United States: How To Comply With Qualified Financial Contract Rules

In the fall of 2017, the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation and the Office of the Comptroller of the Currency promulgated new rules as part of their ongoing efforts to address the "too-big-to-fail" problem.1

The new rules require U.S. global systemically important banking organizations, or GSIBs, as designated by the Basel Committee on Banking Supervision and the Financial Stability Board, the subsidiaries of U.S. GSIBs (including state member and nonmember banks and state savings associations and most of their subsidiaries), national banks or federal savings associations that have more than $700 billion in assets, and the U.S. subsidiaries, branches or agencies of non-U.S. GSIBs (collectively, covered entities)2 to amend certain types of financial contracts, including securities contracts, swaps and other types of derivatives, repurchase and reverse repurchase agreements and securities lending arrangements (qualified financial contracts or QFCs), to include provisions that limit their counterparties' termination rights and other default rights in certain circumstances and permit such QFCs, or related credit support agreements, to be assigned in certain circumstances. We refer to these rules collectively as the QFC rules.

The QFC rules are part of a package of policies intended to enable U.S. banking regulators to wind up the affairs of a covered entity in an orderly fashion. Under the Federal Deposit Insurance Act, the FDIC has certain receivership powers with respect to insured depository institutions that have become insolvent. Title II of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 gave the FDIC orderly liquidation authority under a similar "resolution" regime for financial companies not organized as banks, such as bank-holding companies (the OLA regime). If the FDIC is appointed as the receiver of an insolvent bank or other financial company (whether under the FDI Act or the OLA regime), these receivership powers allow the FDIC to take over the institution's affairs, liquidate its assets, transfer its obligations under its contracts to other solvent entities and otherwise resolve the bank or financial company's affairs in an orderly manner. To the extent the entity in receivership is a covered entity, the QFC rules facilitate this process by eliminating contractual terms that might otherwise limit the FDIC's ability to transfer the covered entity's QFCs to other solvent institutions during a short stay period.

In July of 2018, the International Swaps and Derivatives Association published the ISDA 2018 U.S. Resolution Stay Protocol to enable covered entities and their counterparties to efficiently amend their QFCs to comply with the QFC rules. The obligation to amend QFCs resides with covered entities. However, buy-side counterparties will be requested by such covered entities to participate in the process of amending their QFCs to comply with the QFC rules. Covered entities may stop trading with counterparties who do not so amend their QFCs. Accordingly, buy-side counterparties, including U.S. and non-U.S. corporate end-users, investment funds (including hedge funds and mutual funds), investment advisers, sovereigns, central banks, multilateral development banks, U.S. community banks and non-U.S. banks, that enter into swaps or other QFCs with covered entities will need to take action to enable their counterparties to continue trading with them.

This article describes: (1) key provisions of the QFC rules; (2) key provisions of the 2018 protocol; (3) available compliance methods; (4) compliance deadlines for different types of entities; and (5) next steps to be taken by counterparties who receive requests to amend their QFCs with covered entities.

Key Provisions of the QFC Rules

QFC Defined

The QFC rules incorporate the definition of QFC set forth in the Dodd-Frank Act, which includes any securities contract, commodity contract, forward contract, repurchase agreement, swap agreement and any other similar agreement that may be determined by the U.S. regulators to fall within the definition of QFC. The definition of QFC also includes security agreements and credit enhancements, such as credit support annexes, guarantees or reimbursement obligations, related to contracts meeting the definition of QFC.

While certain contracts, like swaps and repurchase agreements, clearly fall within the definition of a QFC, the term is defined broadly enough to include many types of agreements that are not customarily seen as derivatives. Ancillary provisions in certain agreements might cause them to fall within the definition. Examples of the kinds of agreements that counterparties will need to examine carefully are multibranch master agreements (permitting transactions to be booked by different branches of an entity, some of which are covered entities and some of which are not), investment management agreements, prime brokerage agreements, custody agreements, correspondent agreements, collateral agency agreements, pledge agreements, trust arrangements, escrow agreements and the like.

Covered QFCs

As a general matter, the QFC rules' amendment requirements only apply to QFCs that (1) include certain provisions (i.e., in-scope QFCs) and (2) that are entered into at certain specified times (QFCs meeting both of these requirements, covered QFCs).

