In May 2016, the Board of Governors of the U.S. Federal Reserve System proposed new rules that, if adopted, will constitute a significant shift in the terms of financial contracts such as over-the-counter derivatives, repurchase agreement and securities lending transactions. Under the proposed rules, these qualified financial contracts would have to conform with U.S. special resolution regimes. This would require institutional investors, hedge funds and other market participants to relinquish cross-default rights, including in contracts governed by foreign law, entered into with a foreign party, or for which collateral is held outside the U.S.

The International Swaps and Derivatives Association simultaneously released its ISDA Resolution Stay Jurisdictional Modular Protocol which seeks to allow market participants to comply with the proposed rules in the U.S. and similar rules in other jurisdictions.

In this contribution, we provide a brief overview of these proposals which, if adopted, will significantly affect the terms of many financial transactions.

By Thomas Werlen / Jonas Hertner (Reference: CapLaw-2016-33)

1) Background: Too-big-to-fail issues still unresolved

Financial regulators around the globe have taken to protect the stability of the financial system by addressing the too-big-to-fail problem in two ways: by implementing measures to reduce the probability that a systemically important institution will fail, and by attempting to reduce the potential damage that such a failure would cause if it were to occur. Yet, eight years after the financial crisis the world’s biggest banks still cannot be wound down in an orderly fashion, according to the Financial Stability Board’s 2016 Report on the Implementation and Effects of the G20 Financial Regulatory Reforms.

One of the remaining key challenges concerns the critical time period when an insolvent bank enters bankruptcy proceedings. In an effort to facilitate a potential resolution of a failed bank without either injecting public capital or exposing the overall stability of the financial system, the U.S. Federal Reserve proposes new rules that would restrict default rights of counterparties when contracting with global systemically important banks and allow authorities to step in and take measures to mitigate potential chaos (www.federalreserve.gov/newsevents/press/bcreg/bcreg20160503b1.pdf).

2) Scope of application

By their very nature, global systematically important banks, or G-SIBs, are interconnected with other financial firms (and other G-SIBs) through large volumes of financial contracts of various types. The rules proposed by the U.S. Federal Reserve Board target several classes of these transactions that are collectively defined under U.S. law as qualified financial contracts.

a) Qualified Financial Contracts (QFCs)

The proposed rules define the term qualified financial contracts in accordance with section 210(c)(8)(D) of the Dodd-Frank Act. QFCs include many swaps, repurchase and reverse repurchase transactions, forward contracts, commodity contracts and securities sale, lending and borrowing transactions. The definition also includes master agreements that govern such contracts. For non-U.S. G-SIBs, the QFC definition effectively excludes transactions that are not booked at, and for which no payment or delivery may be made at, a U.S. branch or U.S. agency of the non-U.S. G-SIB. Centrally cleared QFCs are also expressly excluded from the scope of the proposed rules (even though cleared QFCs too are the source of some of the risks that the proposed rules seek to address).

b) Financial institutions directly affected by the proposal

The entities covered by the proposed rules include:

• any U.S. bank holding company that is identified as a G-SIB holding company under the Federal Reserve Board’s rule establishing risk-based capital surcharges for G-SIBs;
• any subsidiary of a U.S. G-SIB described above that is not a national bank, federal savings association, federal branch or federal agency; and
• a U.S. subsidiary, U.S. branch, or U.S. agency of a non-U.S. G-SIB.

3) Default rights risks and U.S. special resolution regimes

a) Risks connected to default rights in contracts with G-SIBs

Generally, a party to a financial transaction has the right to take certain actions if its counterparty defaults on the contract. These include the right of the non-defaulting party to suspend performance of its obligation, the right to terminate or accelerate the contract, the right to set off amounts owed between the parties, and the right to seize and liquidate the defaulting party’s collateral. In general, these rights allow a party to exit the QFC and thus to reduce its exposure to the counterparty, e.g., if the counterparty enters into a resolution proceeding. If the defaulting party is a G-SIB, however, the private benefit of the counterparty allowed to take certain exposure-reducing measures must be balanced against the potential damage that can result from the exercise of default rights: if, for instance, a significant number of QFC counterparties take measures based on their default rights, this might result in a disorderly resolution, affecting not only the parties to the QFCs but potentially destabilizing the wider financial system.

