On October 18, the International Swaps and Derivatives Association, Inc. (“ISDA”) announced that eighteen major global banks had agreed to sign a protocol (the “Protocol”) that imposes a stay on cross-default and termination rights under standard derivatives contracts governed by an ISDA master agreement. The terms of the Protocol, which was developed in close coordination with regulators to facilitate cross-border resolution efforts and to address risks associated with the disorderly unwind of derivatives portfolios, would apply where one of the Protocol signatories becomes subject to resolution action in its jurisdiction.
The push for a temporary suspension of termination rights was prompted, at least in part, by the rush of counterparties to unwind some 900,000 derivatives contracts against Lehman Brothers trading entities and seize collateral upon Lehman’s bankruptcy filing. This stampede to exercise termination rights further destabilized the markets and led to disorder that deepened the financial crisis. In response, certain countries developed statutory resolution regimes. For example, in the United States, Title II of the Dodd-Frank legislation provides a stay of termination rights against “covered financial companies” for which the Federal Deposit Insurance Corporation (“FDIC”) has been appointed receiver until 5:00 p.m., U.S. Eastern time, on the business day following the date on which the FDIC is appointed receiver.[1] However, absent the Protocol, statutory regimes such as that of Title II might only apply to trades between domestic parties under domestic law governed agreements, and not to cross-border trades.
For some time, regulators, industry groups and banks have expressed a strong interest in amending derivatives documentation to recognize the suspension of early termination rights on bilateral uncleared swaps upon the commencement of insolvency or resolution proceedings against a systemically important financial institution. Indeed, in November 2013, four global regulators sent a letter to ISDA expressing their desire for the group to effect changes to its widely-used master agreement documenting derivatives. In this letter, the regulators noted that “[a] change in the underlying contracts for derivative instruments that is consistently adopted is a critical step to provide increased certainty to resolution authorities, counterparties, and other market participants, particularly in the cross-border resolution context.”[2]
Under the Protocol, adhering parties incorporate suspension terms into their derivatives contracts by “opting-into” certain qualifying overseas resolution regimes. In effect, by signing the Protocol, an adhering party recognizes stays under various statutory resolution regimes. The purpose of the suspension is to provide regulatory authorities with a brief period during which they could exercise certain powers, such as the transfer of derivatives contracts to a solvent third party or, possibly, conversion of financial institution obligations into equity. In short, the Protocol will facilitate regulators’ ability to deal with the swap positions of financial institutions that present systemic risk because they are perceived to be “too big to fail,” hence shielding taxpayers from bail-out costs.
The Protocol reportedly will cover more than 90% of the outstanding derivatives notionals of the adhering parties, a percentage that is expected to increase as additional firms agree to its terms, especially if global prudential regulators require its adoption by regulated entities. However, certain end-users have expressed reluctance in having their potential termination rights curtailed, especially during a time of distress and extreme market volatility. Asset managers, in particular, have argued that voluntarily limiting early termination rights could violate fiduciary duties owed to their clients.
The eighteen banks are expected to adhere to the terms of the Protocol by early November—before the next G-20 meeting in Australia—and the Protocol generally will become effective beginning January 1, 2015. Nevertheless, additional work remains to remove obstacles to cross-border resolution. On September 29, the Financial Stability Board launched a public consultation on a set of proposals to achieve the cross-border recognition of resolution actions and remove impediments to cross-border resolution.[3]
[1] Generally, “qualified financial contracts” (“QFCs”) (which are defined to include, inter alia, “swap agreements”), may not be terminated, liquidated and accelerated solely by reason of, or incidental to, the appointment of the FDIC as receiver for a “covered financial company” (i.e., a financial company for which, among other things, the Secretary of the Treasury has made a systemic risk determination) until the earlier of: (i) 5:00 pm on the business day following the date of the appointment of the FDIC as receiver; or (ii) receipt of notice of transfer of the QFC. Wall Street Financial Reform and Consumer Protection Act § 210(c)(10)(B)(i).
[2] Letter to ISDA from the Bank of England, Bundesanstalt für Finanzdiensteistungsaufsicht, Federal Deposit Insurance Corporation and Swiss Financial Market Supervisory Authority, available at https://www.fdic.gov/news/news/press/2013/pr13099a.pdf.
[3] See “Cross-border recognition of resolution action” (29 September 2014), available at http://www.financialstabilityboard.org/publications/c_140929.pdf.