On March 7, 2014 the Spanish Government approved the Royal Decree Law 4/2014 adopting urgent measures on debt refinancing and restructuring ("Real Decreto-ley 4/2014, de 7 de marzo, por el que se adoptan medidas urgentes en material de refinanciación y reestructuración de deuda empresarial" or "RDL 4/2014").
The purpose of this brief newsletter is to analyse if certain provisions of RDL 4/2014 may, under certain circumstances, affect the special regime of derivative instruments established under Royal Decree Law 5/2005 of 11 March, on urgent reforms to encourage, among other, productivity and improve public procurement (“Real Decreto-Ley 5/2005 de 11 de Marzo, de reformas urgentes para el impulso a la productividad y para la mejora de la contratación pública”).
Measures introduced by RDL 4/2014
The aim of this new regulation is the implementation of legal measures necessary to achieve the viable restructuring of debtors. Through this RDL 4/2014 certain provisions of the Spanish Insolvency Act ("Ley 22/2003, de 9 de julio, Concursal" or “Spanish Insolvency Act”) are heavily reformed. The main measures introduced by RDL 4/2014 are the following:
- Reinforcement of the negotiations during a pre-insolvency scenario
RDL 4/2014 modifies article 5 bis of the Spanish Insolvency Act in order to encourage negotiations in order to avoid the initiation of a debtor's insolvency proceedings particularly due to enforcement proceedings over certain assets of the debtor. In this regard, any enforcement proceeding over assets that are necessary for the debtor's activity shall not be initiated or shall be suspended during this period of pre-insolvency or refinancing negotiation. This special standby situation shall affect both collective financial claims (e.g. under a syndicated loan) and their security and also to individual claims hold by individual creditors of the insolvent debtor.
- Mechanisms aimed to encourage refinancing agreements
The refinancing agreements are now regulated under a new article (71bis), which introduces the following reforms:
- The former requirement that the refinancing agreement must be supported by a report issued by an independent expert appointed by the Commercial Registry shall be replaced by a certificate issued by the auditor supporting that the agreement has been approved by at least 3/5 of the creditors.
- Introduction of a new category of agreement with legal immunity. In accordance with article 71bis. 2 any bilateral or multilateral refinancing agreements improving the debtor’s financial position and solvency that might have had been reached between the debtor and one or more of its creditors shall not be rescinded by the judge, creating a safe harbour ("puerto seguro") against a future insolvency proceeding of the debtor.
- Modification to the schemes of arrangement in 4th Additional Provision of the RDL 4/2014
The 4th Additional Provision of the Spanish Insolvency Act has been significantly amended. In particular, specific provisions of the sanctioned scheme of arrangement shall be imposed on dissident creditors on the following terms:
- if the schemes of arrangement have been signed by creditors representing at least 60% of the financial debt, the following effects may be extended to dissident creditors: (i) debt rescheduling ("espera") for a maximum term of five years; or (ii) the conversion of debt into profit participating loans (PPLs) for the same term; and
- if the schemes of arrangement have been signed by creditors representing at least 75% of the financial debt, the following effects may be extended to dissident creditors: (i) debt rescheduling up to 10 years; (ii) debt cut off ("quita"); (iii) debt to equity swaps; (iv) the conversion of debt into PPLs for a period not exceeding 10 years, convertible bonds or subordinated loans, capitalised interest loans or any other financial instrument with a ranking, maturity or characteristics that differ from the original; and (v) the delivery of assets or rights to creditors to release all or part of the debt.
The sanctioned scheme of arrangement will extend to dissident creditors holding unsecured and secured financial debts. In particular, the effects of the arrangement may extend to the part of the credit of a dissident creditor included within the value of its security, provided that the effects of the arrangement that it aims to extend to the dissident creditor are supported by the following majorities (percentage of the value of the security held by the entities accepting the refinancing over the total value of the security granted): (i) in relation to III (i) above, a majority of 65%; and (ii) in relation to III (ii) above, a majority of 80%.
