The Board of Governors of the Federal Reserve System (Board), the Office of the Comptroller of the Currency (OCC), and the Federal Deposit Insurance Corporation (FDIC) adopted rules (together, the QFC Stay Rules) in 2017 requiring amendments to certain qualified financial contracts (QFCs). The compliance dates for these rules depend on the type of QFC counterparty facing a “covered entity” (as defined below), and are being phased in beginning on January 1, 2019 and ending on January 1, 2020. Notwithstanding this compliance phase-in, dealers subject to the QFC Stay Rules have been requesting that all of their counterparties, including end users, take action to facilitate compliance as though the initial compliance date, January 1, 2019, applied to all types of QFC counterparties. This article is intended to help buy-side participants navigate the compliance process, with emphasis on describing (i) the various types of contracts that constitute “covered” QFCs subject to the rules and (ii) the various alternative methods for compliance.
What do the QFC Stay Rules require?
The QFC Stay Rules require “covered” entities to conform the terms of each “covered” QFC to certain restrictions set forth in the QFC Stay Rules. The meaning of “covered QFC” is discussed in the next section. Covered entities are generally defined as U.S. top-tier bank holding companies identified by the Board as global systemically important banking organizations (GSIBs), the subsidiaries of U.S. GSIBs, and the U.S. operations of foreign global systemically important banking organizations (i.e., U.S. subsidiaries, branches and agencies). Strictly speaking, the requirements under the QFC Stay Rules apply solely to covered entities and not to their (non-covered entity) counterparties. That being said, it is expected that covered entities will be unwilling to enter into any covered QFC with a counterparty after the initial compliance date of January 1, 2019 unless the covered QFC conforms to the requirements of the QFC Stay Rules.
The restrictions on covered QFCs generally fall into two categories: (i) required contractual provisions related to the U.S. special resolution regimes (Opt-In Requirement); and (ii) prohibited cross-default rights (Cross-Default Restriction). The Opt-In Requirement requires a covered QFC to explicitly provide both (a) that the transfer of the QFC (and any interest or obligation in or under it and any property securing it) from the covered entity to a transferee would be effective to the same extent as it would be under the U.S. special resolution regimes if the covered QFC were governed by U.S. law and (b) that default rights with respect to the covered QFC could be exercised against the covered entity to no greater extent than under the U.S. special resolution regimes if the covered QFC were governed by U.S. law. The term “U.S. special resolution regimes” refers to the special resolution frameworks under the Federal Deposit Insurance Act (FDI Act) and Title II of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) for failed financial firms, both of which provide that the rights of a failed firm’s counterparties to terminate their QFCs are temporarily stayed when the financial firm enters a resolution proceeding and permit the transfer of the relevant obligations under the QFC to a solvent party. A covered QFC that is governed by U.S. law (or state law) and involves only U.S. parties is excluded from the Opt-In Requirement (provided that the covered QFC does not explicitly carve out the U.S. special resolution regimes from the laws governing the covered QFC), however, because in that case it is sufficiently clear that the stay-and-transfer provisions of the U.S. special resolution regimes would be enforceable.
The Cross-Default Restriction requires that (i) a covered QFC may not include default rights that are related, directly or indirectly, to an affiliate of the covered entity becoming subject to a receivership, insolvency, liquidation, resolution or similar proceeding, subject to certain exceptions, and (ii) a covered QFC may not prohibit the transfer of any “covered affiliate credit enhancement” applicable to the QFC (such as another entity’s guarantee of the covered entity’s obligations under the QFC), along with associated obligations or collateral, upon an affiliate of the covered entity becoming subject to a bankruptcy proceeding. “Covered affiliate credit enhancement” means a credit enhancement provided by an affiliate (that is itself a covered entity) to a party to the QFC that the credit enhancement supports.
What types of contracts constitute covered QFCs subject to these restrictions?
The QFC Stay Rules provide essentially a four-step process for identifying “covered” QFCs that are subject to the restrictions described above: first, narrowing all types of agreements to only those that constitute QFCs; second, narrowing all QFCs to only those that constitute “in-scope” QFCs; third, narrowing all in-scope QFCs to only those that constitute “covered” QFCs; and fourth, determining whether a given covered QFC has terms that require remediation in accordance with the restrictions described above. Each of these four steps is discussed below.
Step one – QFCs. The QFC definition is very broad and includes any securities contract, commodity contract, forward contract, repurchase agreement, swap agreement, and any similar agreement that the FDIC determines by regulation, resolution, or order to be a QFC. In turn, the “securities contract” definition is expansive and includes, among other types of contracts, any contract for the purchase, sale, or loan of a security, certificate of deposit, or mortgage loan, or any option on any of the foregoing; any master agreement that provides for any of the foregoing types of transactions; or any security agreement or arrangement or other credit enhancement related to any of the foregoing types of transactions. Thus, besides the more obvious types of contracts such as ISDA master agreements and swap transactions thereunder, QFCs also include, for example, underwriting agreements or credit agreements that secure hedges.