Necessary Provisions

The QFC rules' amendment requirements only apply to QFCs that contain either of the following kinds of provisions (in-scope QFCs):

  • Restrictions on the transfer of the QFC (or interests, obligations or property securing it) by the covered entity; and
  • One or more default rights that may be exercised by the counterparty against the covered entity.

The term "default right" includes the right to terminate, cancel, rescind or accelerate a QFC or transactions thereunder; setoff or netting rights; the right to exercise remedies against collateral; the right to suspend, delay or defer payment or performance; and the right to demand additional margin or collateral (other than any such right arising solely from changes in economic exposure or the value of the pledged collateral).

QFCs that do not contain either one of the kinds of provisions described above are not in-scope QFCs and, therefore do not need to be amended pursuant to the QFC rules.

Timing Requirements

Subject to certain special rules for entities that recently became (or will become) covered entities, in general covered QFCs only include QFCs that the covered entity (1) entered into after Jan. 1, 2019, or (2) entered into before Jan. 1, 2019, if the covered entity or any affiliated covered entity also enters into a QFC with the same person (or a consolidated affiliate thereof) on or after Jan. 1, 2019. Accordingly, legacy agreements will need to be conformed if a counterparty or one of its consolidated affiliates intends to continue transacting with the cover entity or its affiliates.

Required Amendments

Provisions Relating to Special Resolution Regimes

The QFC rules require that covered entities amend their covered QFCs with their counterparties to include the following provisions:

  • In the event the covered entity becomes subject to resolution under a U.S. special resolution regime (i.e., resolution under the FDI Act or Title II of the Dodd-Frank Act),3 the transfer of the QFC from the covered entity will be effective to the same extent it would be under the U.S. special resolution regime if the QFC was governed by the laws of the United States or a state of the United States; and
  • In the event a covered entity or its affiliate becomes subject to resolution under a U.S. special resolution regime, the counterparty's ability to exercise its default rights under the QFC are limited to the same extent they would be limited under the U.S. special resolution regime if the QFC were governed by the laws of the United States or a state of the United States.

Because the FDI Act and Title II of Dodd-Frank permit the FDIC to impose a short stay period (usually one business day) following an institution's entry into receivership, this means that its counterparties will not be able to terminate their QFCs with such institution or exercise any other default rights with respect to collateral during that stay period. During the stay period, the FDIC could transfer the institution's QFCs to another solvent financial institution, notwithstanding any contractual restrictions on transfer in the QFC. Moreover, even if a QFC is governed by non-U.S. law, if it is amended to reflect the foregoing terms, a foreign court should nonetheless recognize these limits on default rights and the FDIC's ability to transfer the QFC.

Provisions Relating to Affiliate Insolvency Cross-Default Rights

The QFC rules also prohibit a covered entity from entering into a QFC that allows the exercise of any default rights that are related, directly or indirectly,4 to an affiliate of the covered entity becoming subject to a receivership, insolvency, liquidation, resolution or other similar proceeding (in the U.S. or abroad) (a bankruptcy proceeding). The purpose of this provision is to limit the ability of counterparties to declare cross-defaults based on the bankruptcy of affiliates of covered entities to the extent that the covered entity itself remains solvent. Bank regulators do not want the insolvency of one entity in a consolidated group to trigger cross-defaults that cause their otherwise solvent affiliates to also become insolvent. Moreover, regulators want the ability to resolve the insolvent entity's affairs while allowing its solvent affiliates to remain in operation. These limits on exercising cross-default rights are subject to various exceptions and limitations, including the following:

  • The limits do not affect a party's direct default rights (i.e., the right to terminate or close-out the QFC if the Covered Entity itself becomes subject to ordinary U.S. insolvency proceedings or otherwise fails to pay or deliver under the contract). However, if the Covered Entity becomes subject to resolution under an applicable special resolution regime, then the above-described limits on the exercise of default rights would apply.
  • If the affiliate is a credit support provider and fails to pay or deliver under the related credit enhancement, the foregoing will not prevent the counterparty from exercising default rights as a result of such failure to pay or deliver.
  • If the affiliate is a credit support provider and the default rights relate, directly or indirectly, to such affiliate becoming subject to a bankruptcy proceeding, such default rights may be exercised following a stay period (of generally one business day) if certain conditions are not satisfied. In general, the intent is to allow such credit enhancement to be transferred to another solvent entity during this stay period. If such transfer does not occur, or certain other conditions are not satisfied, the counterparty will be permitted to exercise such default rights.

