The unprecedented market shocks caused by the coronavirus have already resulted in a wave of margin calls by banks on leveraged investments and derivatives sold to clients. Clients face an unenviable choice: either meet the margin call, assuming it was justifiably made, and they have the resources available, or face the consequences of realising large losses as banks act to close out positions when margin calls are not satisfied. When the dust settles and markets return to ‘normal’, disputes between banks and clients will mushroom, as they did following the 2008 financial crisis, over losses sustained through questionable margin calls made in the midst of the current meltdown. FRA partners Simon Taylor, Rob Mason and director Gordon MacLeod discuss key considerations for banks and investors.
How can banks and investors prepare for potential litigation arising from disputed margin calls during the Covid-19 market turmoil?
Increased use of Leveraged Products & Derivatives post 2008 Crisis (investors “position”)
In the low interest rate environment which has been prevalent since the credit crunch, many investors sought higher returns by using leveraged products, such as structured notes and leveraged financing, or derivatives. These products enabled an investor to receive the return on a reference asset, whilst only paying a fraction of the price necessary to purchase the asset. The balance to purchase the asset was, in effect, provided by the bank (or other issuing party). In this manner the investors could amplify the returns on the amount invested, with the downside that any losses are also amplified. Banks have been very willing to provide such leveraged products and derivatives given the increased profit margins they were able to charge and investors were likewise keen to take advantage of the low cost of borrowing available.
In order to shield the bank from potential losses, leveraged products and derivatives use a combination of ‘margining’ and ‘unwind’ provisions in the contractual agreements. Margining means that if the value of the leveraged product or derivative falls, the bank can require the investor to ‘post margin’ in order to cover an agreed proportion of the lost value i.e. provide assets to the bank as collateral against the fall in value. As far as ‘unwind’ provisions are concerned, these come into operation in the event that the investor fails to meet the margin call. When this happens the contract will give the bank the right to close out the investor’s position. This has the effect of crystallising the investor’s loss and removes the possibility of future gains for the customer should the markets recover.
Once the position has been closed out, for non-recourse products, the amount of the investor’s losses is limited to the amount originally invested plus any collateral previously posted. However in the case of recourse products, such as most derivatives or contracts for difference, the investor may be subject to further claims from the bank.
POTENTIAL PITFALLS AND PROBLEMS RELATED TO COVID-19
Whilst the combination of margining and unwinding may at first sight give banks high levels of protection against downside in leveraged product classes, as we discuss below there are a number of potential pitfalls and problems that may not only thwart the levels of expected protection but could also result in costly litigation.
Exercising Margin Calls
The first issue to consider is the way in which the decision to exercise the margin call is handled. The bank’s rights with respect to collecting margin will be defined in the product prospectus or contract but will typically afford the bank a level of discretion when making the decision. Notwithstanding the wide discretion available, it is nevertheless essential for banks to follow and document the contractual margin call procedures when making margin calls. Margin calls made during crises such as Covid-19 are risky and need to be handled carefully if the bank is to minimise risks from claims brought by investors suffering losses. In particular the bank will need to demonstrate that margin calls were made promptly, delivered correctly and that the investor was given the appropriate amount of time to meet the margin call.
A further consideration for investors and banks with respect to the margining procedures is whether the client may have acquired rights by virtue of any previous course of conduct by the bank when operating the margin procedure, particularly where the bank has departed in the past from the contractual procedure; for example, by giving additional non-contractual grace periods for the client to meet margin requirements, or prior acceptance of forms of collateral not specified in the contract. Verbal exchanges or email by sales staff to clients may also have inadvertently given the client a legitimate expectation that the contractual margining procedures had been in effect varied.
Calculating the Level of the Margin Call
The second issue is that the calculation of the amount of a margin call is not always straightforward. There are many possible reasons for disagreements and there are areas where errors can creep in. Key issues which should be considered with respect to the calculation of the margin call include:
- Whether the large number or perceived urgency of margin calls lead to any corners being cut in calculations;
- Whether any internal valuation models used, which might be suitable in normal market conditions, are robust and suitable for use in stressed market conditions such as now;
- How any unobservable parameters being used were determined, particularly with the inevitable lack of pricing information in a stressed market;
- Whether all data used in the margin call calculation is timely;
- Whether valuations used for margin calls are consistent with valuations used in the banks own financial books and records; and
- How the bank is valuing the collateral already held.
