On November 12, 2014, the International Swaps and Derivatives Association (“ISDA”) announced that the ISDA 2014 Resolution Stay Protocol (“Protocol”) became open for adherence. More than one-hundred institutions adhered to the Protocol on the launch date, including 18 major banks that had previously committed to their regulatory authorities to adhere. The Protocol is binding only on the adherents.
In the wake of the financial crisis of 2008, financial regulators across the globe developed special resolution regimes for the resolution of systemically important financial institutions (“SIFIs”) that are perceived to be “too big to fail.” One area of regulatory focus has been the concern that counterparties’ exercise of termination rights in over-the-counter derivatives contracts of a SIFI or its affiliates triggered by the SIFI’s financial distress or entry into resolution proceedings might hinder resolution efforts and disrupt markets.
The Protocol was developed at the request of global regulators to address the specific concern that stays of termination under national resolution regimes would not be recognized by courts in other jurisdictions, particularly if the governing law of the derivatives contract or credit enhancement is not the law of the resolution jurisdiction. Additionally, US regulators sought to support a “single point of entry” resolution strategy by contractually supplementing certain US insolvency regimes with provisions similar to the existing override under the Orderly Liquidation Authority (“OLA”) of cross-default rights (such as “specified entity” and “credit support provider” defaults) in transactions with affiliates of the entity subject to the US resolution proceeding.
Regulatory Initiatives Toward Broader Adoption of Contractual Stays
Adherence to the Protocol is not mandatory, and parties that do not adhere will not become subject to the Protocol by virtue of transacting under existing ISDA Master Agreements with adhering counterparties. However, regulators have indicated their intent to promulgate rules to mandate or encourage broader participation.
Mark Carney, chairman of the Financial Stability Board (“FSB”), described the FSB’s approach to contractual stays on termination rights as including commitments from national authorities to put in place regulatory requirements for the use of revised master agreements containing such provisions.1 A consultative document issued by the FSB in September 2014 mentions prudential regulations and resolvability planning mandates as means by which regulated firms could be required to include contractual stays in their documentation with unregulated counterparties.2 In the United States, the Board of Governors of the Federal Reserve System and the Federal Deposit Insurance Corporation (“FDIC”) have cited the adoption of contractual stays as an action to address shortcomings identified in their review of certain financial institutions’ plans for resolution under the US Bankruptcy Code.3
According to an FSB press release, with the adoption of the Protocol by the 18 banks that had previously committed to adhere, more than 90 percent of their over-the-counter bilateral trading activity will be covered by either contractual or statutory stays.4
Operative Provisions of the Protocol5
Special Resolution Regimes
If an adhering party (or its parent or certain other affiliates) becomes subject to resolution under a “Special Resolution Regime” (“SRR”), the non-defaulting adhering counterparty may exercise its “default rights” (defined to include termination, application of collateral and suspension of performance) in respect of a covered master agreement or covered credit enhancement only to the extent that it could do so under the SRR if the master agreement or credit enhancement were governed by the laws of the jurisdiction of the SRR. Other Protocol provisions (i) opt adhering parties in to SRR overrides of default events under agreements other than covered master agreements and covered credit enhancements, and (ii) validate certain transfers pursuant to a SRR of covered master agreements and covered credit enhancements to the extent such transfers would be effective if the master agreements and credit enhancements were governed by the laws of the jurisdiction of the SRR.
The current SRRs include the Federal Deposit Insurance Act (“FDIA”) and OLA in the United States, and specified resolution regimes under French, German, Japanese, Swiss and UK law, excluding any ring-fence provisions, subject in the case of the non-US regimes to country-specific annexes to the Protocol. Other resolution regimes of FSB member jurisdictions will qualify as SRRs only if they meet certain creditor protection criteria.
The SRR provisions of the Protocol take effect between a pair of adhering parties from January 1, 2015 or, if later, the date as of which both such parties’ adherence to the Protocol is effective. The Protocol also includes provisions enabling an adhering party to opt out prior to the commencement of SRR proceedings with respect to a counterparty or that counterparty’s affiliates if, among other reasons, (i) the adhering party’s counterparty does not become subject, by January 1, 2018 (or, if later, 18 months following the initial effective date of a new SRR), to regulatory restrictions that require the use in non-domestic law ISDA Master Agreements of contractual restrictions on resolution-based default rights, or (ii) the adhering party determines in good faith, and provides notice to its counterparty and relevant regulators, that the relevant SRR has been amended in a way that materially and adversely affects the enforceability of certain default rights.