In addition, the QFC rules provide that if (1) an affiliate of the covered entity that is the direct party to the QFC (the direct party) provides credit enhancement (such as a guarantee) and (2) that affiliate is itself a covered entity, then the QFC may not prohibit the transfer of such credit enhancement (or any interest in, obligation under or property securing such credit enhancement) upon any affiliate of the direct party becoming subject to a bankruptcy proceeding.5 As discussed above, the term QFC is defined to include credit enhancement relating to the QFC. Accordingly, any such credit enhancement provided by an affiliate that is a covered entity is subject to the QFC rules. This provision is intended to allow bank regulators, in an insolvency of any such affiliated credit support provider, to transfer the relevant credit enhancement to another solvent entity notwithstanding any contractual restrictions on transfer.

Certain Exclusions

The QFC rules contain certain important exclusions. For example, as noted above, QFCs that do not contain either default rights or transfer restrictions are not in-scope QFCs and, therefore, do not need to be amended pursuant to the QFC rules.

In addition, a covered entity is not required to amend a QFC to reflect the terms described under "Required Amendments – Provisions Relating to Special Resolution Regimes" if it: (1) expressly provides that it is governed by the laws of the United States or a state thereof and does not expressly exclude application of any U.S. special resolution regime; and (2) is entered into with a counterparty that is an individual domiciled in, a company organized under the laws of, or a company having its principal place of business located in, the United States or a state thereof, or is a U.S. branch or U.S. agency. It is important to note, however, that QFCs meeting these requirements may still need to be amended to reflect the terms described under "Required Amendments – Provisions Relating Affiliate Insolvency Cross-Default Rights."

The QFC rules also provide exclusions for the following types of QFCs:

  • QFCs in respect of which one of the parties is a central clearing house;
  • QFCs entered into solely with one or more financial markets utilities, or FMUs;
  • Retail investment advisory contracts that only restrict transfer to the extent required by the Investment Advisers Act of 1940 and do not provide certain default rights; and
  • Warrants relating to the shares of the covered entity or its affiliates issued prior to the effective date of the relevant QFC rules.

Sovereigns, Central Banks and Multilateral Development Banks Not Excluded

U.S. regulators considered, but ultimately did not exclude, sovereigns and central banks from application of the QFC rules. Similarly, multilateral development banks have not been excluded from application of the QFC rules. Accordingly, sovereigns, central banks and multilateral development banks that have entered into QFCs with covered entities will be required to amend such QFCs in accordance with the QFC rules. The QFC rules expressly provide that sovereign entities and multilateral development banks are not "financial counterparties" for purposes of the rules. Therefore, sovereigns, central banks and multilateral development banks will have until Jan. 1, 2020, to so amend their QFCs (as discussed below), but will likely start to receive amendment requests from their covered entity counterparties during 2019.

Key Provisions of the 2018 Protocol

In order to address the requirements of the QFC rules, ISDA published the 2018 protocol. It is worth noting that by adhering to the 2018 protocol, parties "opt-in" to not only the limitations on the exercise of default rights imposed by U.S. special resolution regimes – they also opt-in to such limitations imposed by the special resolution regimes of France, Germany, Japan, Switzerland and the United Kingdom (collectively, the identified regimes).6 The opt-in to the other identified regimes is a requirement of the QFC rules' safe harbor permitting adhering to the 2018 protocol as a permissible method of amending QFCs.

The 2018 protocol contains two principal sets of amendments that would apply to covered QFCs (and related credit enhancements) among adhering parties.

Section 1 Amendments

As a general matter, Section 1 of the 2018 protocol contains a series of provisions which limit the exercise of default rights and permit transfers of covered QFCs (and related credit enhancements), in the following events:

  • A covered entity enters into resolution under an identified regime; or
  • An affiliate of a covered entity enters into resolution under an identified regime.

Under Section 1, such default rights and permitted transfers are limited or permitted to the same extent as they would be if the covered QFC was governed by the laws of the identified regime.

Section 2 Amendments

Section 2 of the 2018 protocol contains provisions which similarly limit the exercise of default rights (except for certain performance-related default rights or unrelated default rights) and, in certain circumstances, permit transfers of covered QFCs (and related credit enhancements) upon the occurrence of the following events:

  • An affiliate of the covered entity that is not a credit enhancement provider enters into ordinary U.S. insolvency proceedings;7
  • An affiliate credit enhancement provider's entry into Chapter 11 bankruptcy proceedings;
  • An affiliate credit enhancement provider's entry into receivership under the FDI Act.

