Legal Concepts Lecture (5) - Derivatives

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University of Oxford

Faculty of Law
BCL/MJur/MLF 2020-21
LEGAL CONCEPTS IN
FINANCIAL LAW

Lecture 5

Simple financial positions (2) - Derivatives

BCL/Mjur/MLF 2020-21
Demystifying derivatives

2
Plan of lecture
Part 1
 1. What is a derivative?

 2. Forwards and futures

 3. Options

 4. Swaps

 5. Credit derivatives

Part 2
 6. Documentation of derivatives

 7. Capacity and mis-selling

 8. Re-characterisation risk

 9. Some policy considerations

3
1. What is a derivative?

4
What is a derivative?
Definition
 A transaction under which the future obligations of one or
more of the parties are linked in some specified way to
another asset or index, whether involving the delivery of
the asset or the payment of an amount calculated by
reference to its value or the value of the index.
 The transaction is therefore treated as having a value
which is separate (although derived) from the values of
the underlying asset or index. As a result, the parties'
rights and obligations under the transaction can be
treated as if they constituted a separate asset and are
typically traded accordingly
◦ Firth at 1.04 – cited in Lomas v JFB Firth Rixson Inc [2012] EWCA Civ 419 at [1]

5
What is a derivative?
Contracts for differences
 Most (though not all) derivative contracts are

contracts for differences

 in that they are intended to be cash settled, ie

◦ fulfilled by the payment of differences in price and not by


delivery
Universal Stock Exchange Ltd. v. Strachan [1896] AC 166
Applied in City Index Ltd v Leslie [1992] QB 98

 See the Regulated Activities Order Art 85, which also includes:

◦ any other contract the purpose or pretended purpose of which is to secure a


profit or avoid a loss by reference to fluctuations in (i) the value or price of
property of any description; or (ii) an index or other factor designated for that
purpose in the contract.
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What is a derivative?
Four basic types of transaction
 Forward
◦ I sell [X] to you for price [Y], delivery on date [Z]

 Option
◦ I have the right (but not the obligation) to sell [X] to you for price [Y], delivery on date
[Z]

 Swap
◦ If you pay me amounts equal to LIBOR + 1% on [GBP XXX], I will pay you amounts
equal to 1.5% pa on the same amount

 Credit Derivative
◦ You will buy this [GBP XXX] bond from me at [GBP XXX] if the issuer defaults.

 Each is a form of transaction in which the market risk of the underlying asset
is transferred, usually in exchange for credit risk
 But sometimes in exchange for cash or other market risk
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2. Forwards and futures

8
Forwards and futures
Definition
A [forward] contract is a legally binding
commitment to deliver at a future date, or take
delivery of, a given quantity of a commodity,
or a financial instrument, at an agreed price
◦ SCF Finance Co Ltd v Masri [1987] QB 1002 at 1007, per Slade LJ

A short forward sale is one where, at the time


when the contract is made, the seller does not
hold the asset being sold

9
Forwards and futures
Terminology (1)
 Under a forward contract:
The buyer has a long position
The seller has a short position
in the reference assets

 Those with long positions make profits when the price of


the reference assets goes up, and losses when it goes down

 Those with short positions make profits when the price of


the reference asset goes down, and losses when it goes up.

10
Forwards and futures
Terminology (2)
 The spot price (or market price) is the price of the
asset in the market

 The strike price is the price agreed under the


transaction

 The delivery/forward price is the price of the asset at


the delivery date

 The cost of carry is the difference between the strike


price and the current market price

11
Forwards and futures
Terminology (3)
Margin
 Margin is a sum put up as security, either with the counterparty or a clearing
house.
 May be a regulatory (eg under EMIR) and/or a contractual requirement

 Initial margin is the margin required when the transaction is entered into.

 Maintenance margin is the minimum level that must be maintained in a margin


account following a trade
 Marking to market is the process of comparing the strike price to the market
price, to assess the extent to which the transaction is out of the money (and often
the extent of margin therefore required)

 Variation margin is the amount required to bring a margin account up to the


required level

 A margin call is a demand for additional margin


12
Forwards and futures
Futures
 Forward contracts on exchanges are known as
futures contracts
◦ The contract is standardised in all respects, except with regard
to price and terms of delivery. Standardisation of contracts
allows interchangeability with all other contracts of the same
delivery period. This allows buyers and sellers to offset or
liquidate any of their open positions with an equal and opposite
transaction of a futures contract. Less than 2% of futures
contracts culminate in the actual delivery of the physical
commodity.
◦ SCF Finance Co Ltd v Masri [1987] QB 1002 at 1007, per Slade LJ

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3. Options

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Options
Terminology (1)
 A call option is the right (but not the obligation) to
acquire an asset in the future at a price (the strike price)
fixed when the option is entered into
 A put option is the right (but not the obligation) to sell

an asset in the future at a price (the strike price) fixed


when the option is entered into
 The person who grants an option is typically called the

writer, seller or grantor of the option


 The person who is given the option is typically called

the buyer or grantee

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Options
Terminology (2)
 An option is in the money when it is profitable, and out of the
money when it is not
◦ So a put option is in the money when the strike price exceeds the market
price
 An option traded on an exchange is a traded option.
 An off-exchange option is an over the counter or OTC option