Special regime for derivative transactions under RDL 5/2005
A derivative transaction agreement allows a non-defaulting party to terminate all transactions upon its counterparty’s default and to calculate its gain or loss on a net basis. The principal legal issues with respect to enforceability of these rights and remedies arise under the governing law of the agreement and the insolvency laws of the defaulting counterparty’s jurisdiction. These insolvency laws may override or affect the termination and close-out provisions even though they are generally enforceable under the governing law of the agreement.
The Spanish Insolvency Act enables the debtor's insolvency administrator the right to continue those performing contracts that are favourable to the debtor (provided that there is not a payment default) or to terminate those which may be deemed unfavourable (action which is usually referred to as "cherry-picking").
Close-out netting is a significant problem in jurisdictions which restricts the right to exercise contractual terms of termination and which permit an insolvency representative to cherry-pick legal relationships within the entire portfolio of agreements of the debtor. This is why in these jurisdictions special laws for derivatives have been issued in order to provide certainty to the enforcement of a derivative transaction.
In Spain this special legal framework is established under Royal Decree Law 5/2005 of 11 March ("RDL 5/2005"), which implemented the EU Financial Collateral Directive 2002. The scope of RDL 5/2005 covers those financial transactions carried out under a derivatives master agreement such as ISDA o CMOF. Article 5 of RDL 5/2005 defines a master agreement ("contrato normativo") as an agreement that envisages the creation of one single legal obligation which covers all the financial transactions included in such agreement and by virtue of which, where there is an early termination, the parties will only have the right to claim the net amount resulting from the liquidation of such transactions.
In particular, RDL 5/2005 recognises the following exceptions to the Spanish Insolvency Act in order to provide enforceability to the provisions of close-out under a master agreement:
- Recognition and enforcement of ipso facto clauses:
The Spanish Insolvency Act does not recognise the provisions which allow the parties to terminate or close-out an agreement merely upon the insolvency declaration. However, article 16 of RDL 5/2005 provides that the termination rights of transactions under a derivative master agreement will not be affected, restricted or limited by the declaration of insolvency of one of the parties. In particular, it establishes that:
“the declaration of an early termination, termination, enforcement of equivalent effect of financial transactions entered into in the context of a master netting agreement or in relation thereto may not be limited, restricted or affected in any way by the opening of an insolvency procedure or an administrative liquidation procedure”.
- Exception to the general insolvency rule in relation to set-off:
Contractual set-off is valid and effective under Spanish law. However, in an insolvency, Spanish insolvency rules provided that set-off is only effective if the relevant "conditions are met before the opening of the insolvency proceedings". This means that the reciprocal claims must have become due before the commencement of the insolvency proceeding.
However, RDL 5/2005 establishes a special set-off regime for derivatives transactions providing that once the insolvency proceeding has been declared the net sum of an early terminated transaction calculated in accordance with the provisions of such agreement, will be included as a claim or, as applicable, as a debt, in the estate of the insolvency party.
- Limitations to claw back actions foreseen under article 71 of the Spanish Insolvency Act:
The Spanish Insolvency Act provides for the possibility of challenging those acts that are harmful to the debtor’s assets up to two years prior to the declaration of insolvency. This possibility will be available even if the debtor acted without fraudulent intent. Notwithstanding this, article 71.5.2ª of the Spanish Insolvency Act expressly protects from claw back actions those acts included within the scope of special laws that regulate the payment, clearing and settlement systems for securities and derivative instruments, among which RDL 5/2005 is included.
Implications of RDL 4/2014 on the special regime for derivative transactions
In our view RDL 4/2014 does not amend or derogate the existing protections to derivatives transactions set out by RDL 5/2005. In particular, the preamble of RDL 4/2014 declares that the existing protections to derivative transactions set out under Chapter II of Title I of RDL 5/2005 shall not be affected by this new reform. Moreover, RDL 4/2014 does not include any provision which expressly reforms RDL 5/2005 as opposed, for example, to Law 9/2012 on the restructuring and dissolution of credit entities, were certain provisions (in particular, article 70) expressly restricts certain protections to derivatives transactions set out by RDL 5/2005.
