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 "triangular" set-off).
Importantly, where the counterparty is a Cayman company, limited liability company ("LLC") or exempted limited partnership, Cayman Islands legislation gives statutory recognition to contractual rights to set-off upon insolvency, including multi-lateral set-off. Upon the insolvency of a Cayman company, Section 140(2) of the Cayman Islands Companies Law provides, inter alia, that in a Cayman liquidation the collection in and application of the property of a company is without prejudice to and after giving effect to any contractual rights of set-off or netting of claims against the company (including without limitation any bilateral or any multi-lateral set-off or netting arrangements between the company and any person or persons). Section 38(2) of the Cayman Islands Limited Liability Companies Law provides a similar provision in respect to Cayman LLCs. Section 36(3) of the Cayman Islands Exempted Limited Partnership Law applies the provisions of Section 140 of the Companies Law upon the insolvency of a Cayman exempted limited partnership. This means that, in contrast with liquidations under the insolvency rules of other jurisdictions, including the UK and US, contractual multi-lateral set off will typically be respected in a Cayman liquidation.
In the absence of any contractual right of set-off or non set-off, mandatory insolvency set-off under Section 140(3) of the Companies Law in the case of Cayman companies and exempted limited partnerships, and Section 38(3) of the LLC Law in the case of Cayman Islands LLCs applies, which each provides that an account shall be taken of what is due from each party to the other in respect of their mutual dealings, and the sums due from one party shall be set-off against the sums due from the other.
Security and Preference Transactions
With many buy side clients currently holding "out of the money positions" and facing tightening liquidity and unable to realise assets other than at discounted prices, financial institutions are left facing the difficult business decision of whether or not to enforce margin calls under their existing collateral documentation and risk pushing their client counterparty into insolvency. Unsurprisingly, financial institutions are exploring with client counterparties other ways to manage their credit risk and limit potential financial losses should the worst occur. We are seeing an increasing number of enquiries from clients looking to take fresh security over other available assets belonging to their Cayman counterparties, such as real estate, bank accounts and portfolio investments. Under Cayman Islands law, secured creditors are free to enforce their security despite the insolvency of the chargor company, LLC or exempted limited partnership and the commencement of formal insolvency procedures.
As is the case when taking any security, parties are well advised to undertake the usual legal due diligence in respect to the underlying assets (checking for issues such title and for any restrictions on sale or encumbrances) and the constitutional documents of the Cayman counterparty (checking that the counterparty has the corporate capacity and authority to grant the new security), and confirm any local security perfection and registration requirements. Where the Cayman counterparty is in financial difficulty, parties must also be alert to general insolvency rules applicable to Cayman Islands companies, LLCs and, in some cases, exempted limited partnerships, most notably the rules on voidable preferences.
In accordance with Section 145(1) of the Cayman Islands Companies Law, every "conveyance or transfer, or charge thereon and every payment obligation" made to a creditor, at a time that a Cayman company, LLC or exempted limited partnership, as applicable, is insolvent, "with a view to giving such creditor a preference over other creditors" shall be invalid if made within six months prior to the commencement of the company's, LLC's or exempted limited partnership's liquidation. Where the transaction is with a related party (a creditor will be treated as a related party if it can exercise significant influence over the company, LLC or exempted limited partnership, as applicable), a payment will be deemed to have been made with a view to giving a preference.
The Privy Council (the final appeal court for cases from the Cayman Islands) considered the application of Section 145(1) in the recent case of Skandinavska Enskilda Banken AB v Conway and another (as Joint Official Liquidators of Weavering Macro Fixed Income Fund Limited) [2019] UKPC 36 and confirmed that the relevant test is whether the transaction was entered into with the dominant purpose of preferring that creditor. In the Weavering case, a redemption payment to a fund investor made because the creditor intended to invest in an affiliate fund was held to be a preference. By contrast, in the earlier case of RMF Market Neutral Strategies (Master) Limited v DD Growth Premium 2X Fund [2014] (2) CILR 316, a payment made to a creditor following commercial pressure was not held to be a preference. Accordingly, whether a transaction constitutes a preference will be highly fact specific and the benefit being received by the company or exempted limited partnership in exchange for the transaction will often be of key importance. As a result, taking additional security in circumstances where there are doubts as to a counterparty's insolvency requires careful consideration taking account of the legal position and the commercial imperatives of the situation.
We have also received enquiries from clients exploring the possibility of inserting a new contractual set-off right into their derivatives agreement, or expanding the scope of an existing contractual set-off right, to gain the benefits discussed in the section above in the event of a close-out and termination. However, the breadth of Section 145(1) means that such proposals will be subject to the same considerations and potential voidable preference challenges as a new security grant.
Where a party is particularly concerned about the prospect of a successful voidable preference challenge, a guarantee from a solvent entity of financial substance within the counterparty's group could be explored as an alternative or additional credit protection.
As a concluding remark, where a party finds itself facing an insolvent Cayman counterparty which owes a net payable, there may be strategic advantages for the creditor in taking control of the insolvency process and petitioning for the Cayman counterparty's winding-up.
Article originally published on 7 May 2020
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