◦ But note that EMIR requires entities that enter into any form of
derivative contract not only to report every derivative contract that
they enter into to a trade repository, but also to:
 Clear certain standardized OTC derivatives through a regulated
CCP (central clearing)
 Implement new risk management standards, including operational
processes and margining, for all OTC derivatives that are not
cleared by a CCP (bilateral clearing).
16
Options
Terminology (3)
 An American-style option
◦ may be exercised at any time before the option expires
(though, on some markets, certain “in the money” options are
automatically exercised)

 A European-style option
◦ may be exercised only at expiration

 A Bermudan option
◦ may be exercised on any one of a number of specified days

17
Options
Terminology (4)
 In an Asian option, the strike price is not set at the time of the
contract, but is based on an average price determined over a
number of future dates
 A cross option (or composite option) is an option on an
underlying asset in one currency with the strike price
denominated in another currency.
 A quanto option is a cross option in which the exchange rate
is fixed at the outset of the trade
 An exchange option is the right to exchange one asset for
another
 A basket option is an option on the weighted average of
several underlying assets

18
Options
Terminology (5)
 Vanilla vs Exotic

 Standard equity options, involving call options or put options in which the investor is
seeking to profit from his assessment of the likely movement of the market in a particular
stock towards or beyond the strike price at which he has purchased his option, are called
Vanilla Options. Exotic Equity Options are derivative products other than Vanilla
Options. They are considerably more complex than Vanilla Options .. At the more
sophisticated end of the Exotic Equity Options trade are Pure Exotic Equity Options .. This
may involve multi-layered transactions of which there are several interlinked options
dependant for their success upon different factors.
◦ Tullett Prebon Group Limited v El-Hajjali [2008] EWHC 1924 (QB) at [4]-[5]

 For 12 months after Termination, you shall not, directly or indirectly undertake, be
employed, engaged or interested in any capacity in the Broking of Commodity and or
Exotic Derivatives including but not limited to Barriers, Calls vs Call, Puts vs Put,
Quantos, Cliquets, Daily Cliquets (Crash protection options), Worst of options, Best of
options, Basket Options, Realized Correlation or Covariance swaps, operating for profit
or otherwise, wheresoever situated
◦ Sunrise Brokers LLP v Rogers [2014] EWHC 2633 (QB) at [7]
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◦ (affmd [2014] EWCA Civ 1373)
Options
Terminology (6)
 A Barrier Option
◦ Is an exotic option on an underlying asset whose existence depends upon
the price of the underlying asset reaching a pre-set barrier level
 The derivative either springs into existence or, if the option already exists,
it is extinguished:
◦ Where the option springs into existence upon the underlying asset's price
reaching the barrier level it is called a knock-in (or up and in, or down
and in) option
◦ Where the option is extinguished upon the underlying asset's price
reaching the barrier level, it is called a knock-out (or up and out or
down and out) option
 See Bank Leumi (UK) plc v Wachner [2011] EWHC 656 (Comm) at [12]-[13]
 A barrier option has a lower premium than a similar option without a
barrier, so provides the hedge of an option at a lower premium than a
conventional option.
20
Options
Risks of buyer and seller
 An option buyer’s risk is limited to the premium. An
option seller’s risk is not usually limited
◦ A purchase gives protection for a defined outlay, while a sale grants
protection to others in return for a defined income. In each case the
protection may or may not be limited, depending on the terms of the
transaction
◦ Bankers Trust International PLC v PT Dharmala Sakti Sejahtera (1995) per Mance J
 The gearing effect of options
◦ The investor who thinks an asset will appreciate can buy a quantity of the asset, or he can buy
an option over the same quantity. To buy the asset costs the full price, and puts all that
capital at risk. To buy the option costs (and risks) only the premium.
◦ For same outlay as buying the original quantity of the asset, the investor could buy an option
over many times that amount, and so have the chance of many times the amount of profit.
◦ However, if he buys the asset, he has the asset. If he buys an option, and it is out of the money,
he loses his entire investment.

21
Options
Risks of buyer and seller (2)
 An example – The Libyan Investment Authority v Goldman Sachs
International (2016) at [2] and [56]-66] per Rose J
 Between September 2007 and April 2008 the LIA and Goldman Sachs
entered into a number of transactions including what have been referred
to in these proceedings as the 'Disputed Trades'. The most important
characteristic of the Disputed Trades for present purposes was that they
were all synthetic derivative trades, comprising a put option and a
forward. Under each trade, the LIA paid a lump sum to Goldman Sachs
(referred to as a premium) in return for which it gained 'exposure' to a
number of shares in a particular underlying company. The Disputed
Trades were also all leveraged which means that the number of shares
to which the LIA gained exposure – called the notional number – was
very many more than the LIA could have bought with the premium.
What 'exposure' means here is that no actual shares were acquired by
the LIA at any time pursuant to the trade.
22
Options
Risks of buyer and seller (2)
 The Libyan Investment Authority v Goldman Sachs
International (continued)
 If the price of the shares in the underlying company rose by
the maturity date of the trade, then Goldman Sachs would
pay the LIA the difference between the share price at the
start of the trade and the share price on the maturity date
multiplied by the total notional number of shares. Depending
on how high the share price rose, Goldman Sachs might have
to pay the LIA a sum greatly in excess of the premium. But if
the price of the shares was the same or lower at the maturity
date than it was at the start of the trades, then Goldman
Sachs kept the premium and the LIA had nothing; no shares
and no money.
23
Options
Pricing an option
 In 1973, Fischer Black and Myron Scholes, published a pioneering mathematical model for
pricing European-style equity option contracts. This (and later) work won Myron Scholes and
Robert Merton the1997 Nobel Prize in Economics (Fischer Black died two years before the
award of the Nobel Prize). Many other pricing models are in use today, but almost all of them
build on the concepts of the original Black-Scholes model.

