An overview of potential disputes caused by market dislocation

History tells us that periods of market dislocation, such as that which has arisen from the introduction of tariffs by the US administration in recent weeks, frequently lead to an increase in disputes. This is because such periods tend to go hand in hand with increased market volatility, and thus a rise in companies facing financial distress and difficulties associated with the pricing of assets. These factors may in turn contribute to a more contentious environment as stakeholders on both sides attempt to navigate the uncertainties and protect their interests during turbulent times. We summarise below the key types of disputes we tend to see in such periods, and address how to guard against the risks of such issues arising. Whilst the list is not exhaustive, the following are the most common type of disputes which arise.

Margin calls and close-outs

A margin call is a demand on one party (A) by a counterparty (B) for A to post additional cash or collateral to cover B's exposure to A in relation to an underlying facility (usually a loan or a derivative transaction). So far, so what. The difficulty for A is that where, in a scenario where a margin call has been made and missed, it is very likely to trigger an acceleration, or termination right in favour of B – in other words, a "close-out" (and this can have knock-on effects on other obligations). A margin call can thus have a serious impact on corporate cashflow and therefore solvency. Commonly, therefore, the question of whether to close-out a particular trade is considered simultaneously with the making of margin calls (or at least, the evaluation of whether additional collateral should be sought, and the consequences of it not being provided).

In periods of market dislocation, sudden market movements tend to lead to a rise in margin calls and (shortly after) close-outs. This is because the value of existing collateral held by B can be negatively affected by market movement and the lender (B) will need to protect its own position. For instance, if the value of publicly traded shares posted as collateral has decreased significantly because of volatility in the relevant stock market, this can lead to loan to value covenants in a margin lending facility being breached, thus triggering a margin call. Alternatively, in derivative transactions governed by an ISDA Master Agreement with a Credit Support Annex (CSA), the value of collateral posted in relation to a collateralised trade may also have been adversely affected in the same way, leading to a margin call. In either scenario, the end result is the same: A is requested to provide more collateral to B to cover B's increased exposure. If A can freely pay, there may be no dispute. The story is different if posting further collateral creates solvency concerns.

Given that the stakes are high, these decisions can prove to be existential if they give rise to an acceleration. Why would a borrower faced with insolvency not challenge the process if its board considers it has a basis for doing so? A decision by a financial institution to make a margin call and/or close-out a counterparty therefore has the potential to give rise to litigation. And separate from actual litigation, claims are often threatened by A to create an opportunity for negotiation. Accordingly, once it has been decided that this is the best course of action, it is vital that the contractual provisions in the relevant agreement are followed meticulously, including timelines, notice requirements and valuation methods. Experience also dictates that good record keeping by the lender is essential.

Taking an ISDA close-out as an example: in ISDA CSA transactions, the contract provides for a prescribed process where a dispute arises (usually under tight time pressure). There is a paucity of English authority on the question of whether a margin call process has been properly followed, possibly because of the fact-sensitive nature of each decision. However, the usual rules on contractual construction apply to interpreting the relevant provisions of the margin lending facility, ISDA CSA or another document.

As well as following the express terms of the contract, financial institutions should guard against a future allegation that the decision to close-out or make a margin call was also subject to an implied term not to act in an irrational, arbitrary or capricious manner and that such duty was breached, arising from Braganza v BP Shipping Ltd [2015] 1 WLR 1661. There is authority that a financial institution may be under such an obligation even where there is an express duty in the contract on the institution to act reasonably (Sucden Financial Ltd v TMT Metals AG & Ors [2024] EWHC 1051 (Comm) (see our blog post)). However, provided that the financial institution has a genuine and commercially justifiable rationale for its actions, it may be difficult to prove breach of either duty. Evidencing the reasons for actions taken is therefore a key component in fending off potential future disputes, hence the importance of meticulous record keeping, minutes of credit committees and so forth.

Similar issues arise when it comes to valuation: in periods of market dislocation, valuing collateral is likely to become difficult and therefore contentious. The parties may disagree on how to determine the value of the assets being closed-out or posted as new collateral. It may also not be possible to find a fair value for the collateral in the dislocated market to evidence that (for example) a collateral obligation has been breached – in a recession the whole market is affected. Adhering to the valuation method agreed by the parties in the underlying customer agreement will therefore be critical in ensuring the fairness and enforceability of the margin call/close-out. This will help minimise the risk of a follow-on dispute with the counterparty for breach of contract (or will, at least, provide an answer should the matter ever reach court).

