Repudiation: Meaning, Examples and FAQs in Fixed Income

What Is Repudiation?

Repudiation involves disputing the validity of a contract and refusing to honor its terms. In investing, repudiation is most relevant in fixed income securities, particularly sovereign debt. Fixed income instruments are fundamentally contracts where the borrower lends a certain amount of principal in return for payments of interest and principal on a preset schedule.

Understanding Repudiation

Repudiation occurs if the borrower refuses to honor this contract and stops making the agreed-upon payments. With fixed income instruments, it is always possible that the borrower may default, dispute the validity of the contract, or otherwise refuse to pay. If the borrower repudiates the contract, the corresponding investors may lose their entire investment unless they can recourse against the borrower. In the case of sovereign debt, however, there is often not any method of recourse against the borrowing nation.

In the context of repudiation, it may be that the repudiating party is unwilling or unable to perform its obligations under a contract. Repudiation is seen to be quite a serious matter, and the court requires a ‘clear indication’ that a party is unready or unwilling to perform the contract. When repudiation occurs before the actual breach of a contract, it can be referred to as an anticipatory breach.

The simplest method of repudiation is when a party comes right out and admits that they are unwilling or unable to perform their obligations under the contract. A party’s conduct can also amount to an act of repudiation. Whether a party repudiates or not is an objective test undertaken by the court making it a complex situation in the legal world. Each matter is considered individually. Put simply, determining repudiation requires a detailed review of the actual terms of the contract and the obligations of each party, and then the conduct and statements of the parties.

Types of Repudiation

There are essentially three main types of repudiation that a party can make when pulling out of an agreement or contract are transferring the deed to the property that is the subject of the deal (such as a home or building), a verbal repudiation when one party unconditionally refuses to stand by the contract, or when one party takes an action that makes it unable for the other party to perform or follow up on the contract or agreement. All three types are ways to breach a contract that is recognizable in the eyes of the law.

Responding to Repudiation

The party on the receiving end of repudiation (i.e., the party not pulling out of the contract) should be careful and ensure they respond appropriately. If one party believes another party has repudiated the contract, the innocent party may:

• Continue with the contract
• Accept the repudiation and elect to terminate the contract

Repudiation itself does not terminate a contract. It simply allows the innocent party to determine how they want to proceed. Such a party should either accept the repudiation or continue the performance of the contract without actually meaning to. In many cases, termination is the only way forward to responding to repudiation since continuing the contract may mean losing money or property.

Repudiation vs. Rescind

Repudiation occurs when one party decided to terminate a contract made with another party by letting them know they cannot (for whatever reason) honor the contract agreement. When a contract is rescinded, it means the contract is terminated by a court of law usually due to an error in the contract itself or because the other party has behaved badly or conducted unlawful business on behalf of the other party. In short, repudiation occurs by a party, a rescission happens in a court of law.

Example of Repudiation

Say a buyer finds a house they love and makes an offer on it. The seller contacts their sales agent arranges to meet the buyer and their agent, and all parties agree on the price offered for the home. A contract is drawn up with contingencies for a home inspection. After the inspection occurs, the seller decides they do not want to sell their home after all. The seller lets the buyer's agent know that they want out of the contract. This is an act of repudiation in the real estate industry. The contract is then breached and the seller will most likely have to return any earnest money given to them by the buyer.