US Insolvency Proceedings of Affiliates and Credit Enhancement Providers
A separate section of the Protocol treats default rights when an affiliate of a direct counterparty to a covered master agreement becomes subject to US Insolvency Proceedings. These US insolvency provisions, set out in Section 2 of the Protocol, nullify certain default rights6 under covered master agreements between two adhering parties and related credit enhancements if an affiliate (other than a credit enhancement provider) of one of the adhering parties becomes subject to proceedings under Chapter 7 or Chapter 11 of the US Bankruptcy Code, the FDIA or the Securities Investor Protection Act (together, “US Insolvency Proceedings”). If a credit enhancement provider with respect to an adhering party’s covered master agreements becomes subject to Chapter 11 or FDIA proceedings, exercise by other adhering parties of affected default rights under the covered master agreements and related credit enhancements is stayed during an initial stay period and thereafter for so long as certain conditions relating to transfer or, in the case of Chapter 11 proceedings, maintenance by the debtor-in-possession of the credit enhancements are met.
Other provisions under Section 2 address the override of (i) certain default rights7 in respect of covered master agreements and related credit enhancements that were unexercised as of the commencement of US Insolvency Proceedings with respect to an affiliate of an adhering party, (ii) default events under agreements other than covered master agreements based on the same events that gave rise to defaults stayed under Section 2 of the Protocol and (iii) certain restrictions on the transfer of credit enhancements.
The US insolvency provisions under Section 2 of the Protocol take effect between a pair of adhering parties from the later of (x) the compliance date of US federal regulations that limit, or have the effect of limiting, the ability of financial companies to enter into transactions under an ISDA Master Agreement without limitations on counterparties’ default rights upon an affiliate of the financial company becoming subject to specified insolvency proceedings, and (y) the date as of which both such parties’ adherence to the Protocol is effective. Under certain conditions, adhering parties that are not subject to the aforementioned US federal regulations will be able to opt out of the US insolvency provisions of the Protocol.
At the moment, the direct effects of the Protocol are limited to the institutions that have adhered. As for the frequently attached press label, “Ending Too Big to Fail,” the Protocol is intended to make SIFI failure easier to manage by reducing uncertainties regarding the continuity of derivative contracts of the SIFI and its affiliates. By itself, however, the Protocol will not eliminate the considerable problems inherent in SIFI failure.
1 Statement by Mr. Mark Carney, chairman of the Financial Stability Board at the Thirtieth Meeting of the International Monetary and Financial Committee of the International Monetary Fund (October 11, 2014).
2 Consultative Document, Financial Stability Board, “Cross-border recognition of resolution action,” (September 29, 2014).
3 Joint Press Release, Board of Governors of the Federal Reserve System and Federal Deposit Insurance Corporation, “Agencies Provide Feedback on Second Round Resolution Plans of ‘First-Wave’ Filers,” (August 5, 2014) (available at: https://www.fdic.gov/news/news/press/2014/pr14067.html).
4 Press Release, Financial Stability Board, “FSB welcomes industry initiative to remove cross-border close-out risk,” (October 11, 2014).
5 Our summary of the Protocol is not intended to be comprehensive. Persons evaluating adherence to the Protocol should seek qualified legal advice. The country-specific annexes to the Protocol are beyond the scope of this Legal Update.
6 The affected default rights are “Default Rights” other than “Performance Default Rights” and “Unrelated Default Rights” as defined in the Protocol. Preserved default rights include those triggered by the direct counterparty entering into insolvency proceedings, by certain payment and delivery failures by the direct counterparty or a credit enhancement provider, and rights that can be shown by clear and convincing evidence to be not related, directly or indirectly, to an affiliate of the direct counterparty becoming a party in “U.S. Proceedings” or to certain transfers or debtor-in-possession motions. The stayed party under Section 2 of the Protocol bears the burden of establishing that default rights may be exercised. In certain circumstances, both the SRR provisions and Section 2 of the Protocol may be applicable, and the exercise of default rights could be subject to both sets of limitations.
7 Preserved default rights under this provision consist only of “Performance Default Rights” but not “Unrelated Default Rights.”