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4. Swaps

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Swaps
Basic concept
 Under a swap the parties exchange – or swap – income streams.
◦ Though, typically, only the difference is paid.

 A[n interest-rate] swap is an agreement between two parties by which


each agrees to pay the other on a specified date or dates an amount
calculated by reference to the interest which would have accrued over
a given period on the same notional principal sum assuming different
rates of interest are payable in each case .. Normally neither party will
in fact pay the sums which it has agreed to pay over the period of the
swap but instead will make a settlement on a “net payment basis”
under which the party owing the greater amount on any day simply
pays the difference between the two amounts due to the other
◦ Hazell v Hammersmith and Fulham LBC [1990] 2 QB 697 at 739

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Swaps
Caps, floors and collars
 A cap is a transaction in which the seller of the cap will make a payment or payments to the
buyer if interest rates rise above a rate specified in the agreement (the “cap rate”). The
payment to be made will be calculated by reference to the amount by which the current
variable rate exceeds the cap rate applied to a notional principal sum specified in the
agreement for an agreed period of time. In return the purchaser pays the seller a premium fee
for entering into the cap. The transaction thus enables the purchaser in return for a premium to
insure against the consequences of interest rates rising above a pre-determined level.

 An interest rate floor is the reverse of a cap.

 A collar .. is an agreement in which both a cap and a floor are sold in the same transaction ..
In these transactions, if the rate fell below the lowest specified fixed rate of interest or rose
above the highest specified fixed rate of interest during the lifetime of the transaction, the
council, the seller was obliged to make payments
◦ Hazell v Hammersmith and Fulham LBC [1990] 2 QB 697 at 740

 For recent examples of collar transactions, see eg


 Greenclose Ltd v National Westminster Bank plc [2014] EWHC 1156 (Ch), Andrews J
 Crestsign Ltd v National Westminster Bank plc [2014] EWHC 3043 (Ch) (Tim Kerr QC)
 Morley (trading as Morley Estates) v Royal Bank of Scotland plc [2020] EWHC 88 (Ch) (Kerr J)

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5. Credit derivatives

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Credit Derivatives
Basic concept
 A transaction under which the credit risk of a corporate
or sovereign borrower is transferred to an entity other
than the lender or debtholder

 Enables parties to trade the credit risk associated with


debt obligations without also trading those debt
obligations

 Often similar in economic effect to guarantees and


credit insurance: but legal structure and terminology is
different
29
Credit Derivatives
Types
 May be unfunded or funded

 Principal types of unfunded transactions:


◦ Credit Default Swaps
◦ Total Return Swaps
◦ Credit Spreads

 Funded transactions, such as


◦ Credit-linked notes
◦ Synthetic securitisations
will be discussed in Lecture 12

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Credit Derivatives
Credit default swaps

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Credit Derivatives
Credit default swaps - basic concept
 In a typical credit default swap transaction:
◦ The protection seller agrees, in return for a fee, to make a payment
to the protection buyer if, during an agreed period, a specified
credit event occurs in relation to a reference obligation of a
reference entity

 Note:
◦ The protection buyer does not need to own (or otherwise be exposed
to) the reference obligation
◦ Non-payment is usually only one of a number of credit events which
will trigger the protection seller’s obligation
◦ The transaction will usually be cash settled

32
Credit derivatives
Total return swaps
 A total return swap allows the buyer of the derivative to obtain
the economic benefits of the reference asset without actually
owning the asset

 A typical total return transaction is a swap agreement in which:


◦ One party makes payments based on a set rate, either fixed or variable,
while
◦ The other party makes payments based on the return of an underlying
asset (including both the income it generates and any capital gains)

 It transfers both the credit risk and the market risk of the
underlying asset

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6. Documentation of derivatives

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Documentation of Derivatives
Basic concept
 Exchange-traded derivatives necessarily involve standard
form contacts prescribed by the exchange.
◦ The range of underlying assets is limited
◦ They can only be traded in standard lots (trading amounts)
◦ They can only be settled at set maturity dates
 OTC contracts are often tailored to the specific transaction
 However, both exchange-traded and OTC derivatives
normally incorporate one of the published standard
documentation sets
 By far the most frequently used set of documentation in
the London derivatives market is that issued by ISDA

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Documentation of Derivatives
ISDA
 ISDA (which stands for the International Swaps and Derivatives
Association) is a not-for-profit corporation incorporated in the State of New
York.