Based on the above, we consider important to highlight the following issues:
- RDL 5/2005: Special rule will override the general rule ("lex specialis derogat legi generali")
The general principle stating that a special rule will override the general rule ("lex specialis derogat legi generali") is a principle generally accepted in Spain for interpretation and conflict of laws. When two or more laws or provisions deal with the same subject matter, priority should be given to the act that is more specific. This principle is justified by the fact that such special law takes better account of the particular characteristics of the context in which it is to be applied than any applicable general law. It is well known that the privilege recognised in the EU Financial Collateral Directive and RDL 5/2005 is justified for the stability of the financial system and the avoidance of financial systemic risk.
RDL 5/2005 is consequently a very special set of legislation, as recognised under the Additional Provision 2 of the Spanish Insolvency Act, which was introduced in Spain following the EU Financial Collateral Directive 2002. RDL 5/2005 recognises a special insolvency regime for those transactions carried out under a master agreement in order to swiftly liquidate all positions of insolvent counterparties and to ensure enforceability of the close-out provisions and their collateral.
RDL 4/2014 is a piece of legislation passed within the general Spanish insolvency regulation through which certain pre-insolvency provisions of the Spanish Insolvency Act are substantially reformed. RDL 4/2014 does not expressly modify or overrides the existing protections to derivative transactions foreseen under RDL 5/2005. In contrast, the above mentioned Law 9/2012 was a set of legislative amendments approved on an exceptional basis for the restoring and strengthening of the Spanish financial system.
Based on the above, RDL 5/2005 as special rule shall prevail over the general rule (the Spanish Insolvency Act as amended from time to time).
- Impact on derivative transactions during a pre-insolvency and insolvency scenario
In our view, and as explained in more detail below, RDL 4/2014 shall not negatively affect a derivative agreement which is currently in force. However, some of the reforms might affect the debt resulting of the derivative agreement once it has been terminated, early terminated or enforced, unless the resulting debt is secured by an in rem security.
- Pre-insolvency scenario
A derivative transaction shall not be affected by a pre-insolvency scenario on the basis that derivatives agreements have a fixed term and shall be maintained until maturity unless early terminated by the non-defaulting party or automatically under the agreement (not a usual provision). A derivative agreement may be early terminated (i) if an event of default is triggered or (ii) if any of the counterparties exercise a break clause (if agreed in the contract). In this regard, the two possibilities that can take place are the following:
- The non-defaulting party triggers an event of default or termination event under the ISDA Master Agreement or under the CMOF in which case the close-out amount shall need to be calculated. In the context of a pre-insolvency scenario such amount shall be an ordinary credit unless the credit is secured, in which case the security shall be enforced.
In accordance with RDL 5/2005, any event of default which allows the parties to terminate an agreement upon a pre-insolvency situation (e.g. composition with creditors) cannot be affected, restricted or limited.
- The agreement is maintained (until maturity). In this case, if/ when the insolvency proceedings are opened any close-out amount shall be an ordinary or privileged (secured) credit depending on the nature of the credits*.
The RDL 5/2005 also protects derivative transactions from cheery picking. In this regard, the non-defaulting counterparty is not obliged to attend to the negotiations during the pre-insolvency scenario when the agreement has not been early terminated, resulting in one of the following possibilities:
- that each party honour their payments under the derivative agreement;
- that some periodical payments by the debtor are outstanding but the agreement has not been early terminated. Under such circumstance, the non-defaulting counterparty shall have against the debtor both a due debt and a potential contingent claim (negative mark to market). Under an insolvency scenario both claims shall be an ordinary or privileged credit depending on the nature of the credit as explained above; or/and
- existing credit support documents: payments due under credit support documents shall be treated equally to payments due under single agreements as these payments –although made as fungible security- they have a legal treatment of transfer of cash or non-cash as true ownership.