Step two – in-scope QFCs. Only QFCs that (i) explicitly restrict the transfer of the QFC (or any interest or obligation in or under, or any property securing, the QFC) from a covered entity or (ii) explicitly provide default rights that may be exercised against a covered entity are “in-scope.” According to the adopting releases for the QFC Stay Rules, this step is intended to prevent the scope of QFCs subject to the restrictions under the QFC Stay Rules from being overly broad. Types of QFCs that would be unlikely to be “in-scope” include, for example, cash market securities and certain spot FX transactions.
Step three – covered QFCs. All in-scope QFCs that a covered entity enters into on or after January 1, 2019 are covered QFCs. Additionally, if (i) a covered entity (or any affiliate that is also a covered entity) and (ii) a counterparty (or any of its consolidated affiliates) enter into a QFC on or after January 1, 2019, then all in-scope QFCs that the covered entity and the counterparty entered into before January 1, 2019 automatically become covered QFCs. In other words, pre-January 1, 2019 in-scope QFCs will be grandfathered only if no QFCs are entered into on or after January 1, 2019 between (i) the covered entity or any of its covered entity affiliates and (ii) the counterparty or any of its consolidated affiliates.
Step four – identifying terms requiring remediation. As noted above, a covered QFC that is governed by U.S. law and includes only U.S. parties is excluded from the Opt-In Requirement. Similarly, a covered QFC that contains no prohibited cross-default rights does not need to be amended to conform to the requirements of the Cross-Default Restriction. Nevertheless, covered entities frequently request that their counterparties agree to amendments related to the QFC Stay Rules regardless of whether the terms of a given covered QFC technically require such remediation. It also appears that some covered entities are providing language to be added to contracts on a “take it or it leave it” basis, stating that because their regulators have approved the language, the language cannot be altered in any respect.
What are the various alternative methods to make covered QFCs compliant?
To address the requirements of the QFC Stay Rules, the International Swaps and Derivatives Association, Inc. (ISDA) has developed: (i) the ISDA 2018 U.S. Resolution Stay Protocol (Protocol); (ii) forms of Bilateral Agreement to Amend Certain Qualified Financial Contracts; and (iii) Standard Language to Comply with Resolution Regime Requirements. Each of these three compliance methods is discussed below.
(i) ISDA 2018 U.S. Resolution Stay Protocol. Adherence to the Protocol automatically amends all in-scope QFCs entered into between the adhering party and any covered entity (assuming it has also adhered) on or before the date of adherence. The Protocol does not apply to any in-scope agreement entered into after such adherence date unless the in-scope QFC incorporates the Protocol by reference. The Protocol may be incorporated by reference into an in-scope QFC only if all parties have adhered to the Protocol (because the Protocol was drafted under a safe harbor contained in the QFC Stay Rules, as described below).
Adherence to the Protocol: (a) satisfies the Opt-In Requirement by amending the terms of in-scope QFCs to expressly recognize existing limits on the exercise of default rights by counterparties under the U.S. special resolution regimes as well as the powers of the FDIC to transfer contracts upon a resolution under the U.S. special resolution regimes; and (b) satisfies the Cross-Default Restriction by amending the terms of in-scope QFCs to (x) limit the ability of the counterparty to the covered entity to exercise default rights related, directly or indirectly, to any affiliate of the covered entity entering into bankruptcy proceedings (including under either the U.S. special resolution regimes or the U.S. Bankruptcy Code) and (y) permit the transfer of related credit support provided by a covered affiliate in such a scenario.
The Protocol was drafted based on the requirements under the QFC Stay Rules for a safe harbored “U.S. protocol,” and therefore any covered QFC that is amended by the Protocol is deemed to comply with the requirements of the QFC Stay Rules. The requirements under that safe harbor allow greater creditor protections than are possible under the stated requirements of the QFC Stay Rules. For that reason, the Protocol offers greater creditor protections than do the bilateral agreements and model language described below, which may incentivize buy-side participants to adhere to the Protocol rather than amend covered QFCs through a different method.
(ii) Bilateral Agreement to Amend Certain Qualified Financial Contracts. ISDA has published separate forms of bilateral amendments depending on whether a covered entity belongs to a U.S. or non-U.S. global systemically important banking organization and whether the counterparty is a corporate entity or an agent adhering on behalf of funds or other principals. The forms provide standalone agreements that are drafted to amend all in-scope QFCs (unless exempt under applicable provisions of the QFC Stay Rules) entered into between members of the covered entity group of affiliates and members of the consolidated counterparty group (or, as applicable, an investment manager or other agent acting on behalf of its clients) on or before the execution date of the bilateral amendments. The bilateral amendments would not amend QFCs with any other covered entity groups (in contrast to the Protocol which, as discussed above, automatically amends in-scope QFCs entered into on or before the date of adherence between the adhering party and any covered entity that has also adhered). Additionally, the terms of the bilateral amendments offer only the creditor protections permitted for bilateral agreements pursuant to the requirements of the QFC Stay Rules which, as discussed above, are fewer than those provided under the Protocol.