 It has over 820 member institutions, including most of the world's major
institutions that deal in OTC derivatives, as well as businesses, government
entities and other end users that rely on derivatives to manage the risks
inherent in their core economic activities. Its primary purpose is to encourage
the prudent and efficient development of privately negotiated derivatives
business. For that purpose it has developed standard contractual wording and
transaction architecture for market participants. This first occurred,
historically, in relation to swaps. Since 1992 its standard terms have been used
for numerous other types of derivatives, including pure contracts for
differences, caps and floors. Thus, interest rate swaps are a sub-class of an
original and still very important class of derivatives for which ISDA's standard
forms, and the master agreement in particular, are routinely used
 Lomas v JFB Firth Rixon Inc [2010] EWHC 3372 (Ch) at [7], per Briggs J
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Documentation of Derivatives
Architecture of the ISDA Document Set
 Master Agreement
◦ Plus Schedule

 Confirmation
◦ Long form
◦ Short form

 Definitions

37
Documentation of Derivatives
ISDA Master Agreement (1)
 Can be used for all types of transaction except repos or stocklending

 First appeared in 1987

 Replaced in 1992
◦ Two versions
 Multicurrency cross border
 Single currency local form (not much used)

 Latest (single) version is 2002


 Example on the SEC website at https://www.sec.gov/Archives/edgar/data/1065696/000119312511118050/dex101.htm

 Contains the overall arrangements between the parties, but not the
specific terms of each deal (which are in the Confirmations)
38
Documentation of Derivatives
ISDA Master Agreement (2)
 The 1992 version of the Master Agreement was the first to
be designed in a form applicable to derivatives other than
just swaps, and to accommodate both financially and
physically settled transactions. The 2002 version
replicates many of the provisions of the 1992 version, but
with adjustments based on lessons learnt since 1992, in
particular from experience of periods of market turmoil in
the late 1990s. Nevertheless the publication of the 2002
master agreement did not lead to its invariable use in
preference to its predecessor.
 Lomas and others v JFB Firth Rixon Inc and others (ISDA
intervening) [2010] EWHC 3372 (Ch) at [7], per Briggs J

39
Documentation of Derivatives
ISDA Master Agreement (3) - Interpretation
 Lomas and others v Burlington Loan Management (Waterfall IIC) [2016] EWHC
2417 (Ch), [2017] 2 All ER (Comm) 275 at [48], per Hildyard J

 [48] In the context of the ISDA Master Agreements, and having regard to their intended and
actual use as standard agreements by parties with such different characteristics in a multiplicity
of transactions in a plethora of circumstances, the following principles are also relevant:
 (1) It is 'axiomatic' that the ISDA Master Agreements should, 'as far as possible be
interpreted in a way that achieves the objectives of clarity, certainty and predictability, so that
the very large number of parties using it know where they stand': Lomas v JFB Firth Rixson at
[53] per Briggs J.
 (2) Although the relevant background, so far as common to transactions of such a varied
nature and reasonably expected to be common knowledge amongst those using the ISDA
Master Agreements, is to be taken into account, a standard form is not context-specific and
evidence of the particular factual background or matrix has a much more limited, if any, part to
play: see AIB Group (UK) Ltd v Martin [2001] UKHL 63
 (3) More than ever, the focus is ultimately on the words used, which should be taken to have
been selected after considerable thought and with the benefit of the input and continuing
review of users of the standard forms and of knowledge of the market: see Lehman Brothers
International (Europe) v Lehman Brothers Finance SA [2013] EWCA Civ 188 at [53] and [88].
40
Documentation of Derivatives
ISDA Master Agreement (3) – Interpretation (cont)
 (4) The drafting of the ISDA Master Agreements is aimed at ensuring, among other things,
that they are sufficiently flexible to operate among a range of users in an infinitely variable
combination of different circumstances: Anthracite Rated Investments (Jersey) Ltd v Lehman
Brothers Finance SA (in liq) [2011] EWHC 1822 (Ch) at [115] per Briggs J: particular care
is necessary not to adopt a restrictive or narrow construction which might make the form
inflexible and inappropriate for parties who might commonly be expected to use it.

 (5) That drafting is also aimed, to adopt what was said in an expert report submitted in a
recent case (Lehman Brothers Holdings Inc v Intel Corp (16 September 2015, unreported),
'the Intel case') in the United States Bankruptcy Court for the Southern District of New York
by one of the principal draftsmen of the 1992 ISDA Master Agreement (Professor Jeffrey
Bruce Golden), at 'mitigating the risk of fact-specific disputes and the attendant risk of
protracted litigation' by providing for the parties to have considerable latitude in the exercise
of contractual rights subject to 'general terms of reasonableness and good faith’.

 Cited and applied by the CA in


 The State of the Netherlands v Deutsche Bank AG (2019)

41
Documentation of Derivatives
ISDA Master Agreement
Basic concepts: 1(c)

Single Agreement
 All Transactions are entered into in reliance on the fact that this Master
Agreement and all Confirmations form a single agreement between the
parties (collectively referred to as this “Agreement”), and the parties would
not otherwise enter into any Transactions
◦ 2002 Section 1(c)
 The purpose:
◦ The reason .. for introducing this artificial link is so as to secure that on the
termination of the relationship between the parties it is possible to set off all of the
amounts owed between the parties and to come to one final, net sum which will settle
all of the exposures of the parties one to another, a provision which may assume very
great importance upon insolvency.
◦ The link is designed to avert the risk that the solvent party may be required to make
payment of all amounts which it owes but not be entitled to recover, save through the
relevant insolvency process and to the extent that there is a sufficiency of assets, the
amounts due to it.
◦ BNP Paribas v Wockhardt EU Operations (Swiss) AG at [48], [49] 42
Documentation of Derivatives
ISDA Master Agreement
Basic concepts: 1(c)