- Restructuring of a derivative agreement
Notwithstanding the above, under a pre-insolvency scenario the counterparties may agree to restructure a derivative agreement. In this regard, a derivative creditor may choose to participate in the negotiations and adhere to a refinancing agreement. Under such circumstances, article 71 bis of the Spanish Insolvency Law as reformed by RDL 4/2014 shall be applicable to these derivative creditors and shall benefit and protect the arrangements and guarantees/security agreed for the derivative transaction under the refinancing agreements. In this scenario, the contingent debt resulting from the restructured derivative should be treated as existing debt (i.e. the mark to market value) upon the date of the refinancing agreement. The Spanish legislator has failed not to align the amount resulting from the restructured derivative to actual/real debt.
The recognition of the restructuring of a derivative agreement in the context of the general restructuring/refinancing of the debtor or even made separately shall also be an important issue to ensure that the capacity and authority of the directors of the company who executed the restructured derivative is compliant with the provisions of RDL 4/2014.
If a derivative is restructured outside of, or prior, to a refinancing agreement, it may be the case that one or more of the following may happen:
- the agreement is extended to a longer maturity;
- a new security is granted;
- a payment to be made by the restructurer is set-off against the negative mark to market position of the debtor and an option is given to the restructurer, or
- payments to be made by the insolvent debtor may be suspended/rescheduled until a certain date in the future (a kind of a temporary waiver of payments).
In these cases, the following shall need to be considered:
- A restructured derivative and any given new security should not be declared null or void by the judge in accordance with article 15 of RDL 5/2005 even if it has been granted in the period of two years before the declaration of insolvency.
In accordance with RDL 5/2005 and article 72.2 of RDL 4/2014 the above agreements should only be challenged by the insolvency administrator and he shall need to prove that these new agreements were granted in fraud of creditors.
- In accordance with 2nd Additional Provision of RDL 4/2014, any amounts put into the insolvency estate (whatever the structure is agreed explicitly or implicitly including any set-off or rescheduled payments) during the two years as from the entry into force of RDL 4/2014 shall be considered to be insolvency credits against any future insolvency estate ("créditos contra la masa") of the debtor. In this regard, any payments carried out in favour of the debtor in the context of restructuring of a derivative transaction shall have this consideration.
- Schemes of arrangement: possible extension to dissident creditors
In accordance with the 4th Additional Provision of the Spanish Insolvency Act as reformed by RDL 4/2014, the sanctioned scheme of arrangements will extend to dissident creditors holding unsecured or secured financial debts.
In relation to derivative transactions, in our opinion, the effects of a scheme of arrangement shall only be extended to the following derivatives counterparties:
- Unsecured derivative counterparties who have early terminated or triggered an event of default. The resulting debt shall be treated as an ordinary credit.
- Secured derivative counterparties who have enforced the security but which is not sufficient to cover the close-out amount. The resulting remaining debt shall be an ordinary credit.
However, the effects of a refinancing arrangement shall not be extended to the credit of a dissident secured or unsecured derivative creditor whose agreement is not early terminated, as it shall be protected by the special regime of RDL 5/2005.
- Financial collateral arrangements
Pursuant to article 15 of RDL 5/2005, the financial collateral arrangements (e.g. a Credit Support Annex with periodical margin calls) have a special regime in an insolvency and/or liquidation scenario. In principle, they are immune to the insolvency and liquidation effects.
In our view this special regime shall prevail over the RDL 4/2014. In this regard, the new restriction to the enforcement proceeding during the pre-insolvency scenarios shall not affect to financial collateral arrangements. Also, (i) they shall not be affected by any of the actions adopted, and therefore, they may be enforced separately; and (ii) they shall not be declared null and void just for the fact that they were granted in the clawback/suspicious period before the declaration of insolvency.
- Clearing of derivative transactions
The effectiveness of the special regime provided under RDL 5/2005 is critical in order to guarantee the stability and effectiveness of clearing transactions developed by Regulation (EU) No 648/2012 of the European Parliament and of the Council of 4 July 2012 on OTC derivatives, central counterparties (CCPs) and trade repositories (TRs) ("EMIR").