Destabilization of the financial system through the precipitous exercise of default rights may occur in different scenarios: The G-SIB may be forced to rapidly sell off assets and collateral underlying these contracts at depressed prices when exits of counterparties drain liquidity. Such fire sales of assets may result in or worsen balance-sheet insolvency of the G-SIB, causing the bank to fail more suddenly and reducing the amount that its other creditors could recover.

b) Restricted default rights under Title II of the Dodd-Frank Act

In the wake of the financial crisis, U.S. legislators passed a set of new laws limiting default rights in financial contracts. Most importantly, this was achieved through the enactment of the Orderly Liquidation Authority (OLA) provisions in Title II of the Dodd-Frank Act and amendments to the Federal Deposit Insurance Act (FDIA).

The OLA provides the Federal Deposit Insurance Corporation (FDIC) with the authority to serve as receiver for financial institutions whose default would pose a significant risk to financial stability. The FDIC also has receivership authority under the FDIA. Both of these regimes in certain circumstances limit the contractual rights of counterparties facing systemically important banks and impose a one or two business day stay on the exercise of default rights by counterparties of a distressed financial institution. The stay allows the receiver or regulatory body to transfer the financial institution’s rights and obligations to another entity that is capable of performing under the QFCs. Following such a transfer, generally, the non-defaulting party’s right to exercise default rights as a result of its counterparty entering the proceeding is permanently stayed.

4) Goals of the proposed rules

The proposed rules identify two risk scenarios that still remain despite the entering into effect of the regimes described above in the U.S. and similar provisions adopted in other jurisdictions. The first concerns the cross-border enforceability of the U.S. special resolution regimes: what would happen if a court outside of the U.S. were to disregard the powers of U.S. regulatory agencies to prevent counterparties from exercising contractual termination rights? The second concerns risks associated with so-called cross defaults, as described below.

a) Cross-border enforceability of U.S. special resolution regimes

First, the proposed rules seek to assure that, with respect to covered entities, the U.S. special resolution regimes would be applied by courts and authorities in other jurisdictions, too. Accordingly, the rules would require covered entities to modify their contractual terms so that the U.S. special resolution regimes apply to cross-border transactions and bind parties (and, indirectly, authorities) outside of the U.S.

Specifically, counterparties in QFCs with G-SIBs would be required to opt into provisions under the U.S. special resolution regimes that allow the transfer of a QFC from the covered entity to another entity notwithstanding the standard restrictions on transfer included in derivatives, repurchase agreement and securities lending documentation.

b) Limitations on default rights under QFCs

Second, the new rules address the cross default problem. Risks in connection with cross defaults arise when an affiliate of the G-SIB entity that is a direct party to the QFC (e.g. the direct party’s parent holding entity) enters a resolution proceeding. For instance, a G-SIB parent entity might guarantee the derivatives transactions of a subsidiary, and those derivatives contracts could contain cross-default rights against a subsidiary of the G-SIB that would be triggered by the entering into a resolution proceeding of the G-SIB parent entity – even though the subsidiary continues to meet its financial obligations under the contract. Accordingly, the proposal seeks to facilitate the resolution of G-SIBs by preventing counterparties of solvent affiliates of the failed entity from unravelling their contracts with solvent affiliates based solely on the failed entity’s resolution.

Specifically, the proposed rules pursue a “single point of entry” strategy whereby only the parent holding company would enter into a resolution proceeding while the subsidiaries would ideally continue to operate and meet their financial obligations if they are able to do so. For this purpose, the proposed rules prohibit operating subsidiaries of G-SIBs from entering into QFCs that allow counterparties to exercise cross-default rights based on the entry into resolution of an affiliate of such subsidiaries.

c) Required amendments of terms

As a result of the proposed rules, covered entities would be required to add two distinct provisions to their QFCs (see Section 83 of the proposed rules):

• Default rights, as (broadly) defined under the proposed rules, that may be exercised against a covered entity are permitted to be exercised to no greater extent than the default rights could be exercised under the U.S. special resolution regimes if the covered QFC was governed by U.S. law and the covered entity were under a U.S. special resolution regime.
• The transfer of the covered QFC (including any interest in, or property securing, the QFC) from the covered entity will be effective to the same extent as the transfer would be effective under the U.S. special resolution regimes, also assuming U.S. law applied and the covered entity were under a U.S. special resolution regime.

