On November 12, 2014, the International Swaps and Derivatives Association, Inc. (“ISDA”) published the ISDA Resolution Stay Protocol (“Protocol”). Eighteen of the world’s largest banks and their affiliates1 (“G-18”) have agreed to sign the Protocol, which is open for adherence and has an effective date of January 1, 2015. The Protocol temporarily restrains close-out and early termination rights under ISDA Master Agreements between parties adhering to the Protocol for cross-border trades when a counterparty is subject to insolvency proceedings in its home jurisdiction.

Background

Under current ISDA Master Agreements, parties may exercise certain close-out rights during termination events, which include the insolvency or bankruptcy of their counterparty. These rights include termination of the agreement, netting of outstanding obligations, and foreclosure on collateral.

Following the financial crisis, regulators have expressed concerns that when a large financial institution faces insolvency, the rapid, simultaneous exercise of close-out rights by multiple counterparties could lead to results similar to a run on the bank. This in turn could destabilize the financial system and hinder efforts by regulators to conduct an orderly resolution and/or liquidation.

Regulatory Problems

To manage this risk, regulators in some jurisdictions have sought to enhance their resolution procedures for large, systemically important financial institutions through regulations that limit the exercise of close-out rights under ISDA Master Agreements and certain other financial contracts. For example, in the European Union, the Bank Recovery and Resolution Directive (“BRRD”) provides a regulatory stay during which close-out rights cannot be exercised against covered institutions. This stay period enables regulators to facilitate a more orderly liquidation. In the United States, the Orderly Liquidation Authority (“OLA”) established under Title II of the Dodd-Frank Act provides regulators with similar authority to impose temporary stays and limit close-out rights. However, there are potential gaps between the different jurisdictional regimes. One issue is that a stay imposed by a particular regulator may only be enforceable with respect to trades between domestic counterparties or trades that are governed by the laws of that jurisdiction. Cross-border trades between counterparties in different jurisdictions may still be subject to the same close-out rights, as it is unclear whether a stay of such close-out rights arising out of the resolution regimes of one jurisdiction would be enforceable against both counterparties. This is particularly concerning to regulators in the case of an insolvency of a global bank with affiliates trading in and under the laws of multiple jurisdictions. The regulatory gaps created the need for a documentation solution.

Protocol Solutions

Under the Protocol, each member of the G-18 agrees to amend its ISDA Master Agreements and voluntarily subject itself to the resolution regime of other G-18 members with respect to swaps executed pursuant to an ISDA Master Agreement between the adhering parties. For example, if a G-18 member located in the United Kingdom becomes insolvent and a stay is imposed under the BRRD, both domestic counterparties and foreign G-18 counterparties would become subject to the BRRD’s stay with respect to swaps executed pursuant to an ISDA Master Agreement between the parties.

United States Insolvency Proceedings and Protocol Expansion

Additionally, Section 2 of the Protocol limits cross-default rights under ordinary United States resolution proceedings, such as bankruptcy. This provision is included because the U.S. Bankruptcy Code and the Federal Deposit Insurance Act do not provide for a stay of these rights by statute (although, regulators have the authority to impose a stay under certain circumstances with respect to certain systemically important financial institutions under the OLA). According to ISDA, regulators anticipate requiring the counterparties of some financial institutions to give up certain cross-default and direct-default rights when that financial institution’s affiliate becomes subject to proceedings under ordinary U.S. insolvency regimes. Section 2, which is modeled on the provisions of the OLA and would ultimately extend the use of such a stay to a broader set of institutions in the United States, will not become effective until the related U.S. regulations become effective and are implemented.

Initially, the Protocol will apply to the G-18 and will take effect as of January 1, 2015. Regulators expect that additional systemically important institutions will sign on throughout 2015. However, there are potential issues with broader adoption of the Protocol. For example, some buy-side institutions have expressed concern that their fiduciary obligations would make it difficult to voluntarily agree to give up valuable close-out rights that they currently enjoy. These market participants would likely only adhere to the Protocol as a result of future regulation.