The European Union implemented throughout EMIR the G20 commitments on OTC derivatives agreed in Pittsburgh in September 2009. The purpose of the G20 was to improve transparency in the derivatives markets and to mitigate systemic risk. EMIR requires standard derivative contracts to be cleared through Central Counterparties (CCPs) as well as margins for uncleared trades. Therefore it is essential to respect and protect collateral agreements in order for clearing members and clients to comply with this obligation.
Pursuant to the rule books of clearing houses, it is customary that upon an early termination date in respect of one or more of the transactions between a clearing member and a clearing client, the relevant clearing member may instruct the clearing house to transfer the open position represented by the cleared contracts from the client account to its clearing member proprietary account. Also if the clearing member is defaulting it is vital for the clearing system that the clearing house may enforce immediately the member's collateral.
Based on the above, the RDL 5/2005 must prevail in all circumstances over the Spanish insolvency general regime in order to guarantee the correct performance of the new OTC derivative clearing system established under EMIR.
Any interpretation of the RDL 4/2014 affecting the special regime of derivatives transactions shall carefully consider the following:
- Suspension of enforcement of the collateral: under a pre-insolvency scenario, if the CCP or a clearing member is not entitled to use the margins posted by the defaulting clearing member or client upon an event of default this may cause that the CCPs may not consider eligible the transaction or that the CCPs can reject it.
- Cost of collateral: the Spanish clearing members/Spanish clients might be in a clear disadvantage as the posting of collateral might be more expensive for them whether for cleared transaction or for the more burdensome uncleared transactions.
Having said all the foregoing, it seems to us that the Spanish legislator has chosen the easy route to leave the market participants to rely on the short statement in the preamble of RDL 4/2014 and on the effectiveness of few provisions of RDL 5/2005. However this latter piece of legislation has already suffered the attack of ordinary and non-privileged creditors and inexperienced courts.
Given our very recent derivatives case law on insolvency (coming from zero) and our courts´ understandable inconsistencies and lack of perspective on the implications of their rulings in global financial markets, it is our view that in the short term our legislator is asking too much from the legal sector to correctly understand the subject matter.
Our government is in a clear path to introduce a number of reforms on insolvency just for the purpose of avoiding the liquidation of companies. These reforms prove that the previous ones were not successful (at least not entirely). Indeed historically the Spanish insolvency legislation is a story of failure if seen through a wide lens. Another good example of this is the recently introduced (in late 2013) odd concept and regulation of the "insolvency mediation".
After some years of financial and high street crisis and after a large number of insolvencies of companies of all sizes the markets would had expected a deeper thought and understanding of insolvency complex matters and not another legal patch.
*Please note that there have been discrepancies between the scholars and case law regarding the nature of the amounts resulting from a derivative transaction during an insolvency context. In our opinion and in accordance with article 16 of RDL 5/2005, (i) the amounts accrued before the declaration of insolvency shall be an ordinary or privileged credit depending on their nature, and (ii) the amounts accrued once the declaration of insolvency has taken place shall be an insolvency credit ("créditos contra la masa"). However, the Spanish Supreme Court has recently considered that credits resulting from a derivative agreement, including those accrued during the insolvency proceeding shall not be considered insolvency credits ("créditos contra la masa"). The Supreme Court based its ruling on deciding whether or not the obligations resulting from a swap agreement are reciprocal. The Supreme Court considered that there was no “functional synallagma,” (in which the two obligations are linked so closely they must be performed simultaneously). In our opinion this is not a valid rationale given that a derivative transaction (particularly a swap) is intrinsically reciprocal as per the counterparties obligations and the nettled payments. This case law argument could be acceptable in the event that a derivative transaction has a pure speculative nature or the transaction is artificially maintained after the declaration of insolvency. However, it is hard to accept that the obligations arising from a derivative transaction are not reciprocal if the purpose of the agreement is to continue hedge a risk which is outstanding during the insolvency of the debtor and it is necessary or beneficial to it (e.g. a financial liked swap or a balance sheet swap).