On July 26, 2013, law no. 2013-672 relating to the separation
and regulation of banking activities, which was presented last
December to the Government by the Finance Minister, Mr. Pierre
Moscovici, was formally enacted (the "Regulation Banking
Act").
The law addresses a number of sensitive issues. It was introduced
to respond to lessons learned from the 2007–2008 financial
crisis which highlighted the limited number of tools and resources
available to supervisory authorities to limit the risks created in
the financial system by systemically important financial
institutions because of their size, complexity, or
interconnectedness.
The European Union ("EU") is currently working on a
proposed Resolution and Recovery Directive that will set out the
necessary resolution framework to ensure that bank failures across
the EU are effectively managed on a coordinated basis. On June 28,
2013, Member States' finance ministers agreed upon a general
approach to such a draft directive. This opens the way for trilogue
negotiations between the Council, the Commission, and the
Parliament, with the aim of finalizing the directive before the end
of this year—a schedule that many consider optimistic given
the discrepancies among the three drafts currently proposed and a
more general political debate on the topic.
The provisions of the Regulation Banking Act extend over a broad
array of issues such as ring-fencing of certain proprietary trading
activities, bank resolution regimes, anti-tax haven rules, money
laundering, trading of agricultural commodities, high-frequency
trading, transparency, market abuse, mandatory clearing, central
counterparties' supervision, and local authorities'
borrowings. This Commentary will focus on the Act's
provisions relating to bank resolution and, in particular, how
these provisions are likely to affect the enforceability of
close-out netting provisions of national and international market
master agreements for financial transactions entered into by French
banks and investment firms.
GENERAL CONCEPT AND CONTEXT
The Concept of "Resolution"At the outset, an important distinction must be made between (i)
"prudential administrative measures," (ii)
"reorganisation and winding up measures" (as defined in
European Directive 2001/24/CE of April 4, 2001 on the
reorganization and the winding up of credit institutions (the
"Banks' Winding Up Directive")), and (iii)
"resolution measures." It is only because resolution
measures are distinguished from reorganization and winding up
measures that the French Parliament has concluded that it may enact
a domestic resolution regime without waiting for a European
position.
Indeed, since the adoption of the Banks' Winding Up Directive,
the conditions for the enforceability of close-out netting
provisions against the administrator of a French insolvent
bank—and therefore against the relevant French supervisory
authority (the Autorité de contrôle
prudentiel or "ACP")—are not to be determined
by French law (i.e., the country where the insolvency proceedings
are opened (lex fori)), but solely by the governing law of
the relevant netting agreement (lex contractus). If
resolution were also to be considered as a reorganization or
winding up measures, this conflict-of-law rule would, by
designating the lex contractus as the sole competent law,
have rendered any French resolution regime inapplicable.
THE RECENT CHALLENGE OF CLOSE-OUT NETTING REGIMES
Although often cited as one of the most effective legal tools
against systemic risk, close-out netting has, since the onset of
the financial crisis, often been presented as an obstacle to the
reorganization process and recovery of a failing financial
institution. Hence, a temporary stay on the exercise of close-out
netting rights during a resolution proceeding has now officially
been proposed at an international level by the Key Attributes
for Effective Resolution Regimes for Financial Institutions,
published by the Financial Stability Board (the "FSB") in
October 2011.
Specifically, key attribute no. 4.2 proposes that the "entry
into resolution and the exercise of any resolution powers should
not trigger statutory or contractual set-off rights" or
constitute an event enabling "any counterparty to exercise
contractual acceleration or early termination rights provided the
substantive obligations under the contract continue to be
performed." Key attribute no. 4.3 further provides that in the
event that such rights are nonetheless exercisable, the resolution
authority shall be entitled to temporally stay such rights
"where they arise by reason only of entry into resolution or
in connection with the exercise of any resolution
powers."
The stay may be discretionary or automatic, but in all
circumstances, the following safeguards are required:
- The duration of the stay shall be strictly limited in time;
- The integrity of financial contracts shall be ensured, and legal certainty shall be provided to counterparties;
- The close-out netting rights of a counterparty shall not be affected when they rely on an event of default occurring before, during, or after the period of the stay but not related to the entry into resolution or the exercise of the relevant resolution power;
- The beginning and the end of the stay period shall be clearly determined; and
- In any event, creditors should have a right to compensation where they do not receive, at the minimum, what they would have received in the liquidation of the firm under the applicable insolvency regime (the "no creditor worse off than in a liquidation" principle).
One of the purposes of the Regulation Banking Act is to
implement these safeguards in France.
CREATION OF A BALANCED RESOLUTION REGIME FOR FRENCH FINANCIAL COUNTERPARTIES
Personal and Material Scopes of the Resolution RegimeThe Personal Scope
The resolution regime applies to credit establishments,
financial companies, mixed financial holding companies, and
investment firms, with the exception of portfolio management
companies.