Single Agreement
 The rationale for this is that, if there is only one contract between the parties, the
liquidator of an insolvent party will have to choose between enforcing or
disclaiming (under IA86 s 178) the agreement as a whole .. [and] an administrator
cannot choose to enforce only those transactions which are profitable to the
insolvent estate.
o Firth para 5-027

43
Documentation of Derivatives
ISDA Master Agreement
Basic concepts: 1(c)

Single Agreement
 The fact that a provision to this effect is included in a master agreement, however, will
not necessarily be conclusive.
 In one sense, transactions entered into at different times clearly do amount to separate
contracts: each is separately agreed upon and supported by separate consideration.
However, in itself, this is not inconsistent with the single agreement concept. An
agreement to vary the terms of an existing contract, for example, is a separate contract for
the same reasons, yet once it has been entered into it has no independent life. It is
conceivable, therefore, that a new transaction entered into under a master agreement
could take effect as an amendment to the rights and obligations under that agreement.
 In the derivatives market, the reality is that market participants often treat transactions as
having a continued separate existence. This can be seen clearly with options and credit
default swaps, which are exercised independently of other transactions. However, even
with quite straightforward transactions, the language used by participants in the
derivatives market .. frequently implies that they continue to exist independently of other
transactions between the parties, rather than being mere additions to the payment and
delivery obligations under the master agreement they have entered into.
o Firth paras 5-027 and 5-041 to 5-043 44
Documentation of Derivatives
ISDA Master Agreement
Basic concepts: 2(a)(i)

Payment and delivery


 Each party will make each payment or delivery
specified in each Confirmation to be made by it, subject
to the other provisions of this Agreement.
 2002 Section 2(a)(i)

45
Documentation of Derivatives
ISDA Master Agreement
Basic concepts: 2(a)(i)

Payment and delivery


 Problem with negative interest rates:
◦ 2006 ISDA Definitions provide for alternatives, at the parties’ choice: either
the Negative Interest Rate Method, under which the absolute value of the
negative floating rate is payable, or the Zero Interest Rate Method, which
effectively provides for a zero floor.
◦ In May 2014, ISDA issued its “Collateral Agreement Negative Interest
Protocol” designed to be used to modify ISDA compliant collateral
agreements, including the Credit Support Annex.
 In The State of the Netherlands v Deutsche Bank AG (2019) the CA
held that
◦ The standard form ISDA Credit Support Annex does not not provide for the
payment of negative, as opposed to positive, interest.

46
Documentation of Derivatives
ISDA Master Agreement
Basic concepts: 2(a)(iii)

Payment and delivery


 Each obligation of each party under Section 2(a)(i) is
subject to
◦ (1) the condition precedent that no Event of Default or Potential
Event of Default with respect to the other party has occurred and
is continuing
◦ (2) the condition precedent that no Early Termination Date in
respect of the relevant Transaction has occurred or been effectively
designated, and
◦ (3) each other condition specified in this Agreement to be a
condition precedent for the purpose of this Section 2(a)(iii).
 2002 Section 2(a)(iii) 47
Documentation of Derivatives
ISDA Master Agreement
Basic concepts: 2(a)(iii)(continued)
Effect of Section 2(a)(iii)
 s 2(a)(iii) applies only to obligations which arise after the relevant default by the
counterparty.
 Where it applies, obligation of non-defaulting party is suspended, rather than
extinguished, during the currency of an event of default, and will revive if the event
of default is cured at any time before the outstanding transactions were terminated
 Not necessary to imply a term that the obligation would revive on the maturity of
the transaction or all outstanding transactions
 No terminus, either by way of extinction or revival, to the condition precedent under
2(a)(iii). It continues in force until the event of default is cured. If it is never cured,
continues to be no obligation on the non-defaulting party to make payment
 The operation of section 2(a)(iii) on insolvency does not engage the anti-deprivation
principle or breach the pari passu rule
 Lomas v JFB Firth Rixson Inc (CA, 2012)

 Contrast September 2009 decision of US Bankruptcy Court in Metavante


◦ Section 2(a)(iii), if operated on bankruptcy, is unenforceable as an “ipso facto clause” that does not fall
within the “safe harbor” provisions of the US Bankruptcy Code.
48
Documentation of Derivatives
ISDA Master Agreement
Basic concepts: 2(a)(iii) (continued)

ISDA 19 June 2014 Amendment to Section 2(a)(iii)


 May be adopted as part of either the 1992 or the 2002
version of the ISDA Master Agreement.

