Netting Provisions

The Spanish Ministry of Economy has recently circulated among Spanish experts on banking activities, the securities market and insurance, a Financial Law Draft (the "Draft") for their information and comments. The Draft intends to introduce certain important amendments to the Spanish regulations in the three areas mentioned.

This Draft is not a complete statute on finance law, but has global coverage, including several amendments to the current regulations in the areas of banking, the securities market and insurance. Therefore, the Draft is not an attempt to provide a consolidated regime on the areas mentioned, but only foresees certain changes, mainly, to the regulation of banking activities, to the Spanish Law 24/1988, on Securities Markets, as well as to the Law 30/1995, dated November 8, on the Regulation and Supervision of Private Insurance

According to the above, one of the most important provisions foreseen by the Draft is in relation to contractual netting. This provision, which reflects a common concern in most legal systems, must be understood as a further step in updating the insolvency regulations in light of the current reality of the securities and banking markets, which, as commonly occurs, are more dynamic than legal systems.

1. What Is Behind?

Over the last twenty years, there has been an important advancement, principally in the inter-bank area, in the development of certain contracts called "derivatives". These kinds of contracts, which group several types of agreements of different legal nature together, have turned into a common financial instrument among banks and other financial entities, in both Spain and international markets.

The rapid development of these contracts, as well as the fact that most of them were entered into between the same parties, was concluded in the creation of standard agreements to be executed in different banking markets. In this sense, not only the Spanish Banking Association drafted a Financial Transaction Master Agreement ("Contrato Marco de Operaciones Financieras" or "CMOF"), but also, in the international market, the International Swaps and Derivatives Association published several standard forms, known under the ISDA acronym, for entering into derivative transactions.

All of the standard agreements above-mentioned fall into the category of "regulatory agreements", which intend to cover several different transactions which are governed by the provisions of a unique contract. In this sense, some of the most important provisions of the agreements cited are those referring to the early termination of any of the transactions covered by the relevant master agreement and its connection with the early termination of other transactions covered thereby. The effectiveness and enforcement of this provision would, in principle, not pose any problem in Spain, where the set-off is even legally admitted out of insolvency proceedings, but would present several difficulties in the event of a bankruptcy proceeding carried out against a Spanish debtor.

In fact, there is a common concern in almost all legal systems (not only those of Latin origin but also those being Anglo-Saxon) regarding the regulation of insolvency proceedings and the powers granted to the trustees appointed therein, to affirm or reject transactions which have been entered into by the insolvent debtor (what is known as "cherry picking"). Therefore, over the last ten years, the regulatory process has focused on amending the regimes cited, at least, regarding certain types of contracts. This process, which has also been carried out in Spain, has been aimed at introducing several exemptions into the general insolvency regime, whereby at the time the relevant transactions are included under a master agreement, the provision regarding the netting of all the obligations stemming from said master agreement (and, thus, from the transactions covered thereby) will be considered as valid and enforceable, and, therefore, for the purposes of an insolvency proceeding, they will be considered as only one obligation.

2. Current Spanish Regulation

Under Spanish law, the first step in this regard was taken with the introduction of Law 3/1994, dated April 14, which implemented the Second Banking Directive. The wording of this law was in fact, a little confusing, and was modified by the Tenth Additional Provision of the Law 37/1998, of November 16, which amended the Law 24/1988/, of July 28, on the Securities Market. This Additional Provision was conceived as a legal prescription of wide scope whereby all the problems which the legislative body had at that time in this regard, were covered.

The provision cited above "breaches" the Spanish legal principle of "pars conditio creditorum" (i.e., the equal treatment of all creditors of the same kind) in respect of financial transactions related to derivative instruments made within the framework of a netting agreement, provided that several factors are present. Therefore, under said Provision, the declaration of early termination or the equivalent declaration on the different financial transactions included in the Netting Agreement shall not be limited, restricted or affected in any way by a request for or state of bankruptcy or suspension of payments, liquidation, administration, intervention or creditors meeting which affects any of the parties of the Netting Agreement, its subsidiaries or branches.

