is a specified procedure to be followed in declaring an illegality or force majeure event under the ISDA Master, including in respect of notices, timing and calculation of a termination amount payable by one party to the other. It is important, for example, that a termination notice is sent in accordance with the notice provisions of the ISDA Master in order to be effective, and that it takes into account any fallbacks or remedy periods provided in respect of the affected transaction, and that the termination notice comes after the waiting period stipulated in section 5 of the ISDA Master. In addition, other factors to consider may be that if a branch is unable to perform due to an illegality or force majeure event, the head office of the party may be required to attempt performance.
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COVID-19, also known as the Coronavirus, is an infectious disease caused by severe acute respiratory syndrome coronavirus 2 (SARS-CoV-2) that was declared a pandemic by the World Health Organization on 11 March 2020. The disease has since been reported in over 190 countries.
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