The contractually agreed upon valuation method is typically a matter of choice for the non-defaulting party. As before, how that discretion is exercised will be important. This is the case for close-outs under the ISDA Master Agreement following an Event of Default, a topic that has been considered extensively by the courts. Both the 1992 ISDA and the 2002 ISDA expressly provide the thresholds to be met by the decision-maker when calculating the amount payable; there is no need to imply a Braganza or indeed any other term. However, as we will see below, the threshold under the 1992 ISDA is accepted to be very similar to the Braganza standard, albeit different to the threshold under the 2002 ISDA.

• The 1992 ISDA contains two alternative techniques for assessing the amount payable following close-out: "Market Quotation" and "Loss". While the Market Quotation method prescribes the methodology to use in calculating the amount payable, the Loss method does not. The definition of Loss is, so far as is relevant for present purposes, "an amount that a party [in our example, B] reasonably determines in good faith to be its total losses and costs". The key authorities on the definition, which arose in the context of Lehman Brothers' collapse in the wake of the 2008 Global Financial Crisis, have held that "reasonable" in this context is in essence a test of rationality (ie is the decision so unreasonable that no reasonable person acting reasonably could have made it). This test is akin to the rationality test developed in the quite different context of public law duties (Associated Provincial Picture Houses Ltd v Wednesbury Corporation (1948) 1 KB 223) and is applicable to both the decision-making process in reaching the amount payable, as well as the actual figure itself (Fondazione Enasarco v Lehman Brothers Finance SA [2015] EWHC 1307 (Ch) and Lehman Brothers Finance AG (in Liquidation) v Klaus Tschira Stiftung GmbH [2019] EWHC 379 (Ch) (see our blog post)). An institution in this position would therefore be well-advised to follow the methods set out above, of good record-keeping and the like.
• In contrast, the methodology used to determine the amount due upon a close-out changed with the 2002 ISDA, with the definition of "Loss" being replaced by "Close-out amount". This definition provides that "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". The authorities have confirmed that this is a different standard to that provided for under the 1992 ISDA; namely it is an objectively reasonable standard (both of the process and final amount due), rather than simply a requirement to use rational procedures to produce a rational result (Lehman Brothers Special Financing v National Power Corporation [2018] EWHC 487 (see our blog post)).
• It will therefore be harder to demonstrate a calculation made under the 1992 ISDA is "irrational", as opposed to "objectively unreasonable" under the 2002 ISDA. For example, it is entirely plausible to imagine a circumstance in which a counterparty calculated the amount payable on a close-out in a subjectively reasonable manner that happened to lead to an uncommercial result. While this is unlikely to be "objectively reasonable" (either in process or amount) as required under the 2002 ISDA, it may be considerably harder to demonstrate that the calculation method was so unreasonable that no reasonable person acting reasonably could have made it.

Loans

It will come as no surprise that repayment of loan agreements has, over the years, been the subject of much litigation. There are a range of potential disputes that may arise in connection with loan facility agreements.

Almost all facility agreements will contain detailed covenants designed to protect the lenders, and very few obligations on the lenders other than to make the loans. The financial covenants are intended to provide early warning signs which allow lenders to detect financial ill health on the part of the borrower and to take necessary action. Breaches of financial covenants contained in facility agreements (such as Loan to Value or Interest Cover ratios) are more common during periods of market dislocation. This is often because either the asset value to which the facility is pegged has deteriorated, or the borrower's income has reduced, such that income-related covenants (where interest payment levels have remained constant) are breached.

Facility agreements will almost always require borrowers to provide representations at defined times (for example quarterly, or when new drawdowns of funds are sought). These representations may directly relate to the borrower group's financial position or may be qualified by materiality or Material Adverse Effect wording such that they may be indirectly breached by a market dislocation having a significant effect on a borrower group's business. During periods of market dislocation, there can be concerns over whether borrowers are able to make the same unqualified representations; if they cannot, and a default occurs as a result, they would need to seek a waiver of default and the lenders may, (at the very least) issue a reservation of rights letter.