Among the financial transactions mentioned, relating to derivative instruments, swaps, transactions over interest rates and forwards, options and futures, spot transactions of currencies, or any combination of the above, are included, as well as any similar derivative transaction.

Notwithstanding the above, the Tenth Additional Provision may be considered as an exception to the general rules applicable to insolvency proceedings under Spanish law. As such, its interpretation requires that transactions such as derivatives having commodities as underlying assets or pure collateral, as well as credit derivatives, the most modern evolution of derivatives transactions, amongst others, be excluded from its scope.

The limitations above mentioned are those that the current Financial Law Draft attempts to eliminate, extending the recognition of the netting not only to derivative transactions but also to transactions concerning any other financial instruments and to guarantees granted thereunder.

3. Financial Law Draft

The Financial Law Draft published by the Ministry of Economy attempts to respond under the title "Making the Guarantees Regime Flexible" ("Flexibilización del régimen de garantías", Article 14) to the weaknesses of the netting regime above-mentioned, covering those transactions which are not foreseen under the current wording of the Tenth Additional Provision.

In fact, under such a generic title, which seems to have nothing to do with netting issues, the intention of Article 14 of the Draft is to include among the transactions covered by the Tenth Additional Provision those guarantees granted within derivatives transactions, so that the guarantees cited also fall into the set-off or netting provisions.

Likewise, in addition to the transactions cited which are now covered, it is also intended that the current wording of the financial instruments to which the Article refers to be amended.

In fact, currently, this wording includes a specific list of the financial instruments which the transactions covered in the netting agreement can refer to (i.e. swaps, transactions over interest rates and forwards, options and futures, spot transactions of currencies, or any combination of the above, as well as any similar derivative transaction) and the Draft intends to replace such list by a cross reference to Article 2 of the Spanish Law 24/1988, dated July 28, on the Securities Market.

Therefore, the transactions which, according to the new wording in the Draft, will be covered by the Spanish netting provision will be those regarding the following financial instruments:

1. Agreements of any type which are negotiated within a secondary market, whether official or not.
2. Forward financial agreements, options and swaps, provided that they are granted over negotiable securities, indexes, currencies, interest rates, or any other type of underlying of a financial character, regardless of the settlement proceeding or whether or not they are negotiated in a secondary market.
3. Agreements and transactions over instruments not mentioned above, provided that they are able to be negotiated in a secondary market, whether official or not, and even though their underlying assets are not of a financial character (i.e. commodities, raw materials and any other fungible asset).

In addition to the above, the following two kinds of transactions are expressly included, which are not covered under the current wording of the Tenth Additional Provision:

1. Security loans.
2. Any transaction carried out under the netting agreement for guarantee purposes, which has as its object a public debt, other negotiable securities or cash.

The netting provision cited will be valid and effective vis-à-vis third parties without any further requirements other than its formalisation under a private written agreement and the delivery, transfer or registration of the securities and the deposit or transfer of the relevant cash.

All of the transactions above-mentioned (among which the absence of credit derivatives must be mentioned) will be subject to the benefits of not being affected by the retroaction rules currently in force on bankruptcy proceedings, as well as by any other insolvency situation of the relevant party. Therefore, due to the existence of a netting agreement which meets all the requirements mentioned in the Tenth Additional Provision, in the event of insolvency of one of the parties to the relevant master agreement, all the obligations covered under the netting agreement will be deemed to be, as a result of their settlement, a single obligation.

4. Conclusion

This is, in conclusion, the main intention of Article 14 of the Draft Financial Law, i.e. to extend the coverage of the Tenth Additional Provision of Law 24/1988, dated July 28, on the Securities Market, to the guarantees issued as a result of derivative transactions. This is the main reason for the title "Making the Guarantees Regime Flexible", which, at first, seems to have nothing to do with the content of the Article.