Authored by Andrew Cross
This post is the second in a series that we are preparing in response to questions from clients, colleagues, and contacts. Yesterday’s post, which addressed interest rate swaps in a zero or negative interest rate environment, is available here.
In today’s post, we address considerations related to Decline in Net Asset Value (NAV) provisions in agreements that govern the trading of over-the-counter (OTC) derivatives and other financial contracts.
As we explore in greater detail, the recent volatility across financial markets makes it more important than ever for investment managers and their clients to understand – and focus on – these fairly common contractual provisions.
Background: The Use of Master Agreements to Mitigate Counterparty Risk
It is customary for the counterparties to an OTC derivative or other bi-lateral financial transaction to enter into a master agreement, such as the 2002 ISDA Master Agreement, as published by the International Swaps and Derivatives Association (“ISDA”), or the 2012 version of the Master Securities Forward Transaction Agreement (“MSFTA”), as published by the Securities Industry and Financial Markets Association. In short, a master agreement establishes the “relationship level” terms and conditions that will govern all of the transactions that the counterparties will enter into under that agreement for as long as the parties have a trading relationship with one another.
One of the central functions of a master agreement is to mitigate the risk that the counterparties will be unable to meet their obligations to one another under the agreement. For that reason, counterparties negotiate contractual provisions that allow one or both of the parties to terminate all or some of the outstanding transactions under the agreement when certain events happen. For example, the counterparties to an ISDA Master Agreement negotiate Events of Default and Termination Events. The former is triggered when one party is at fault, while the latter is triggered when an event happens (not necessarily due to the fault of either or both parties) that makes it unlikely or impossible that the party affected by the event will be able to perform its obligations under the ISDA Master Agreement.
Master Agreements and Investment Managers
Investment managers usually enter into a master agreement as an agent on behalf of its clients. It is important to emphasize that a properly drafted master agreement will identify each client, severally and not jointly, as the principal to the master agreement and every OTC derivative or other financial transaction governed by that agreement. The other counterparty, which is almost always a bank, usually seeks to include provisions that mitigate the risk that the investment manager’s client will be unable to meet its obligations to the bank in respect of all or some the outstanding transactions between the bank and the investment manager’s client.
If one of events specified in the provisions occurs with respect to the investment manager’s client, then the bank counterparty will be entitled to terminate the outstanding transactions that it has entered into with the investment manager’s client. At the risk of oversimplifying the termination process, the bank counterparty would be permitted to determine the value of the terminated transactions, determine the amount of a payment that is owed to or by the counterparty as a result of the occurrence of the particular event, and exercise set-off rights against any collateral posted by the investment manager’s client to support its obligations to the bank.
Decline in NAV Provisions
Banks frequently require a master agreement with an investment manager’s client to include what is called a “decline in NAV” provision. In sum, such a provision permits the bank to terminate all of the client’s transactions outstanding under the master agreement, if that client’s NAV declines by a specified percentage over a specified period of time. For example, a decline in NAV provision may permit the bank counterparty to terminate all open transactions with an investment manager’s client, if that client’s NAV declines by 25% over a 30-day period. Another variation of this type of provision is referred to as an “NAV Floor” provision, which permits the bank to terminate all of the outstanding transactions if the NAV of an investment manager’s client declines by a specified percentage relative to a fixed dollar amount specified at the time the agreement is entered into (or even, in some cases, the highest level of the client’s NAV during the course of the trading relationship between the bank and the investment manager’s client).
Decline in NAV provisions could become particularly relevant, in light of the recent levels of volatility across many (if not all) of asset classes. For this reason, we recommend that clients familiarize themselves key aspects of a decline in NAV provision, such as:
- Percentage Triggers – Understand the levels of decline that could trigger the termination of transactions under a trading agreement.
- Examples: 25% over a 30-day period, 35% over a 90-day period, 50% over a 1-year period, etc.
- Timing of Triggers – Understand how the time period is measured in respect of these triggers.
- Examples: Rolling 30-day period, 30 days since the last business day of the prior month, etc.
- Definition of Net Asset Value – Understand how NAV is defined in the first instance.
- Examples: Total assets less total liabilities, the value of assets under management by the investment manager (the latter often used if the investment manager is a sub-adviser or the client is an institutional separate account), etc.
- NAV or NAV per Share – Determine whether the provision is drafted to exclude declines in NAV due to redemptions or withdrawals.
- Comment: This distinction may become particularly relevant when rapidly declining markets are coupled with increased shareholder redemptions.
- Fish-or-Cut Bait Clause – Identify whether the provision restricts the ability of the bank to designate an early termination date in respect of the transactions after a period of time has passed.
- Examples: Termination must be made during the 60-day period following notice of the occurrence of the decline.
- Notice Provisions – Understand whether notice of a decline in NAV must be provided to the bank (or perhaps another third party) and, if so, whether that notice must be given within a particular time period following the occurrence of the decline. Also, confirm that all related, required notices (such as monthly NAV or NAV per share reports) are being delivered to the bank, since the failure to deliver such notices could constitute the independent grounds for an event of default.
- Waivers – Consider whether to seek a waiver from the bank, if a decline in NAV has occurred by an amount that would otherwise permit the bank to terminate transactions outstanding under the master agreement.
A similar analysis should be undertaken for any NAV Floor provisions, since those provisions could also result in a termination of all transactions outstanding under the master agreement.
In closing, it is important to emphasize that every trading agreement has the potential to be different from every other trading agreement – so, a facts and circumstances analysis must be undertaken on an agreement-by-agreement basis. Moreover, this post is informational only and does not constitute legal advice. However, it is our hope that the information that we have provided in this post is useful as market participants consider the potential impact of current market volatility on OTC derivatives and other financial transactions.
Good day. Good especially to be mindful of “the basics”. DR2.