To fail or not to fail: Should a failure to deliver trigger an Event of Default?
Monday 4 June 2018
The issue of whether a failure to deliver securities should be an Event of Default has sparked much debate in the repo market. Over the years, the repo market has gone back and forth in its approach to delivery failures but has now settled on allowing both parties the right to choose in their legal documentation. It is one of the main negotiation points in repo negotiations and agreement on this point can often be the difference between execution and deadlock. Both parties entering into a repo transaction therefore need to ask themselves an important question – ‘Should a failure to deliver securities trigger an Event of Default under a GMRA?’
What is a repo?
Repo is a generic name for “repurchase agreement” and means a sale and repurchase of securities. It is an agreement in which one party sells securities to a counterparty, and simultaneously commits to repurchase the same or similar securities from the counterparty, at an agreed future date, at a repurchase price equal to the original sale price plus a return on the use of the sale proceeds during the life of the repo.
The delivery of securities is clearly a fundamental part of a repo transaction, yet a failure to deliver such securities may or may not be considered an Event of Default depending on what is agreed to by the parties. So, what options are available when a party fails to deliver securities in a repo?
The repo contract remains open and the Buyer withholds cash from the Seller until such time as the Seller delivers the securities
The Buyer terminates the failed transaction at any time
The parties may negotiate a solution allowing the repo transaction to continue until such time as the Buyer re-delivers the securities
The Seller can call a Mini Close-Out (see below)
If the parties have agreed to treat a failure to deliver securities as an Event of Default, then the non-failing party can place the failing party in default.
The applicable provision in the GMRA which allows parties to decide on whether a failure to deliver is an Event of Default is 10(a)(ii). Those in favour of applying 10(a)(ii) as an Event of Default see a failure to deliver securities is a serious event and should be considered as much a default as any other Event of Default (i.e. failure to pay).
On the other hand, some banks do not want to trigger their own Event of Default given that settlement failures are commonplace in the repo market. Such failures are considered insignificant and often blamed on a variety of reasons, including operational problems, temporary illiquidity in the market or a failure to deliver by another party down the chain of transactions (which is outside the control of the bank itself).
Calling an Event of Default for a settlement fail, especially when the fail is not related to the creditworthiness of the party, is considered the nuclear option and the consequences are very serious. It can lead to the termination of the entire repo relationship and, if cross-defaults exist in other master agreements, these can also be triggered leading to the termination of other repo, derivative and securities lending transactions and relationships.
Some parties, when negotiating their GMRA, will often seek to introduce complex amendments to 10(a)(ii) in an attempt to move negotiations forward (or slow down the negotiations and delaying both parties ability to trade with each other). Examples of proposed amendments include the following:
“10(a)(ii) shall apply provided such failure to deliver Purchased Securities on the Purchase Date or Equivalent Securities on the Repurchase Date is not remedied within [insert number of days/months]”
Introducing grace periods may appease those parties who are concerned about defaults to settlement fails outside of their control (and not related to their creditworthiness). What is an appropriate length for the grace period? 30 days or 3 months? Or does it need to be longer?
“10(a)(ii) shall apply to Party B only”
Some banks will be more concerned that their repo counterparty will be defaulting and will therefore consider a failure to deliver securities to be an Event of Default. Non-mutual provisions are often met with resistance from those on its receiving end and will be difficult to incorporate into the GMRA.
“10(a)(ii) shall apply, provided that the Defaulting Party can evidence to the Non-Defaulting Party that such failure to deliver Purchased Securities on the Purchase Date or Equivalent Securities on the Repurchase Date was a result of an operational or administrative error”
The above amendment is designed to alleviate the concerns of those banks who are concerned they could be placed into default due to an operational or administrative error – if the settlement fail is as a result of an administrative error and can be clearly evidenced by the failing party, it is not considered a default.
Mini Close Out
Another option available to the Seller is to call a Mini Close-Out – this allows the non-failing party to terminate the affected transaction without impacting all other trades under the GMRA (and any other trades under other agreements that the parties may have in place). If the failing party fails to comply with the mini close-out provisions (i.e. they fail to pay the cash difference), an Event of Default can be triggered under 10(a)(iii) and all transactions under the GMRA may then be terminated. This approach to settlement fails is the preferred approach of many banks and financial organisations.
Recent developments in the regulatory landscape will have a significant impact on settlement fails in the repo market. Article 7 of the Central Securities Depositories Regulation (“CSDR”) introduces a settlement discipline framework, designed to incentivise parties to maintain high levels of settlement efficiency by subjecting failing parties to cash penalties for each failed transaction. It remains to be seen how the introduction of a cash penalty mechanism will impact 10(a)(ii) negotiations in the GMRA. Some parties may see a cash penalty as sufficient punishment for failing to deliver securities without needing to trigger an Event of Default.
Deciding whether or not to apply 10(a)(ii) as an Event Default ultimately rests with an organisation’s credit risk department. It is important for repo lawyers to educate their credit risk counterparts on the repo market itself and the options available to parties in the event of a settlement fail – resorting to default should be considered as a last resort.
 All major master agreements contain events of default and are considered the most important provisions in any master agreement. They provide parties with the ability to terminate the trading relationship and all active transactions prior to their maturity dates
 The Global Master Repurchase Agreement
 “If the parties have specified in Annex I hereto that this sub-paragraph shall apply, Seller fails to deliver Purchased Securities on the Purchase Date or Buyer fails to deliver Equivalent Securities on the Repurchase Date, and the non-Defaulting Party serves a Default Notice on the Defaulting Party;”
 The Seller terminates the failed transaction only, with all other transactions remaining unaffected. The securities in such transaction are valued using the default methodology set out in the GMRA, set it off against the cash owed to the Buyer and settle the difference