 Entitles the party that is subject to an Event of Default


to serve a notice on the Non-defaulting Party, requiring
the Non-defaulting Party at the end of a specified
period (the Condition End Date) to elect either to make
its scheduled payments or deliveries and continue the
contract, or to designate an Early Termination Date.
49
Documentation of Derivatives
ISDA Master Agreement
Basic concepts: 2(c)

Netting of payments
 If on any date amounts would otherwise be payable (i) in the same
currency; and (ii) in respect of the same Transaction, by each party to
the other, then, on such date, each party’s obligation to make payment
of any such amount will be automatically satisfied and discharged and,
if the aggregate amount that would otherwise have been payable by one
party exceeds the aggregate amount that would otherwise have been
payable by the other party, replaced by an obligation upon the party by
which the larger aggregate amount would have been payable to pay to
the other party the excess of the larger aggregate amount over the
smaller aggregate amount.
 Section 2(c)

 Parties may also elect for Multiple Transaction Payment Netting

50
Documentation of Derivatives
ISDA Master Agreement
Basic concepts: 5

Events of Default and Termination Events


 Events of Default give the non-defaulting party the
right to specify an Early Termination Date in respect
of all outstanding transactions
 Termination Events (if they cannot be avoided by a

Transfer to Avoid Termination Event) may also give


one or other party the right to specify an Early
Termination Date in respect of affected transactions
 The Schedule may also provide for Automatic Early

Termination

51
Documentation of Derivatives
ISDA Master Agreement
Basic concepts: 5 (continued)

Events of Default
 Failure to Pay or Deliver
 Breach of Agreement; Repudiation of Agreement
 Credit Support Default
 Misrepresentation
 Default Under Specified Transaction
 Cross-Default (if specified in the Schedule)
 Bankruptcy
 Merger Without Assumption

52
Documentation of Derivatives
ISDA Master Agreement
Basic concepts: 5 (continued)

Termination Events
 Can occur without fault; affected party may have grace
period; only transactions affected can be closed out;
may be differences in calculating close-out amount
◦ Illegality
◦ Force Majeure Event
◦ Tax Event
◦ Tax Event Upon Merger
◦ Credit Event Upon Merger (if specified in the Schedule)
◦ Additional Termination Events

53
Documentation of Derivatives
ISDA Master Agreement
Basic concepts: 6

Consequences - close-out netting


 2002 ISDA Master provisions

 Obligation to perform primary obligations ends, and is replaced by obligation to pay the
Early Termination Amount

 If the Early Termination Date results from an Event of Default, the Early
Termination Amount will be an amount equal to (1) the sum of (A) the Termination
Currency Equivalent of the Close-out Amount or Close-out Amounts (whether
positive or negative) determined by the Non-defaulting Party for each Terminated
Transaction or group of Terminated Transactions, as the case may be, and (B) the
Termination Currency Equivalent of the Unpaid Amounts owing to the Non-
defaulting Party less (2) the Termination Currency Equivalent of the Unpaid
Amounts owing to the Defaulting Party. If the Early Termination Amount is a
positive number, the Defaulting Party will pay it to the Non-defaulting Party; if it is
a negative number, the Non-defaulting Party will pay the absolute value of the
Early Termination Amount to the Defaulting Party
 2002 Section 6(e)(i)
54
Documentation of Derivatives
ISDA Master Agreement
Basic concepts: 6 (continued)

Consequences - close-out netting


 2002 ISDA Master provisions
 Close-out Amount means, with respect to each Terminated Transaction or each
group of Terminated Transactions and a Determining Party, 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, (a) the material terms of that
Terminated Transaction or group of Terminated Transactions, including the
payments and deliveries by the parties under section 2(a)(i) in respect of that
Terminated Transaction or group of Terminated Transactions that would, but for
the occurrence of the relevant Early Termination Date, have been required after
that date (assuming satisfaction of the conditions precedent in section 2(a)(iii)) and
(b) the option rights of the parties in respect of that Terminated Transaction or
group of Terminated Transactions.
 Section 14 (Definitions) 55
Documentation of Derivatives
ISDA Master Agreement
Basic concepts: 6 (continued)

Consequences - close-out netting


 Any Close-out Amount will be determined by the Determining Party (or its agent),
which will act in good faith and use commercially reasonable procedures in order to
produce a commercially reasonable result.
 Section 14 (Definitions)
 "[The provision] clearly imposes two objective standards. The first is that the
procedures used should be commercially reasonable and the second is that the result
produced should also be commercially reasonable. Plainly, that leaves a bracket or
range both of procedures and results within which the Determining Party may
choose .. It nonetheless imposes an objective standard which, if for example the
Determining Party refused to determine a Close-out Amount at all, could be applied
by the court itself”
 LBIE v LBF SA (2012) per Briggs J
 The fact that there was a range did not mean that the determining party could simply
take the result which suited it best. It had to use procedures that were objectively,
commercially reasonable in order to produce, objectively, a commercially reasonable
result
 LBSF Inc v National Power Corporation (2018) per Robin Knowles J
56
Documentation of Derivatives
ISDA Master Agreement
Basic concepts: 6 (continued)

Consequences - close-out netting


 Contrast the 1992 ISDA Master provisions
◦ The parties are supposed to elect in the Schedule to the Agreement a
payment measure (either “Market Quotation” or “Loss”) and a payment
method (either “First Method” or “Second Method”).

◦ If no election has been made, then “Market Quotation” is deemed to be the


measure and “Second Method” is deemed to be the method.

