THERE MAY BE TROUBLE AHEAD
What are the likely consequences of COVID-19 for financial institutions in 2021?
While the world wrestles with the day-to-day realities of the pandemic, 2021 will bring further challenges. With the memory of the litigious and regulatory aftermath of the global financial crisis still fresh, what should be on your radar?
1. Disputed margin calls and close-outs
The financial dislocation caused by COVID-19 has already prompted institutions to make margin calls and close-out positions on a scale not seen since 2008. Investors reluctant to deposit cash or securities, or liquidate positions and lock in losses to meet calls, will scrutinise all calls and calculations. Firms must ensure they fully understand their rights and obligations, including the steps required to call for extra margin, acceptable valuation methods and pricing sources, and the method in which calculations are made. Similarly, firms should consider the applicable close-out obligations of their contracts, including requirements to comply with grace periods, timing of default notices and formal notice requirements. Bear in mind the need to scenario plan: there will be occasions when it may not be in a firm’s interest to trigger a close-out even when an event of default has occurred, for example, when a close would undermine capital requirements. This analysis will prevent financially detrimental decisions being made by an automated system or by teams under significant time pressure.
2. Distressed and insolvent counterparties
We have seen a surge in distressed counterparties relying heavily on force majeure clauses, material adverse change clauses and/or challenging notices of default. The success of these arguments will turn on the language of the contracts and so it will be important for this to be analysed by Legal before the business communicates with, or responds to, clients. Insolvency will also radically affect the approach to any disputes and settlement strategy. You should monitor the financial standing of counterparties where you anticipate a possible dispute. Also watch out for any market announcement, changes in their financial position, or likely insolvency events.
We also expect to see an increase in potential claims being acquired by litigation funders from insolvent businesses and being pursued by those funders.
3. Competition damages actions from insolvent companies
The increase in corporate insolvencies is likely to lead to an increase in competition damages actions being led by insolvency practitioners with duties to recover sums on behalf of company creditors. We also expect to see an increase in potential claims being acquired by litigation funders from insolvent businesses and being pursued by those funders. Prior to the more recent pivot towards Big Tech companies, competition authorities focused significant attention and resources on the financial services industry. This led to investigations and large fines being levied on financial services providers; for example, in relation to anticompetitive interchange fees and manipulation of the foreign exchange market. Time is still available for claimants to bring damages claims in relation to those infringements and, with ever increasing sums being made available to litigation funders, financial institutions should brace themselves for potential claims.
…where a firm has suffered a dramatic decrease in share price, it faces the risk of claims of inadequate disclosure of future pandemic risks.
4. Inadequate disclosure claims
Investors holding products that have declined in value may assert claims that a firm has failed to disclose adequately potential risks, mis-sold products or acted improperly during marketing. Similarly, where a firm has suffered a dramatic decrease in share price, it faces the risk of claims of inadequate disclosure of future pandemic risks. Claims of this nature have become more common following the financial crisis and we anticipate that COVID-19 will accelerate this trend. Prepare by reviewing disclosures made to anticipate any areas of vulnerability.
5. Preserving business today at the expense of tomorrow
What you do now may change the strict legal rights you have under a contract. You may be held to any alleged assertions, variations, concessions or representations you make to clients to attempt to preserve relationships. Counterclaims relying on such representations were a particularly active area of litigation after the 2008 financial crisis: it is important to take legal advice and have a plan before the business and/or the legal team enter into discussions with clients. Ensure you understand your rights and obligations under the existing contract, as well as any contractual formalities for effective variation of terms.
We expect time will reveal that COVID-19 was a perfect storm for an increase in corporate fraud and misconduct.
6. Significant increase in white collar crime
Cyber-crime has increased as criminals seek to exploit more people working remotely and the government-created financial hardship funds. Employees must remain vigilant to the risk that clients’ systems and accounts may be compromised, and reminded of information security risks. We expect time will reveal that COVID-19 was a perfect storm for an increase in corporate fraud and misconduct, as businesses in financial crisis take desperate and illegal measures to alleviate their situation. Market abuse will also increase as bad apples allow greed to tempt them to take advantage of unusual market fluctuations. Firms must remain vigilant, and adapt, to new and emerging threats.
7. Employment disputes
The extension of the Coronavirus Job Retention Scheme (“CJRS”) until 31 March 2021 means that many financial institutions will now need to make finely balanced workforce decisions that can withstand any subsequent challenge. As long as the eligibility criteria are met, any employee can be furloughed. Although the cost to an employer for furloughed employees is relatively low, it is likely that many employers will now need to make longer term strategic decisions. Employers may decide to make employees redundant, rather than placing them on furlough. Indeed, if there is little prospect of a particular role existing when the CJRS ends, there seems to be some merit in dismissing at this stage. In relation to those employees who have two years or more of continuous service, care should be taken to ensure that the dismissals are carried out fairly. In addition, in all cases, employers will need to ensure that such dismissals are not discriminatory.