If a margin call is made when it should not have been because of a failure to calculate or model accurately as set out above or is made for an amount in which it should not have been made, this is likely to result in significant legal and regulatory risk.
Closing Client Positions
As referred to above, if the client fails to post collateral in response to the margin call the bank has a right to close the client’s position to prevent further loss to the client and to the bank. In the normal course of business it is rare that client’s positions are closed dues to failed margin calls. However, when market conditions are as challenging as they are now with large losses and therefore large margin calls, it is likely that more customers will be unwilling or unable to meet the calls made by their banks and more positions will be closed out. It is therefore perhaps the area with the most possibility for disagreement.
Specific procedures for closing the client’s position are often not contractually documented, meaning that the bank will have discretion as to how the ‘close out’ is performed. With regard to the client’s position, careful consideration will need to be given during ‘close out’ as to whether the bank is acting as a counterparty in a bilateral contract with the client or as an agent trading in a market on behalf of the client. In volatile markets with banks scrambling to limit losses and where complex hedging positions are being unwound, lines may become blurred leading to the potential for ‘close out’ actions, to be viewed as being unfair or prejudicing investors when looked at with the benefit of hindsight.
In order to demonstrate that the bank treated customers fairly in this scenario it is necessary to consider the bank’s actions, including:
- When and why the decision to close the client position was made;
- Once the decision was made to close the client position, was the close out performed promptly;
- Was the product priced accurately at the time the position was closed out;
- Were any hedges closed at the same time as the client position;
- Was the closeout performed at the low point of the day; and
- Did the bank profit from closing out the position.
Conflicts of Interest & Conduct Risk
Whilst the decision to close a client’s position should be made objectively, following the failure of the client to meet a margin call, the actual liquidation of the client’s position and collateral will be executed by a trader. Trading desks have their own P&L responsibility within the bank and individual traders have a direct financial incentive to maximise the bank’s profits and minimise any losses. This presents a potential area where conflict of interest may arise with the client as gains by the bank in the process of the sell-off may be losses for the client. Problematic conduct to be aware of in this regard might include:
- Front running the client’s position, for example, by closing out the bank’s hedges, prior to closing out the client’s position.
- Using hindsight, for example by choosing the price during the day at which the client position was deemed to be closed out, so as to maximise the gains to the bank.
- Closing out the client’s position at a different price to the price at which the bank closed out its own positions or hedges.
- Failing to treat all clients equally by favouring some clients over others.
In addition to the pitfalls and problems we identify above in relation to the process of making and valuing margin calls and closing out positions in default, there is also the potential for customers to seek to avoid the losses relating to margin calls by contending that they were mis-sold the product in the first place.
As leveraged products are, by their nature, a higher risk product, there is always a possibility that investor might seek to claim mis-selling of the product by the bank. Typical challenges are that the risks were not properly explained and/or that the products were unsuitable for the investor. In this area at least, the banks have learnt lessons from last financial crisis and have been subject to strict regulatory guidelines. This has led to the implementation of improved, defensive selling procedures such as: client suitability assessments, product risk disclosures and client risk declaimers. On the assumption that these have been accurately completely and thoroughly reviewed with an appropriately sceptical eye (big ‘ifs’), the banks may find themselves in a better position today than in the past.
Low interest rates and the availability of cheap finance following the financial crisis of 2008 has contributed to large volumes of leveraged products. The current shock to the financial system as a result of the Covid-19 outbreak will result in banks facing decision about whether, when and how to make vast margin calls on affected customers. As the crisis deepens so will these problems. As access to finance dries up or becomes more expensive some customers will be unable to meet the requests of their banks and provisions allowing for positions to be closed out will be triggered. This will crystallise losses for customers and banks. Once the dust has settled and markets return to some semblance of normality, affected customers will look to their lawyers for ways of recouping losses from the banks through litigation. Making and following through on margin calls is a high stakes game which is full of pitfalls – an uptick in litigation is sure to follow soon!
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