Unlike Section 1, Section 2 is specific to U.S. law (i.e., the affiliate's entry into insolvency proceedings under U.S. law, such as Chapter 11 proceedings or FDI Act receivership).

By entering into the 2018 protocol, counterparties to covered entities will generally agree that, notwithstanding any express contractual rights in their covered QFCs or the governing law provisions of such agreements, the default rights and transfer restrictions contained in such covered QFCs will be limited as provided in Sections 1 and 2 of the 2018 protocol.

Like the QFC rules, the provisions of the 2018 protocol are quite complex and contain a number of exceptions and variations that may apply in a multitude of circumstances. The precise effect of the 2018 protocol on a counterparty's rights under a covered QFC (or related credit enhancement) can be quite varied depending on various factors, including:

  • The express terms of the covered QFC (or credit enhancement);
  • The nature of the events giving rise to default rights under the covered QFC or credit enhancement;
  • The type and jurisdiction of any insolvency proceedings to which a covered entity or its affiliates may become subject;
  • The satisfaction of certain conditions in such insolvency proceedings; and
  • The mechanism utilized by the parties to comply with the QFC rules as described under "Compliance Methods" below.

Compliance Methods

The 2018 protocol is an industry standard document which permits parties that adhere to it to amend their covered QFCs to reflect the requirements of the QFC rules. Parties that adhere to the 2018 protocol do so on a "universal" basis, which means that they agree to amend all of their covered QFCs with every covered entity that has adhered to the 2018 protocol. The 2018 protocol is not the only way to amend QFCs. Covered QFCs may also be amended by adherence to the ISDA 2015 Universal Stay Protocol8 (the 2015 protocol) or through incorporation by reference of the 2018 protocol provisions into a QFC, although incorporation by reference is only effective if all of the parties to the QFC have already adhered to either the 2018 protocol or the 2015 protocol.

Compliance with the QFC rules may also be accomplished through negotiated bilateral arrangements. Parties may wish to utilize bilateral amendments in circumstances where, for example, they wish to opt in to the U.S. special resolution regime only, but do not wish to opt in to the other identified regimes. Bilateral amendments would also permit a party to pick and choose specific GSIBs and QFCs with respect to which it wishes to enter into the required amendments. Parties may also use bilateral arrangements if they do not wish to agree to the 2018 protocol's affiliate insolvency provisions because their QFCs (and related credit enhancements) do not contain cross-defaults related, directly or indirectly, to affiliate insolvency proceedings or transfer restrictions. ISDA has prepared standard bilateral amendments that parties may use for this purpose. However, the QFC rules incentivize compliance by adherence to the 2018 protocol (or the 2015 protocol) by providing a safe harbor for parties that choose to comply in that fashion as noted above. The safe harbored 2018 protocol and 2015 protocol provisions contain certain creditor protections, particularly in the event of the insolvency of an affiliate of a covered entity, that are not available to parties that choose to comply with the QFC rules through bilateral amendments. Accordingly, parties should consider the benefits and drawbacks of using bilateral amendments.

Compliance Deadlines

Although the QFC rules are already in effect, compliance will be phased in over time as follows:

  • Covered entities are required to conform their QFCs with other covered entities by Jan. 1, 2019.
  • QFCs between covered entities and other financial counterparties (other than small financial institutions) that are not themselves covered entities, such as non-U.S. banks that are not GSIBs, must be conformed by July 1, 2019.
  • For QFCs between covered entities and all other counterparties, such as small financial institutions, sovereigns, central banks, corporations and other end-users, the compliance deadline is Jan. 1, 2020.

The term "financial counterparty" is broadly defined and includes, among others, banking holding companies (and their affiliates), depository institutions, credit unions, trust companies and other fiduciaries, industrial banks, credit and lending entities, money services businesses, broker-dealers, investment advisers, registered investment companies, private funds, commodity pools, futures commission merchants, employee benefit plans and insurance companies, among others. The definition of "financial counterparty" also includes foreign banks engaged directly in banking business outside the U.S. and foreign entities engaged in activities that would cause them to fall within the definition of "financial counterparty" if they were organized under the laws of the U.S. or any state of the United States. In general terms, "small financial institutions" are banks, savings associations, credit unions with total assets of $10 billion or less. The definitions of "financial counterparty" and "small financial institution" are fairly complex and the determination whether your institution falls within either of these definitions (or any exceptions thereto) may depend on the precise nature of the activities in which you are engaged.

