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The ongoing events with COVID-19 and its impact on the travel industry have a number of potential implications for airlines’ derivative transactions.
Most airlines will be holding positions in derivative transactions. These may include commodity hedging for fuel, foreign exchange hedging relating to the ordinary course of business or hedging of risks associated with debt exposure (i.e. interest rate hedging and foreign exchange hedging).
Market participants should consider the events of default and termination events under derivative contracts involving airlines to determine whether any may be potentially triggered by current events. We consider certain of the Events of Default and Termination Events found under the 2002 International Swaps and Derivatives Association (ISDA) Master Agreement (the “2002 ISDA Master”) (in each case, as defined in the 2002 ISDA Master).
The 2002 ISDA Master contains a ‘Force Majeure Event’ Termination Event. This arises under the 2002 ISDA Master, in summary, as a result of a force majeure or act of state occurring that is beyond the contracting parties’ control, and which prevents performance or renders performance impossible or impracticable.
Consequences may include (i) relief for one or both parties from the obligation to perform under the relevant 2002 ISDA Master for a certain period of time or for as long as the ‘Force Majeure Event’ Termination Event exists or (ii) the right of a party to terminate the relevant 2002 ISDA Master. Section 5(d) of the 2002 ISDA Master provides that upon the occurrence and during the continuance of a ‘Force Majeure Event’ Termination Event, payments and deliveries are deferred until the earlier of: (i) the expiry of any applicable Waiting Period (as defined in the 2002 ISDA Master), and (ii) the date on which the ‘Force Majeure Event’ Termination Event is cured. Section 6(b)(iv)(2) further provides that if the ‘Force Majeure Event’ Termination Event still exists following the expiration of the Waiting Period (as defined in the 2002 ISDA Master), either party may, by not more than 20 days’ notice, designate an Early Termination Date (as defined in the 2002 ISDA Master) on which all or some Affected Transactions (as defined in the 2002 ISDA Master) will terminate, provided that such party must specify which transactions it wishes to terminate if terminating less than all transactions.
In determining whether there has been a ‘Force Majeure Event’ Termination Event under a 2002 ISDA Master, the following should be considered: (1) has an event constituting a “force majeure or act of state” for purposes of the 2002 ISDA Master occurred; (2) was performance prevented, impossible, or impracticable or would be so prevented, impossible or impracticable (if compliance was required on the date of determination) as a result of such event; (3) was such event beyond the control of such party; and (4) did the relevant party use “all reasonable efforts” to overcome such prevention, impossibility or impracticability.
The determination of whether any ‘Force Majeure Event’ Termination Event has occurred in respect of any specific contract will need to be looked at on its facts and on a case-by-case basis. It can be said, however, in general terms that although the current circumstances involve many events occurring that are outside the parties’ control and that may include “acts of state,” in many cases such events will not prevent performance or render performance impossible or impracticable. This will be particularly the case for cash settled transactions.
The 2002 ISDA Master contains a ‘Bankruptcy’ Event of Default which includes various insolvency related events. If an airline intends to use applicable bankruptcy laws to seek reorganization or relief, consent to an entry of decree for voluntary or involuntary bankruptcy, appoint a receiver or similar official or makes assignments or other proposals for the benefit of creditors, admit it is insolvent or admit in writing its inability to pay its debts generally as they become due, or commit another “act of bankruptcy” under any applicable bankruptcy law, it will need to consider whether such action could trigger a ‘Bankruptcy’ Event of Default under the 2002 ISDA Master. LATAM, Colombia’s Avianca Holdings SA and Australia’s Virgin Australia Holdings Ltd have all filed for bankruptcy protection as they seek to restructure their debt. If such action triggers a ‘Bankruptcy’ Event of Default with respect to the airline, this will give its counterparties a right to early terminate or close-out all outstanding transactions under the relevant 2002 ISDA Master. Its counterparties will also have the right to withhold payment in reliance of Section 2(a)(iii) of the 2002 ISDA Master for as long as the ‘Bankruptcy’ Event of Default or ‘Bankruptcy’ Potential Event of Default persists.
The 2002 ISDA Master contains a ‘Credit Event Upon Merger’ Termination Event. This can arise under the 2002 ISDA Master, in summary, as a result of a potentially broad range of merger or reorganisation transactions or changes of control where the creditworthiness of the party in question, or the successor, surviving or transferee entity of such party, is materially weaker immediately after the occurrence of the relevant event than the creditworthiness of such party prior to the relevant merger or reorganisation transaction or change of control. Such Termination Event will apply where it is specified in the schedule to the 2002 ISDA Master as applying to a party. Where it is applicable to an airline and the airline is considering a restructuring or reorganisation or where there could be a change in ownership of the airline, the airline should consider whether the ‘Credit Event Upon Merger’ Termination Event could be triggered giving its counterparty a right to early terminate or close-out all outstanding transactions under the relevant 2002 ISDA Master.
The 2002 ISDA Master contains a ‘Cross-Default’ Event of Default. A default under an airline’s borrowed monies could result in a ‘Cross-Default’ Event of Default under the 2002 ISDA Master. If there is a default under the borrowed monies of an airline, it should be considered whether such a default has a consequence under the derivative contracts.
A derivative contract may have specially negotiated additional events of default and termination events that could be relevant in the current circumstances, for example, downgrade trigger events, change of control events and over-hedging events. Each derivative contract will need to be analyzed.
The 2002 ISDA Master provides that: (i) an event that constitutes a ‘Force Majeure Event’ Termination Event or an ‘Illegality’ Termination Event would not count as a ‘Failure to Pay or Deliver’ Event of Default or a failure by a party or its credit support party to comply with or perform any agreement with respect to a ‘Credit Support Default’ Event of Default; (ii) in circumstances other than (i), a ‘Force Majeure Event’ Termination Event or ‘Illegality’ Termination Event which also counts as an Event of Default or Termination Event would only count as the relevant Event of Default or Termination Event, and not the ‘Force Majeure Event’ Termination Event or ‘Illegality’ Termination Event; and (iii) if a ‘Force Majeure Event’ Termination Event also constitutes an ‘Illegality’ Termination Event, it is treated as an ‘Illegality’ Termination Event and not a ‘Force Majeure Event’ Termination Event (unless covered by (i)). Whether an event constitutes a Termination Event or Event of Default under a 2002 ISDA Master affects parties’ rights to terminate the relevant 2002 ISDA Master and obligations with respect thereto.
In light of current market conditions, an airline’s hedging needs may have changed. An airline should consider its book of derivative transactions. To the extent an airline has over-hedging, it should consider whether it has any obligations to reduce the over-hedge under the terms of its derivative documentation or other contracts. Recent changes in oil prices may mean that the derivative transactions are out-of-the-money for airlines; they will need to consider whether they can afford to settle. To the extent an airline is planning to put in place any of its hedging for future periods, it will need to update any models used for hedging to take account of the expected recovery forecasts.
The current market conditions mean that there are more likely to be fluctuations in the value of derivative transactions. Where an airline has cleared derivative transactions, this may mean it is required to post more margin. The airline will need to be able to satisfy its margin requirements.
Where any of the commodity derivative transactions with respect to fuel or other commodities are physically-settled, an airline will need to take delivery of the fuel or other commodity upon settlement. Airlines should consider if they will be able to take delivery.
[1] For further information on ‘force majeure’ under derivative contracts, please refer to our previous publication “COVID-19: Derivatives Implications.”
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