Navigating Trading Agreements in Volatile Markets: Tips for NAV Waivers and Counterparty Risk Management

During the market volatility resulting from the COVID-19 pandemic over the past month, we have seen a growing number of inquiries from investment manager clients concerned about breaching default triggers in their trading agreements tied to a decline in a fund’s net asset value (NAV) over a designated period of time. Concurrently, we have also seen many clients concerned about potential dealer counterparty insolvencies and thinking about measures they can take to mitigate their counterparty risks. Below we provide some recommended actions for funds experiencing concerns about these issues.

Recommended actions for a fund facing a potential breach of a NAV trigger  

• Take a deep breath and know that you are not alone. Many funds have breached (or have come very close to breaching) NAV triggers as a result of recent market volatility.  
• If you are expecting to breach any NAV triggers, speak to your dealer counterparties in advance. Relationships matter, and a dealer will be more likely to treat a client well if the client is transparent about potential changes to its NAV. Also, because many funds are facing breaches of NAV triggers, there may be a benefit to having these discussions early as dealers are now beginning to field large numbers of similar requests.
• Provide dealers with your proposed form of waiver (instead of waiting for dealer to provide one). Ideally the waiver will include a waiver of the current breach as well as a reset of the fund’s NAV at current levels to use as the measuring point for further NAV decline triggers.
• At this time, we cannot say whether dealers are granting formal legal waivers for most fund clients. The response can vary greatly depending on a fund’s strategy as well as its overall relationship with a particular dealer. If the dealer does not grant a waiver request, it does not necessarily mean the dealer will exercise remedies against the fund. There may be other actions an investment manager can take (like novating or electively terminating positions) to reduce exposure if a dealer is unwilling to grant a formal legal waiver quickly.

Quick steps that can mitigate counterparty risk to a financially distressed dealer counterparty 

• Take inventory of all relevant documentation, and confirm you have fully executed copies of those documents in your files. This includes all master trading agreements (prime brokerage, term financing, International Swaps and Derivatives Association (ISDA) Master Agreements etc.). In particular, if your dealer has offered a guaranty or other credit support document, be sure you have a signed copy in your files. This can have a significant effect on the strength and value of your claim in an insolvency. 
• Consider whether the fund is holding the full amount of collateral it is entitled to under the relevant agreement or whether it can ask for more, or whether the fund is entitled to demand a return of any excess collateral its dealer counterparty is holding above the amount the fund would owe as a result of a default termination (i.e., mark-to-market exposure). Remember the biggest risk for a fund with an ISDA counterparty is the risk of losing such excess collateral. In a dealer counterparty insolvency, the fund will be an unsecured creditor with respect to claims for this collateral.
• Move fully paid assets held by the fund’s prime broker to a custodian bank with which the fund has no other trading relationship. This removes the possibility of the prime broker (or any of its affiliates) exercising setoff rights against those fully paid assets with respect to unrelated trading liabilities.