◦ If Second Method and Market Quotation apply, then an amount will be


payable broadly equal to (a) the sum of the “Settlement Amount”
determined by the Non-defaulting Party in respect of the Terminated
Transactions and the “Unpaid Amounts” owing to the Non-defaulting Party
less (b) the “Unpaid Amounts” owing to the Defaulting Party
57
Documentation of Derivatives
ISDA Master Agreement
Basic concepts: 6

Consequences - close-out netting


 In making these calculations, the 1992 Master requires it to be
assumed that each applicable condition precedent has been satisfied.
 This means that the loss of bargain must be valued on an
assumption (the continuity or value-clean assumption) that, but for
termination, the transaction would have proceeded to a conclusion,
and that all conditions to its full performance by both sides would
have been satisfied, however improbable that assumption may be in
the real world
 Lomas v JFB Firth Rixson
 Any positive number will be paid to the Non-defaulting Party by the
Defaulting Party; the absolute value of any negative number will be
paid to the Defaulting Party by the Non-defaulting Party
58
Documentation of Derivatives
ISDA Master Agreement
Basic concepts: 6 (continued)

Consequences - close-out netting


 Back to the 2002 ISDA Master provisions
 It is wrong, in making the calculation required by the
2002 ISDA Master Agreement to make the continuity or
value-clean assumption made under the (different)
provisions of the 1992 Master
◦ LBIE v LBF (CA, 2013)

59
Documentation of Derivatives
Confirmations
Basic concepts
 No requirement for writing. Oral contracts valid
 Transactions usually confirmed in writing.
 In the ISDA Architecture, the Confirmation will contain the specific
terms of the particular transaction
 Terms of Confirmation may deem Master Agreement to exist
◦ Until we execute and deliver that agreement, this Confirmation, together with all
other documents referring to an ISDA Master Agreement (each a
"Confirmation") confirming transactions (each a Transaction") entered into
between us shall supplement, form a part of, and be subject to, an agreement in
the form of the 2002 ISDA Master Agreement as if we had executed an
agreement in such form (but without any Schedule except for the election of
[English law] [the laws of the State of New York] as the governing law [and
specify currency] as the Termination Currency]) on the Trade Date of the first
such Transaction between us
 Terms of Master Agreement may be incorporated by course of dealing
 Calyon v Wytwornia Sprzetu Komunikacynego PZL Swidnik SA
60
Documentation of Derivatives
ISDA Definitions
Basic concepts
 Often incorporated by the Confirmation
 Cover many types of transaction
◦ 1997 ISDA Government Bond Option Definitions
◦ 1998 FX and Currency Option Definitions
◦ 2005 ISDA Commodity Derivatives Definitions
◦ 2006 ISDA Interest Rate and Currency Derivatives Definitions
◦ 2007 ISDA Property Index Derivatives
◦ 2008 ISDA Inflation Derivatives Definitions
◦ 2011 ISDA Equity Derivatives Definitions
◦ 2014 ISDA Credit Derivative Definitions

 Often contain substantive obligations not spelled out elsewhere


◦ See eg the Conditions to Settlement in the Credit Derivative Definitions
 Upon the occurrence of a Credit Event applicable to a Credit Derivative
Transaction and satisfaction of all the Conditions to Settlement .. The parties shall
perform their respective obligations in accordance with the applicable Settlement
Method 61
7. Capacity and mis-selling

62
Capacity and mis-selling
Ultra vires
 Derivative contracts are still contracts
 So still subject to normal contractual rules, including capacity and
pre-contract misrepresentation
 The ratio of the Hazell case has mostly been superseded by
statutory changes in LA powers, but foreign state corporations still
try to take the capacity point
 See, for example:
◦ Credit Suisse International v Stichting Vestia Groep (2014), where the
capacity argument succeeded, but Andrew Smith J still held the defendant
Dutch social housing association liable, for misrep/breach of the additional
warranties as to capacity in the Master Agreement
◦ Ukraine v The Law Debenture Trust Corporation Plc (2018), where the CA
rejected Ukraine’s argument that because, under Ukrainian law, the state
lacked the capacity to issue the Notes, it should be treated under English law
as lacking that capacity, despite being a sovereign state.
63
Capacity and mis-selling
Mis-selling
 Derivatives linked to LIBOR sold by banks linked to allegations of
LIBOR rigging may be vulnerable to challenge
◦ Eg Graiseley v Barclays; Deutsche Bank v Unitech (2013)
◦ Property Alliance Group v RBS (2018)
◦ Marme Inversiones 2007 SL v Natwest Markets Plc (2019)
 Mis-selling of interest-rate derivatives to SMEs by lending banks
was so widespread that, in May 2013, the FSA (now the FCA)
required the banks to conduct a review of all sales of interest rate
hedging products to unsophisticated customers since 2001. See eg
◦ R (Holmcroft) v KPMG (2016)
◦ CGL Group v RBS (2017)
◦ Elite Property Holdings Ltd v Barclays Bank plc [2018] EWCA Civ 1688,
[2018] 2 BCLC 460; [2019] EWCA Civ 2212; Elite Property Holdings Ltd v
BDO LLP [2020] EWHC 1937 (Comm)

64
8. Re-characterisation risk

65
Re-characterisation risk
Characterisation of derivatives
 Opinion dated 24 June 1997 by Robin Potts QC for
ISDA
◦ Credit derivatives cannot be characterised as insurance
business under the Insurance Companies Act 1982, and a credit
derivative on ISDA terms is not a contract of insurance
◦ Primarily because no requirement for any insurable interest
 Questioned by Marcus Smith QC The legal nature of
credit default swaps; and by Juurikkala, Credit Default
Swaps and Insurance: Against the Potts Opinion
 In practice, Potts opinion reflects practice: and

correctness assumed in European regulatory legislation

66
Re-characterisation risk
Re-characterisation generally
 Characterisation is a two-stage process

 At the first stage [the court] must construe the instrument .. and seek
to gather the intentions of the parties from the language they have
used. But the object at this stage of the process is not to discover
whether the parties intended to create a [particular type of
instrument]. It is to ascertain the nature of the rights and
obligations which the parties intended to grant each other ..