(iii) Standard Language to Comply with Resolution Regime Requirements. ISDA has also provided model language for inclusion in a covered QFC to address the Opt-In Requirement. The model language does not address the Cross-Default Restriction and therefore is intended only for covered QFCs that do not have default rights related directly or indirectly to affiliate bankruptcy proceedings or transfer restrictions on credit enhancements in the event of an affiliate bankruptcy proceeding.
What is the regulators’ stated rationale for the QFC Stay Rules?
Regarding the policy rationales underlying the QFC Stay Rules, the adopting release to the Board QFC Rule states, for example: “This final rule responds to the threat to financial stability posed by [certain] default rights in two ways. First, the final rule reduces the risk that courts in foreign jurisdictions would disregard statutory provisions that would stay the rights of a failed firm’s counterparties to terminate their contracts when the firm enters a resolution proceeding under one of the special resolution frameworks for failed financial firms created by Congress under the FDI Act and the Dodd-Frank Act. Second, the final rule facilitates the resolution of a large financial entity under the U.S. Bankruptcy Code and other resolution frameworks by ensuring that the counterparties of solvent affiliates of the failed entity cannot unravel their contracts with the solvent affiliate based solely on the failed entity’s resolution.”
 Restrictions on Qualified Financial Contracts of Systemically Important U.S. Banking Organizations and the U.S. Operations of Systemically Important Foreign Banking Organizations; Revisions to the Definition of Qualifying Master Netting Agreement and Related Definitions, 82 Fed. Reg. 42882 (September 12, 2017) (Board QFC Rule); Restrictions on Qualified Financial Contracts of Certain FDIC-Supervised Institutions; Revisions to the Definition of Qualifying Master Netting Agreement and Related Definitions, 82 Fed. Reg. 50228 (October 30, 2017) (FDIC QFC Rule); Mandatory Contractual Stay Requirements for Qualified Financial Contracts, 82 Fed. Reg. 56630 (November 29, 2017) (OCC QFC Rule).
 The OCC QFC Stay Rule also applies to national banks and federal savings associations that are not subsidiaries of a bank holding company but that have total assets exceeding $700 billion.
 The requirements under the Board QFC Rule, the FDIC QFC Rule, and the OCC QFC Rule are “substantively identical.” Board QFC Rule at 42887. As defined in the Board QFC Rule, the term “covered entity” excludes state savings associations and state nonmember banks (FSIs), which are supervised by the FDIC, and GSIB subsidiaries (such as national banks), U.S. branches, and U.S. agencies that are supervised by the OCC. FSIs and entities supervised by the OCC are subject to the FDIC QFC Rule and the OCC QFC Rule, as applicable (the FDIC QFC Rule and the OCC QFC Rule refer to such entities as “covered FSIs” and “covered banks,” respectively). For simplicity, this article refers to “covered entities” (as defined in the Board QFC Rule), covered FSIs and covered banks collectively as “covered entities.”
 For purposes of simplicity, this article refers to such proceedings as “bankruptcy proceedings.”
 The QFC Rules also provide that the following types of contracts are not required to be conformed: (i) retail investment advisory contracts that do not include restrictions on transfer (except to the extent necessary to comply with the Investment Advisers Act) and that do not include default rights, (ii) warrants issued prior to a designated date (under the Board QFC Rule, November 13, 2017, and under the FDIC QFC Rule and OCC QFC Rule, January 1, 2018) that evidence rights to subscribe for securities of the covered entity or an affiliate thereof and (iii) QFCs in respect of which a central clearing house is party or in respect of which each party other than the covered entity is a financial markets utility.
 The text of the Protocol is available at: https://www.isda.org/a/CIjEE/3431552_40ISDA-2018-U.S.-Protocol-Final.pdf.
 ISDA previously released the ISDA 2015 Universal Stay Protocol. However, it is expected that market participants other than the original adherents to the ISDA 2015 Universal Stay Protocol will only adhere to the ISDA 2018 U.S. Resolution Stay Protocol.
 The amendments also include such recognition of equivalent provisions under certain other identified resolution regimes (i.e., the special resolution regimes in France, Germany, Japan, Switzerland and the United Kingdom) to the extent applicable if the covered entity (or, in some cases, certain related entities of the covered entity) becomes subject to proceedings under such identified resolution regimes.
 Available at: https://www.isda.org/a/EVAEE/ISDA-Part-I-Language-Final.pdf.
 Board QFC Rule at 42883.