The Board of Governors of the Federal Reserve System (the "Federal Reserve") recently issued a proposed rule (the "Proposed Rule") that would significantly limit derivative counterparty remedies upon the insolvency of US global systematically important banking organizations ("GSIB") and their affiliates and the US operations of foreign GSIBs (collectively, "Covered Entities"). The Proposed Rule restricts the exercise of insolvency-triggered default rights against Covered Entities under swaps, repurchase transactions, reverse repurchase transactions, securities lending and borrowing transactions, commodity contracts, forward agreements and guarantees of or credit enhancements related to the foregoing (such agreements, "qualified financial contracts" or "QFCs"). If the Federal Reserve ultimately adopts the Proposed Rule, Covered Entities will need to amend many of their current QFCs to bring them into compliance and analyze the business impact on the buy-side derivative market, more than 80 percent of which are Covered Entities under the Proposed Rule.

The Proposed Rule Limits Direct and Cross-Defaults. Under the current regulatory scheme, counterparties can terminate safe harbored QFCs containing direct default or cross-default provisions when a GSIB or affiliate commences a bankruptcy or an analogous insolvency proceeding.1 The Proposed Rule seeks to prevent runs on a failed GSIB/affiliate and its solvent affiliates. The Proposed Rule requires Covered Entities to essentially "opt in" to specific contractual limitations under QFCs to limit traditionally safe harbored counterparty termination rights.2

The Proposed Rule identifies two goals: (1) reduce the risk that courts in foreign jurisdictions will disregard the temporary stays present in the FDIA and the Dodd-Frank Act3 limiting the ability of the insolvent firm's QFC-counterparties to exercise termination rights upon entry into resolution; and (2) facilitate Covered Entity resolution under the Bankruptcy Code and similar resolution proceedings. The Proposed Rule addresses the first issue by requiring that Covered Entity-QFCs include provisions stating that default rights are limited to the same extent they are under the FDIA and the Dodd-Frank Act.4 The Proposed Rule addresses the second issue by limiting a QFC counterparty's direct and cross-default rights.

Direct Default Rights. All Covered Entities' QFCs must contractually limit direct default rights and remove restrictions on the transfer of a QFC to the same extent as exists under the FDIA and the Dodd-Frank Act. The special resolution regimes under the FDIA and the Dodd-Frank Act impose a temporary stay on a counterparty's exercise of default rights to provide an opportunity for the transfer of the QFCs to a solvent affiliate or a third party. No similar temporary stay exists under the Bankruptcy Code. If an insolvent Covered Entity transfers a QFC to a financially viable entity during the stay period, the Proposed Rule prohibits the counterparty from exercising default rights. Importantly, default rights do not include markto-market or same-day netting provisions based on collateral value fluctuations.5

Cross-Default Rights. The Proposed Rule also requires Covered Entities to eliminate cross-default rights under QFCs triggered by the Covered Entity's entering into resolution under the FDIA, the Dodd-Frank Act, the Bankruptcy Code or an analogous insolvency proceeding. Similar to the right to transfer direct QFC obligations to solvent counterparties, QFCs also must permit the transfer of credit enhancements supporting QFCs to a transferee upon a Covered Entity insolvency trigger. For these guaranteed QFCs, after the temporary stay,6 counterparties still are able to exercise certain default rights in limited situations.7

If a dispute arises over a counterparty's ability to exercise a default right against a Covered Entity under a QFC, the counterparty has the burden of proving the QFC permits exercise of the default right by clear and convincing evidence (or a similar more stringent standard).

The Proposed Rule Provides for Alternative Compliance. As an alternative to complying with the Proposed Rule, Covered Entities can amend QFCs to conform to the International Swaps and Derivatives Association 2015 Universal Resolution Stay Protocol (the "ISDA Protocol").8 The ISDA Protocol generally contains requirements similar to the Proposed Rule, albeit with narrower stay and transfer provisions that may provide greater flexibility for Covered Entities.9

Finally, the Proposed Rule provides a process by which a Covered Entity may seek approval from the Federal Reserve for otherwise impermissible additional creditor protections. The Federal Reserve will determine whether the additional protection mitigates risks to the financial stability of the United States, addressing many of the same issues prompting issuance of the Proposed Rule. If the Federal Reserve approves the additional protection, any other Covered Entity could use the protection.

Proposed Rule Enactment. The Federal Reserve is accepting comments on the Proposed Rule until August 5, 2016. The final rule becomes effective on the first day of the first calendar quarter that begins at least one year after issuance of the final rule. Any entity that is a Covered Entity on the date the final rule is issued would be required to comply with the final rule beginning on the effective date. An entity that does not become a Covered Entity until after the final rule is issued would be required to comply with the rule by the first day of the calendar quarter that begins at least one year after it became a Covered Entity. 

Conclusion. The Proposed Rule will impact the QFC risk sharing between Covered Entities and counterparties, the ramifications of which could materially shift the QFC marketplace. This alert provides only a high-level overview of some of the key provisions in the Proposed Rule.