Next Steps in Addressing Amendment Requests

End-user counterparties to QFCs, including non-U.S. banks, investment funds, investment advisers, U.S. community banks, sovereigns, central banks, multilateral development banks, U.S. and non-U.S. corporations and other end-users, have already begun to receive from covered entities requests to amend their QFCs in accordance with the QFC rules. We expect that amendment activity pursuant to the QFC rules will increase substantially in 2019 as the deadlines for noncovered entities approach. In preparation for such amendment requests, end-users should consider taking the following steps:

  • Seek advice regarding your status as a "financial counterparty" or a "small financial institution" for purposes of determining the compliance deadline applicable to you.
  • Seek advice regarding any exemptions from the QFC rules' amendment requirements that may be applicable to your QFCs, including any related credit enhancements.
  • Seek advice regarding contractual limitations on your default rights and transfer restrictions, and creditor protections, that would apply if you were to adhere to the 2018 protocol (or the 2015 protocol) and any differences that would result if you were to instead enter into bilateral amendments with your covered entity counterparties.
  • Evaluate whether you wish to opt-in to all of the identified regimes or the "Protocol-Eligible Regimes" set forth in the 2015 protocol, as the case may be, or whether there are business or legal justifications for opting in to special resolution regimes in a more limited subset of jurisdictions.
  • Evaluate whether you wish to amend all of your covered QFCs with all covered entities that have adhered to the 2018 protocol (or the 2015 protocol) or whether there are business or other reasons to limit the universe of covered entities and QFCs with respect to which you wish to enter into the required amendments.

Footnotes

1 These rules were separately issued by the Federal Reserve, the FDIC and the Office of the Comptroller of the Currency. Each set of rules applies to the relevant types of financial institutions regulated by such organizations. However, the rules are very similar. See 82 Fed. Reg. 42,882 (Sept. 12, 2017), 82 Fed. Reg. 50,228 (Oct. 30, 2017) and 82 Fed. Reg. 56,630 (Nov. 29, 2017).

2 On November 16, 2018, the Financial Stability Board, in consultation with the Basel Committee on Banking Supervision and national authorities, published the 2018 list of GSIBs. That list can be found online.

3 *Note: As further discussed below, the 2018 Protocol expands this to include all "Identified Regimes."

4 A credit ratings downgrade trigger is an example of a default right that is indirectly related to an affiliate of the Covered Entity becoming insolvent.

5 However, QFCs may prohibit any such transfer if such transfer would result in the supported party becoming the beneficiary of credit enhancement in violation of any law applicable to the supported party.

6 See "Required Amendments—Provisions Relating to Special Resolution Regimes" above. The Protocol includes limitations on the exercise of default rights and similar overrides on restrictions on transfer in the case the counterparty becomes subject to special resolution under the laws of an Identified Regime.

7 This is defined to include Chapter 7 or Chapter 11 bankruptcy proceedings under the US Bankruptcy Code, FDI Act receivership or proceedings under the Securities Investor Protection Act.

8 This is a separate protocol that was published by ISDA in 2015 and addresses issues similar to those addressed in the 2018 Protocol. The 2015 Protocol was published before the QFC rules were finalized. Many large financial institutions and derivatives dealers (but not as many end-users) adhered to the 2015 Protocol as between themselves. It appears the 2018 Protocol will be more widely adopted in the marketplace.

Under the 2015 Protocol, adhering parties opt-in not only to the Identified Regimes, but also special resolution regimes in a number of other countries{7} (Protocol-Eligible Regimes), so long as such regimes meet certain creditor protection standards. It is important to note also that certain differences exist in the creditor protections available under the 2018 Protocol and the 2015 Protocol, which counterparties will also want to consider when analyzing the method by which they will comply with the QFC rules.

We also note that ISDA has published protocols designed to amend QFCs based on special resolutions regimes in other countries (including France, Germany, Japan, Switzerland and the United Kingdom). This article is restricted to a discussion of US law and does not consider the laws of such other jurisdictions.

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.

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