5) ISDA Resolution Stay Jurisdictional Modular Protocol

In a coordinated effort, and simultaneously with the vote of the Board of Governors of the U.S. Federal Reserve System to publish the proposed rules described here, the International Swaps and Derivatives Association published the “ISDA Resolution Stay Jurisdictional Modular Protocol” (JMP) (https://www2.isda.org/functional-areas/protocol-management/protocol/24). Like other ISDA protocols, the JMP seeks to allow parties to amend a large number of contracts in one go. The JMP is the third protocol published by ISDA designed to address compliance with the requirements of special resolution regimes, following the 2014 Resolution Stay Protocol and the 2015 Universal Resolution Stay Protocol. In many respects, the JMP is similar to the ISDA 2015 Universal Resolution Stay Protocol (https://www2.isda.org/functional-areas/protocol-management/protocol/ 22), and the U.S. Federal Reserve has expressed the view that a covered entity may comply with the requirements of the proposed rules by adhering to the 2015 Universal Stay Protocol.

ISDA published the JMP in order to allow counterparties to QFCs to comply with the proposed rules and similar regulations in other jurisdictions to ensure that stays or overrides of default rights under the respective jurisdiction’s own special resolution regime would be enforced by courts in other jurisdictions. Accordingly, the JMP has been developed to facilitate compliance with specific legislative or regulatory requirements in different jurisdictions (such as the proposed rules in the U.S.).

If the proposed rules are adopted, there would be clear advantages of market participants agreeing to the applicable provisions through a market-wide ISDA protocol rather than via bilateral agreements. For instance, this would increase the chances that all counterparties to QFCs with a covered entity will be stayed to the same extent in the resolution of the covered entity and thus increase the likelihood that the covered entity will be resolved in an orderly manner.

ISDA will publish a jurisdictional module for a particular jurisdiction once regulations in that jurisdiction are finalized. Parties would then be able to choose whether to adhere to specific jurisdictional modules or to the 2015 Protocol, although ISDA expects that counterparties will adhere to the respective JMPs in order to comply with the different jurisdictions’ various stay regulations.

6) Conclusions

Regulations similar to the proposed rules discussed here have been adopted in other jurisdictions, too. For instance, the Swiss Federal Council requires banks to ensure that new contracts and amendments to existing contracts entered into by the group holding and individual entities, and that are subject to foreign law or designate a foreign jurisdiction, are entered into only if the counterparty recognizes a stay of termination rights in accordance with the special resolution provisions under the Swiss Financial Market Infrastructure Act.

Regulations of this kind require parties to relinquish contractual rights designed to reduce exposure in the event of default of the counterparty. Such limitations can only be justified by a legitimate policy objective. The proposal by the U.S. Federal Reserve Board discussed here complements other recent proposals intended to address the too-big-to-fail problem, including rules on total loss-absorbing capacity, long-term debt, and clean holding company requirements for G-SIBs. It focuses on facilitating an orderly resolution of a G-SIB by limiting disruptions to a distressed G-SIB through its financial contracts with its counterparties. As in other fields, U.S. regulators are seeking to expand the application of U.S. law on cross-border business relationships. With respect to qualified financial contracts involving global systemically important banks, a certain harmonization of the rules governing the resolution of these large and complex institutions is to be welcomed. Against this background, the rules appear reasonable.

It is to be expected that counterparties entering into QFCs with covered entities will be required to agree to the applicable final provisions by early 2018, either by adherence to the respective ISDA Protocol or by individually amending contract terms.

Thomas Werlen (thomaswerlen@quinnemanuel.swiss)
Jonas Hertner (jonashertner@quinnemanuel.swiss)