Contributed by Abigail Lerner
This past Saturday, October 11, 2014, marked an important day in the too-big-too-fail regulatory and industry initiative. The International Swaps and Derivatives Association, Inc. (ISDA) announced on Saturday that 18 major global banks (G-18) have agreed to sign a new ISDA Resolution Stay Protocol, developed in coordination with the Financial Stability Board, to support cross-border resolution and reduce systemic risk. For a copy of ISDA’s press release, click here.
ISDA reports that the Protocol will impose a stay on cross-default and early termination rights within standard ISDA derivative contracts between G-18 firms in the event one of them is subject to resolution action in its jurisdiction. Although the existing resolution framework imposes a stay on early termination rights (see below discussion), the stay may only apply to domestic counterparties trading under domestic law agreements and, thus, might not capture cross-border trades. Therefore, the issue ISDA aimed to address through implementation of the Protocol was whether stays on termination rights under a particular resolution regime would be enforceable against all swap counterparties of a banking group, which would likely be located in different jurisdictions and transacting under the laws of a variety of jurisdictions. Because statutory regimes do not typically contain provisions that recognize the resolution regimes of other jurisdictions, the new stay resolution Protocol has the potential of aiding resolution efforts of large, cross-border banks dealing with the close-out of derivatives transactions.
The new Protocol addresses what seems to be a hot button topic–whether to limit the exercise of termination rights under derivatives contracts–for regulators and scholars alike. Indeed, both the Bankruptcy Code and the Dodd-Frank Act include provisions governing the close-out of derivatives contracts.
Under the Bankruptcy Code, “qualified financial contracts” (QFCs), including repurchase agreements, interest rate and currency swaps, credit default swaps, and other derivatives, are exempt from the automatic stay. Therefore, QFC counterparties are afforded special treatment and are free to take certain actions that otherwise would be prohibited by the automatic stay when their contract counterparties commence bankruptcy cases, including closing out their derivatives contracts. The rationale for this special treatment has been that allowing counterparties to exit immediately from their contracts upon the failure of an important market participant would stem the tide of the potential chain reaction of insolvencies that could occur. Some scholars, however, have disagreed with this rationale reasoning that the Bankruptcy Code’s special treatment of derivatives may actually increase systemic risk by causing a run on the failing firm and a massive destruction of value.
To address the potential systemic collapse of the financial system, and without amending the safe harbor provisions of the Bankruptcy Code, Congress enacted different procedures for the treatment of QFCs in Title II of the Dodd-Frank Act. Title II, the Orderly Liquidation provision of the Dodd-Frank Act, provides a process to quickly and efficiently liquidate a large, complex financial company that is close to failing. Title II provides an alternative to bankruptcy in which the Federal Deposit Insurance Corporation (FDIC) is appointed as a receiver to carry out the liquidation and wind-up of the company. For a discussion of Title II of the Dodd-Frank Act, click here.
Unlike the Bankruptcy Code, the Orderly Liquidation Act (OLA) suspends ipso facto close outs of QFCs for one business day period to allow the Federal Deposit Insurance Corporation (FDIC), as receiver of the failing financial company, to identify how to manage the company’s QFC portfolio. Dodd-Frank Act §210(c)(10)(B). Under OLA, during this short stay period, the FDIC has the option to, among other things, transfer the QFCs to another financial instruction.
It remains to be seen whether exempting financial contracts from the automatic stay will exacerbate systemic risk. Similarly, only time will tell whether the new Protocol will be effective in improving cross-border resolution actions and address the problem, identified by ISDA, of cross-border trades “falling between the cracks.”
The terms of the Protocol have been agreed in principle, and it is scheduled for implementation in early November. The Protocol will take effect January 1, 2015, and will govern both new and existing trades between adhering parties. We will post a follow-up article once more details of the Protocol become available.