As the opening of a resolution proceeding will evidence the extreme
difficulties encountered by the financial institution, such
proceeding may be triggered only by the occurrence of one of the
following circumstances:
- The entity no longer complies with applicable minimum capital requirements;
- The entity can no longer fulfil its payment obligations immediately or in the near future; or
- The entity needs financial assistance from the French Government.
The Material Scope
The resolution regime may apply to any agreement entered into
with any of the financial institutions listed in the above
paragraph.
Article L. 631-31-16 paragraph IV of the French Monetary and
Financial Code provides for protection of the single agreement
principle under master agreements and prevents the resolution
authority from "cherry picking" or dismantling a master
agreement by, for example, staying the equity derivatives
transaction of a failing financial institution while transferring
its fixed income transaction. In other words, assets, rights, and
obligations governed by a netting agreement mentioned in article
L.211-36-1 of the French Monetary and Financial Code may be
transferred only as a whole. Thus, netting agreements entered into
with French financial institutions will be effective, and
counterparties will be able to take into account net positions for
the purpose of determining capital requirements.
Resolution Measures
Under this resolution regime, the ACP, renamed the Prudential
Control and Resolution Authority (Autorité de
contrôle prudentiel et de résolution or
"ACPR"), is granted the power to manage such difficulties
and may adopt a number of resolution measures.
Such resolution measures may consist of a variety of actions and
prohibitions ranging from requesting information, appointing a
special resolution administrator, changing governance, transferring
all or part of a business unit (branche
d'activité), temporarily using a bridge financial
institution in support of all or part of the activities of the
failing institution before their assignment, activating the loss
absorption clause of subordinated bonds, mandatory recapitalizing
of the failing institution, suspending payments, and suspending or
prohibiting certain businesses of the failing financial
institution.
Among these measures, two are of particular relevance to all
financial derivatives counterparties to French banks and investment
firms and affect, permanently or temporarily, the right to close
out and net outstanding transactions as a result of a resolution.
Specifically, they are as follows:
Transfer
The first measures would apply when the ACPR decides to:
- Transfer all or part of one or more business units of the failing institution. Such transfer will give rise to an outright transfer of assets and will occur on the date set out by the ACPR; or
- Temporarily transfer to a bridge financial institution all or part of the assets, rights, and obligations of such entity with the aim to permanently transfer them later.
In both situations, the Regulation Banking Act provides that
"contracts relating to the transferred activities shall
continue as no termination or close-out netting provisions may be
invoked as a result of such transfer."
It should be noted that counterparties will remain free to close
out their master agreements:
- If those agreements are not determined by the ACPR as being part of the relevant assigned business unit; and
- Once the transfer has been made, if an event of default or a termination event, not related to the transfer, occurs in respect of the succeeding counterparties.
General Temporary Stay
The ACPR, when opening a resolution proceeding against a failing
institution, may—but is not obliged to—declare a
temporary stay of the exercise of early termination and close-out
netting rights until 5:00 p.m. the next business day following the
publication of such decision. When the ACPR decides upon the
opening of a stay period, such period shall start from the
publication of the decision pronouncing such stay until 5:00 p.m.
the next business day at the latest. All provisions to the contrary
shall be deemed null and void.
At the expiry of the stay, the regime mentioned in the above
paragraph ("Transfer") will apply or not depending on the
actions/transfers decided upon by the ACPR during this period of
time.
As mentioned above, in all instances, no dislocation of a single
netting agreement is permissible.
EXTRATERRITORIALITY ISSUES
Upon the request of the FSB and national supervisory
authorities, market associations are now working on the drafting of
amendments to their master agreements in order to temporarily
suspend the parties' termination rights following an event of
default when such default results from the opening of a resolution
proceeding. These amendments will be crucial for domestic
resolution regimes, such as the new French one, so as to ensure
their effectiveness in practice.
Moreover, in the absence of any international convention or
European law providing for mutual recognition of resolution
proceedings among Member States, it is highly debatable whether any
such domestic regime can extend its effects beyond its
borders.
From an international private law perspective, the extraterritorial
effect of a domestic resolution regime is a particularly
interesting issue to consider. While little doubt is left for
derivatives netting agreements governed by French law, whether or
not modified to take the new regime into account, one can question
how an English or New York court would treat the exercise of
close-out netting rights against a failing French institution on
the sole ground that a domestic French resolution proceeding has
been opened against it, absent express contractual provisions
addressing the issue.
It is therefore essential that any non-French law governed netting
agreement involving a French counterparty subject to the Regulation
Banking Act—at least until an international or European law
comes into force and renders it optional—provide for
contractual provisions modifying close-out netting rights in a
fashion that mirrors the terms of the Regulation Banking Act.
Prudential supervisors will doubtless consider whether persons and
entities subject to their control have adequately reflected in
their netting agreements the resolution regime and rules that they
regard as essential to their administrative powers and supervisory
prerogatives. Participants in the over-the-counter derivatives
market should therefore carefully review their master and other
netting agreements with French financial institutions for purposes
of compliance and due diligence as well as from a credit risk
analysis perspective.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.