On 16 December 2016 an act amending the insolvency laws applicable to financial derivatives transactions passed the Bundesrat (the second chamber of the German legislature). The new law was finalised only six months after the German Federal Court of Justice passed its landmark judgment that held a netting provision based on the German Master Agreement for Financial Derivatives Transactions to be partially ineffective in the event of insolvency. The new law will provide greater flexibility to market participants to agree on the determination of close-out amounts and the date that derivative transactions are terminated in an insolvency. We expect the law to be published in the Federal Gazette and to come into effect in January 2017.
Unexpected BGH decision of 9 June 2016 raises concerns among market participants
On 9 June 2016 the German Federal Court of Justice (Bundesgerichtshof, BGH) ruled that the determination of the close-out amount in a netting provision based on the German Master Agreement for Financial Derivatives Transactions (Rahmenvertrag für Finanztermingeschäfte, DRV) is not legally effective in the event of insolvency to the extent that it deviates from section 104 of the German Insolvency Code.
Section 104 sets out the effects of insolvency proceedings on financial derivatives transactions. As currently in force, it provides for a termination of such transactions upon the opening of insolvency proceedings, i.e., the formal commencement of proceedings by court order. It further provides that the parties may agree on a day for the determination of the values of the terminated transactions, as long as that date is no later than five business days after the opening of the insolvency proceedings. If the parties do not agree on a date for the determination of the transactions’ values that is after the opening of the insolvency proceedings, then the second business day after the opening is deemed the relevant date. The values of the terminated transactions are determined by looking at the difference between the price agreed by the parties on the one hand and the market or stock exchange price on the relevant date on the other. The values of transactions which are subject to the same DRV are then netted to determine a single net sum (the close-out amount). In the case adjudicated by the BGH, the netting provision deviated from section 104 because it provided for a stock option agreement to terminate and for the close-out amount to be determined on the basis of market prices on the (earlier) date of the insolvency application. In addition, the parties capped the close-out amount.
In an immediate reaction to the ruling, the German Ministry of Finance and Ministry of Justice issued a joint statement saying that the German government would immediately initiate a change of the relevant insolvency law provisions if the BGH’s judgment had a broader impact on the acceptance of the commonly-used master agreements in the marketplace. The current reform will change the relevant section 104 of the German Insolvency Code as announced by the ministries at the time.
The new law
Under the new section 104 of the Insolvency Code, financial derivatives transactions will terminate once insolvency proceedings have opened with respect to one of the parties, unless the parties agree that the transactions will terminate at another time. Values are calculated for the terminated transactions which are subject to a master agreement such as the DRV, and netted off to derive a single net sum. If a replacement trade is entered into without undue delay, and at the latest within five business days of the opening of insolvency proceedings, then the price paid for that replacement trade on a market or exchange determines the value of the terminated transaction. If no replacement trade is entered into, then the hypothetical price that would have to be paid for a replacement trade on the second business day after the opening of the insolvency proceedings determines the value of the terminated transaction. If no replacement trades are available on the market, then valuation methods that ensure an appropriate valuation of the terminated transactions need to be applied.
Under the new law, market participants may agree on netting provisions which will continue to be effective in the event of insolvency, even though they deviate from the above rules. Market participants may, in particular, agree that:
- transactions will terminate on a date before the opening of insolvency proceedings, such as the day when a party files for insolvency or meets the grounds for insolvency; and
- the values of the terminated transactions are calculated by reference to (i) replacement trades which are entered into without undue delay, and at the latest within 20 business days of the termination of the transactions if such time period is needed to preserve value, or (ii) if no replacement trades are entered into, hypothetical replacement trades on a date which is within five business days of the termination of the transactions.
The DRV provides for a termination of transactions if insolvency proceedings with respect to a party are applied for and the party has either applied for the insolvency itself or meets the grounds for insolvency. Losses incurred by the solvent party are also calculated by reference to replacement trades although the provisions are not entirely identical to the ones set out above.
Market participants may agree on other deviations from the rules under the new section 104 of the Insolvency Code and these agreements will remain effective in the event of an insolvency, provided that they comply with the fundamental principles of the relevant provision in section 104.
Retroactive effect of the amendment
With some modifications, the new rules will become retroactively effective from 10 June 2016 (the day after the BGH judgment) onwards to the extent they provide that agreements between parties remain legally effective in the event of an insolvency, even if the agreements deviate from section 104 of the Insolvency Code. These new rules will apply to insolvency proceedings that are filed in the period of time from and including 10 June 2016 to the day before the date that the new law comes into force.
Apart from the modifications to the termination date of transactions and the determination of the close-out amount described above, the legislator took the opportunity to clarify the types of transactions that the new section 104 of the Insolvency Code will apply to. The new rules are also extremely important for energy trades. However, the legislator did not specifically mention energy trades in the new section 104, even though the German government, in the reasons accompanying the draft reform act, expressed the opinion that the new rules will also apply to energy trades. This corresponds to the view widely held by market participants. Nevertheless, an explicit provision would have been preferable.
On the whole, the greater flexibility that market participants will have in agreeing on the termination date of transactions and the determination of the close-out amount should go a long way to meeting the practical requirements of the financial markets.