 Once these have been ascertained, the court can then embark on the
second stage of the process, which is one of categorisation. This is a
matter of law. It does not depend on the intention of the parties ..
 Agnew v IRC at [38]

67
Re-characterisation risk
Shams
 Generally, English law respects legal form over economic effect
◦ Eg hire purchase, which the law accepts as a chattel lease containing an option to purchase,
even though the economic effect is a loan on the security of the chattel

 However, the law treats the legal form as a sham (and therefore disregards it)
in (at least) two sets of circumstances

 Where parties have done things or executed instruments which are intended
by them to give to third parties or to the court the appearance of creating
between the parties legal rights and obligations different from the actual
legal rights and obligations (if any) which the parties intend to create
 Snook v West Riding Investments
 Where an agreement is not intended to have the effect stated, but is intended
to evade the operation of a statute out of which the parties cannot contract :
 Bankway Properties v Pensold Dunsford at [43]-[44]

 In both cases, the court will look at the substance and reality of the
transaction entered into
68
9. Some policy considerations

69
Source : BIS Quarterly Review Sept 2020
70
Source : BIS Quarterly Review Sept 2020

71
Source : BIS Quarterly Review Sept 2020

72
Some policy considerations
Traders in the derivatives market
 Hedger
◦ Someone who faces risk associated with price movement of an
asset, and who uses derivatives to manage that risk
 Can provides economic balance to the market
 Speculator
◦ Someone who accepts risk in relation to the price movement of
an asset in pursuit of profit
 Can provide liquidity and depth to the market
 Arbitrageur
◦ Someone who exploits price differences between markets or
transactions for profit
 Can help price transparency and uniformity

73
Some policy considerations
Economic benefits
 Risk management (hedging)
◦ The primary use of derivatives is to hedge one’s positions i.e., to reduce or eliminate the risk inherent
in commodities, foreign currencies and financial assets. Farmers who want to guarantee the prices of
their future crop can sell them at any time in the futures or forward market. Exporters, exposed to
foreign exchange risk, can reduce their risk using derivatives (forward, futures, and options). Pension
funds who invest in securities can avoid disastrous consequences by buying insurance in the form of
put options.
 Information
◦ The ABX indices .. were one of the first instruments to provide information to the marketplace on the
deteriorating “subprime” securitization market; exchange traded funds .. provide information on the
prices of securities ahead of the .. indexes; and option prices on individual equities which reveal
private information more quickly into the market. Derivatives also allow market participants to
extract forward looking, as opposed to historical, information .. Such information is used, among
others, by central banks in making policy decisions, investors for risk and return decisions on their
portfolios, and corporations for managing financial risk.
 Enhancement of liquidity
◦ Bring to the market additional players who use derivatives as a leveraged substitute to trading the
underlying
◦ Provide a hedge to market makers allowing a reduction in transactions costs through a lower bid-ask
spread.
◦ By and large, spot markets with derivatives have more liquidity and thus lower transaction costs than
markets without derivatives.
 Acharya and Richardson,
 Restoring Financial Stability: How to Repair a Failed System (2009) Ch 10 74
 I view derivatives as time bombs, both for the parties that deal in them
and the economic system. Basically these instruments call for money
to change hands at some future date, with the amount to be determined
by one or more reference items, such as interest rates, stock prices, or
currency values.

 Unless derivatives contracts are collateralized or guaranteed, their


ultimate value also depends on the creditworthiness of the counter-
parties to them. But before a contract is settled, the counter-parties
record profits and losses – often huge in amount – in their current
earnings statements without so much as a penny changing hands.
Reported earnings on derivatives are often wildly overstated ..

 .. derivatives .. can exacerbate trouble that a corporation has run into


for completely unrelated reasons .. [they] also create a daisy-chain
risk that is akin to the risk run by insurers or reinsurers ..
.. derivatives are financial weapons of mass destruction ..

Warren Buffett
Berkshire Hathaway annual report for 2002
75
Some policy considerations
Some of the legal concepts involved
 Characterisation
◦ Distinguish from insurance, guarantee etc
 Law of Contract
◦ Freedom of contract
◦ Protection of expectation interest
◦ Public policy – gaming and wagering
◦ Misrepresentation
 Legal personality
◦ Capacity
 Payment
◦ Set-off and netting

76
Oxford University Faculty of Law
BCL/MJur/MLF 2020-21

LEGAL CONCEPTS IN
FINANCIAL LAW

Lecture 5

Simple financial positions (2) - Derivatives


The End

BCL/Mjur/MLF 2020-21

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