It is also common for facility agreements in some markets to include standalone "Material Adverse Event" events of default (as well as for various representations and covenants to be qualified by Material Adverse Effect). Given the uncertainty associated with these clauses, lenders are often reluctant to rely on them to accelerate the loans following an Event of Default occurring and continuing. This uncertainty arises from the (often) general drafting and the associated reputational risk to a lender of relying on such a clause. Although not in a lending context (and a situation-specific exercise), the English High Court has recently given some helpful guidance on how "Material Adverse Event" clauses may be construed and what "material" can mean (BM Brazil v Sibanye Stillwater [2024] EWHC 2566 (Comm) (see our blog post). That type of clarity is welcome, because it provides some tramlines around whether the incident in question is in fact a "material" event or change.

Bondholder activism

At points of dislocation in the bond markets, we have also seen disputes where groups of activist noteholders with long-dated investments seek to use the contractual terms of their bonds to increase their returns. This manifests itself with activist bondholders seeking to find ways to accelerate their bonds, thereby bringing forward the date for repayment (plus interest), or finding other ways to achieve improvements in the terms of the bonds they hold.

Bondholder Trust Deeds and Subscription Agreements usually contain clauses broadly similar to those described above in relation to loan agreements. They therefore contain covenants and warranties on a range of financial and non-financial metrics for the protection of bondholders (ie lenders) as against issuers (ie borrowers). Periods of dislocation present opportunities for activist bondholders to seek to test those covenants / representations to ascertain whether an actual or potential event of default has occurred.

If an actual or potential event of default has occurred, it may be possible for issuers to maintain that it is not subsisting, or is remediable, especially once the period of market dislocation subsides. However, such arguments present clear risks for issuers, especially where a trustee is not minded to take a position on the matter and the noteholders are threatening court action, which could (if it goes against the issuer) lead to a very public acceleration of the bonds, or otherwise seek a preferential rate / modification of the bonds' terms in order to remain as noteholders. In circumstances where institutional corporate issuers have usually planned their finances in lockstep with bond maturity dates, a sudden need to repay that debt earlier than envisaged can have material impacts on the issuer's financial health. But compromising at an appropriate level may be more cost-effective than litigating the matter.

Mis-selling

Not a cause of action in itself, mis-selling is an umbrella term which covers a range of claims. Mis-selling disputes commonly arise where there has been a significant dislocation of the market leading to cashflows under financial transactions operating in a way which one party did not expect at the outset.

Such claims are usually advanced in both contract and tort. In particular, financial institutions may face allegations that they breached an alleged advisory duty owed to the customer to advise on the merits of a specific transaction. Such duties can be difficult to prove, so as a complement to those allegations, financial institutions may face claims that they failed to provide any or adequate information as to the features, benefits and risks associated with a particular transaction. These causes of action may be coupled with misrepresentation claims, often put on the same basis. Increasingly, during the financial crisis, there was an uptick in allegations of fraudulent misrepresentation. More recently (and transaction permitting), we have seen claims from non-corporate customers that their relationships with lenders were unfair under section 140A of the Consumer Credit Act 1974.

Putting some colour on this, following the 2008 Global Financial Crisis for example, there was a proliferation of claims in the UK relating to interest rate hedging products. The effect of the crisis was that borrowers found themselves paying levels of interest far above the new normal, historic lows. The alternative was to pay the significant costs of exiting the product if they wanted to terminate early. Across these claims, there was a common underlying theme: most, if not all claims were advanced on the premise that the defendant financial institution owed some form of duty to have explained or mitigated against the risk of interest rates falling to record historic lows for a sustained period of time.

In relation to such claims, the principal defences available to financial institutions are that customers were sophisticated/understood the risks of a transaction; the courts also typically upheld the various contractual protections around the scope of the duty owed, or "non-reliance" wording (ie "contractual estoppel"). Litigants also found that many cases that were on their face simple, did not stand up to scrutiny when the factual questions about alleged breach of duty, reliance, causation, or arguments about the extent of the losses claimed were put under the microscope.

Conclusion

Market volatility, such as that which has been gathering in the aftermath of the introduction of new international tariffs, almost invariably leads to disputes between market participants, typically borrower and lender. This article has explored some of the ways in which those disputes commonly arise, and how any associated risks can be mitigated. If there is one takeaway from this article, it is the importance of adhering to contractual process, with clear record-keeping for the commercial rationale for taking whatever action is decided upon. Those actions can only be helpful for any financial institution facing legal proceedings.