We expect to see a steady stream of policyholders issuing claims in court or referring their claims to the Financial Ombudsman Service both for COVID-19 and non-COVID-19 losses.
8. Rise in (re)insurance disputes
Insurers have been subject to close scrutiny as a result of the pandemic and we expect this to continue as we head into 2021. Additionally, the volume and significance of claims in 2020 will have had an impact upon many insurers. As a result, we can expect all claims to receive additional internal attention because insurers will try to apply policy terms as restrictively as possible and keep capital in the business where possible, whether claims are related to COVID-19 or not. Consequently, we expect to see a steady stream of policyholders issuing claims in court or referring their claims to the Financial Ombudsman Service both for COVID-19 and non-COVID-19 losses. There will also be major disputes in the reinsurance market, as coverage under reinsurance treaties is contested. The ability to add losses together to maximise claim recovery will be the key issue. Lack of existing precedent on some of the language used (especially the word “catastrophe” and the operation of “hours clauses”) and no market standard drafting could cause problems. Many treaties contain arbitration clauses so published decisions may be scarce and limited to those where arbitration awards have been appealed.
9. Data security threats
The prolonged nature of the COVID-19 crisis risks organisational complacency. External data security threats from hackers will remain constant, as these actors find new ways to exploit system vulnerabilities inherent in the likely permanent pivot to greater remote working. Businesses may be overly confident relying on the security of short-term measures put in place in a rush to facilitate mass remote working at the start of the year. Equally, internal data security threats (e.g. leaks of information, poorly secured information, use of BYO devices) should not be overlooked. If staff are not in the office to receive upgraded equipment or return work devices (e.g. when leaving their employment), organisations will lack critical oversight of data and risk regulatory penalties. Institutions should be wary of assuming the ICO has mellowed in its enforcement practices following the lower than anticipated BA and Marriott fines. We cannot yet say whether these lower fines herald a definite trend in UK enforcement activity or are merely lower due to the systemic economic volatility caused by COVID-19. Scrupulous data security measures should therefore be a given, to mitigate regulatory risk.
10. Tax risk
2021 is likely to bring changes to the tax regime, as the UK emerges from lockdown 2.0 and the government seeks to both re-start the economy and fund the deficit created by the significant package of COVID-19 relief measures. While we do not anticipate that any new tax measures will be specifically targeted at financial institutions (in contrast to the government’s response to the previous financial crisis in 2008) all firms in the UK should be alive to the threat of an increase in the corporation tax rate.
…all firms in the UK should be alive to the threat of an increase in the corporation tax rate.
We also expect the number and pace of HMRC enquiries and investigations to increase during 2021 as an immediate way of raising revenue and balancing the books. During the peak of the pandemic, HMRC adopted a temporary suspension of most of its existing enquiries and confirmed that new enquiries would only be opened in exceptional circumstances. As HMRC’s internal resource is redeployed to its usual compliance activity and no longer required to implement the COVID-19 support packages, we expect that many new enquiries will be opened, with a particular focus on cases where there has been a potential serious loss of tax. Tax risk frameworks and controls should therefore be reviewed as a priority.
11. Health and safety risks
Whilst COVID-19 is, predominantly, a public health issue, health and safety obligations and duties also apply. Financial institutions need to ensure that they consider COVID-19 risks and the steps required to be taken when considering discharge of their health and safety obligations. The current COVID-19 legislation requires businesses to undertake specific risk assessments, consult employees, and implement social distancing measures in line with sector-based guidance. A failure to do so could lead to both prosecution and significant reputational risk. Key considerations also include the resilience of an organisation’s supply chain, in particular: whether key contractors that provide essential services are still able to do so; whether the business still has the financial and/or human resources to properly discharge its obligations; and, where works were planned pre-pandemic that relate to safety issues, whether it has been possible to carry them out. Businesses that have been required to close in lockdown periods may find these factors particularly challenging.
12. Compliance with new laws and regulatory scrutiny
Governments worldwide have responded to COVID-19 by rushing through new laws and regulations, with virtually immediate effect but limited detail and guidance. As a result, firms may face complaints regarding implementation and compliance. Counterparties may also seek to rely on these new laws to renegotiate agreements or avoid payment obligations. Litigation is likely because these new legislative provisions are untested and many companies seeking to rely on them were in financial distress before the pandemic. COVID-19 has already caused an increase in regulatory scrutiny. Firms are expected to provide assistance and support the real economy as consumers and small businesses face challenges. In parallel, firms are expected to manage their financial resilience and actively manage their liquidity. These pressures raise difficult questions of how firms should simultaneously support clients whilst also making commercial decisions and maintaining adequate liquidity. It is imperative that senior decision-makers can fully articulate the commercial decisions taken and evidence that clients have been treated fairly.
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This document provides a general summary and is for information/educational purposes only. It is not intended to be comprehensive, nor does it constitute legal advice. Specific legal advice should always be sought before taking or refraining from taking any action.