Will the COVID-19 Pandemic Trigger the ISDA Master Agreement’s Force Majeure Clause?
The ISDA Master Agreement is the most common form contract in the derivatives market. It provides the terms for over-the-counter derivative deals worth trillions of dollars. When a crisis like the COVID-19 pandemic arises, it can wreak havoc on the derivatives markets. It is thus crucial for parties to understand the Master Agreement’s terms—and the underlying laws on which the agreement relies. One of the defenses a party to an ISDA Master Agreement contract may wish to invoke in this time of crisis is the force majeure clause, which was added to the Master Agreement in 2002. But when can that defense be used?
The ISDA Master Agreement includes force majeure as a “Termination Event” that would excuse a party’s non-performance, and permit it to terminate the contract. Under that provision, if an event (1) is beyond a party’s control; (2) prevents that party (or its credit support provider) from making or receiving payments or deliveries; and (3) the party (or its credit support provider) cannot overcome the event by using all reasonable efforts, then after a waiting period of eight business days, the party affected by the force majeure can terminate the contract.
The ISDA Master Agreement does not provide any examples of what constitutes force majeure. ISDA purposely did not provide elaboration when it added the force majeure provision to the 2002 Master Agreement, preferring that the courts in the relevant jurisdiction decide what specific circumstances constitute force majeure in that jurisdiction. While the parties have the option to define force majeure in their own contracts, many ISDA agreements do not do so.
Therefore, the meaning of force majeure in any given ISDA agreement largely depends on the jurisdiction in which the contract is interpreted. ISDA agreements are typically governed by either New York or English law—only the former is addressed here.
New York law, unlike some civil law jurisdictions, does not recognize force majeure as a defense for non-performance as a matter of general contract law. It does recognize other general defenses such as impossibility, impracticability, and frustration of purpose. Those tend to be construed narrowly. In particular, those defenses are not normally considered to allow parties to escape performing their contracts just because they face financial difficulty.
However, New York law may recognize force majeure as a defense where the parties have specifically included a force majeure clause in their contract. Courts are careful to allow the parties’ own agreement to “dictate the application, effect, and scope of force majeure”. New York courts are especially wary of rewriting a contract when the parties are sophisticated—a group that almost by definition covers parties to ISDA agreements.
New York law contemplates that the force majeure clause will excuse performance only where the reasonable expectations of the parties have been frustrated due to circumstances beyond the control of the parties. Accordingly, whether an event preventing performance is so beyond a party’s control that it triggers a force majeure clause is a fact-intensive question that must be decided on a case-by-case basis.
It remains to be seen whether making payments of cash or securities, as ISDA agreements call for, may be affected by the pandemic in a manner that is beyond the parties’ reasonable expectations. Unless payment and clearing systems completely shut down, payment under an ISDA contract may well remain physically possible.
That severe market disruption may make a derivative contract unprofitable, even ruinous, may not in itself suffice under New York law. Because most performance under the contracts occurs electronically, quarantine, shelter-in-place orders, and other government restrictions on travel may not frustrate performance, and even mass unavailability of key employees would be unlikely to stop completely the sophisticated entities entering derivatives contracts.
The most likely category of derivatives that might be affected by force majeure terms are commodities future contracts that call for physical delivery. Physical quarantine orders may also trigger such terms if employees have to be in the office to carry out transactions. Payments that must be delivered by courier might also be prevented by travel restrictions.
That said, ISDA agreements contain other provisions that may allow non-performance as a result of the pandemic even if force majeure terms do not apply. For example, in equity, FX, or currency options transactions, disruptions in trading, extreme fluctuations in share price, or the forced shutdowns of exchanges may count as a “Disruption Event” or a “Market Disruption Event” under the applicable definitions. Payment due dates and notice due dates might be affected by unscheduled holidays or bank closures.
Parties to ISDA agreements should carefully review their contracts and applicable ISDA definitions to best understand whether there is a colorable basis not to perform under the contract—or on the other side, to evaluate the responses to a counter-party’s claim that its non-performance is excused by force majeure.
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