Until recently Russian legislation was not familiar with the concept of close-out netting. Although there was no prohibition for market participants to enter into netting agreements, Russian courts would not enforce such agreements in case of bankruptcy. This led to the use of complex structures to avoid the negative consequences of the application of Russian law and was a strong argument in favor of using foreign entities and application of foreign law to derivative transactions.
In December 2008 the Russian Government adopted the strategy for the development of the Russian financial market which discussed, among others, the need for the development of the Russian derivatives market and the implementation of close-out netting for the purpose of attracting foreign investors and improving the investment climate in Russia. Following more than two years of discussions on 9 February 2011 the Federal Law No.7-FZ “On Clearing and Clearing Activities” (the “Clearing Law”) was officially published. The Clearing Law introduces the concepts of netting and close-out netting and sets out protection mechanics for the creditors of the company in bankruptcy. In addition, the Clearing Law and related amendments introduced concepts of the central counterparty, model terms and master agreements and improved the regulation of clearing activity and clearing organisations.
We analyze below the major provisions of the Clearing Law, as well as other legislative acts implementing the concept of close-out netting. Although the Clearing Law is far from being perfect and some of its provisions are vague and require interpretation, we believe it will have positive influence on the Russian securities market and constitutes another critical step in developing and improving Russian financial markets legislation.
Netting and close-out netting
Previously Russian law did not recognise the concept of close-out netting. The main risks relating to enforcement of netting agreements in bankruptcy were: (i) their reclassification as a set-off agreement subject to the limitations applicable to set-offs in bankruptcy; and (ii) reclassification of each transaction arising out of the netting agreement as a separate standalone obligation. The risk of reclassification of each transaction as a separate standalone obligation was particularly disadvantageous to the creditors. This was the main reason why the participants of the Russian securities market were so reluctant to enter into Russian law governed master agreements in respect of repo or derivative transactions as the administrator in bankruptcy could make “cherry picking” decisions with respect to creditors’ claims under these transactions.
After long debates the Clearing Law has finally introduced the concepts of netting and close-out netting and set out the protection mechanics for the creditors of the company in bankruptcy. In particular, it provided that the transactions concluded pursuant to eligible master agreements must be treated as a single transaction and therefore prohibited the “cherry picking” approach.
The Clearing Law and the amended bankruptcy laws provide that the following transactions will be eligible for close-out netting: (i) repo transactions; (ii) derivative transactions; and (iii) other transactions in respect of securities or foreign currency provided that they are concluded on the basis of the Model Terms (as defined below) or the model terms developed by international industry bodies (the “Finance Agreements”).
The drafting of the relevant provision of the Clearing Law is pretty vague1 and, in fact, could be construed either (i) as covering all repo and derivative transactions, as well as “transactions of other type the subject of which is foreign currency and/or securities” or (ii) only covering “transactions the subject of which is foreign currency and/or securities.” The more restrictive reading would limit the list of transactions eligible for close-out netting only to instruments the underlying assets for which are foreign currency or securities to the exclusion of other derivative products.
Pursuant to Article 1062 of the Russian Civil Code, a cash‑settled derivative transaction is enforceable if it involves an obligation of one party or both parties to pay money depending on changes in respect of the following eligible assets: (i) commodities’ prices; (ii) securities’ prices; (iii) exchange rates; (iv) interest rates; (v) inflation rates; (vi) any combination of (i) to (v); and (vii) any other underlying asset that Russian law specifies. Neither the Clearing Law nor the amendments to other legislative acts amended the list of eligible underlying assets in respect of which the derivative transactions may receive judicial protection in Russian courts. Therefore, if the underlying assets for a derivative transaction are not enumerated in Article 1062 of the Civil Code it may not have the benefit of judicial protection in Russian courts. The list of transactions eligible for judicial protection under the Civil Code is broader than the list of transactions eligible for close-out netting under the Clearing Law. As a result, the derivative transactions in respect of inflation rates, commodities and interest rates enjoy the judicial protection under Russian law but may not be eligible to close-out netting in bankruptcy if the closeout netting provisions of the Clearing Law are construed restrictively (see 2.4 above).
To receive judicial protection and become eligible for close‑out netting transactions should be entered prior to: (i) the date determined in accordance with the relevant rules to be adopted by the clearing organisation (the “Rules”) or (ii) the date preceding the declaration of the bankruptcy of a relevant party by the arbitrazh court and the introduction of insolvency proceedings (in case of entities other than Russian banks) or appointment of temporary administration or revocation of banking licence (in case of Russian banks).
To be eligible for close-out netting, both parties to the Finance Agreements shall fall within one of the following categories and at least one of the parties shall fall within at least one category set out in sub-clauses (A) – (E) below:
- Russian credit institutions or professional participants of securities market (such as brokers, dealers, asset managers, etc.);
- Central Bank of Russia;
- foreign2 bank or foreign professional securities market participant authorised to act in such capacity in accordance with the laws of its jurisdiction;
- international financial organisations;
- central banks of Eligible Jurisdictions;
- Russian legal entities;
- Russian Federation, its regions or municipalities;
- holders of units in mutual investment funds;
- Eligible Jurisdiction states and their sub-divisions; and
- foreign legal entities incorporated in Eligible Jurisdictions.
Taking into account this list, it appears that the transactions between corporates or individuals will not benefit from close-out netting provisions, which will impact structuring of derivative transactions between such parties and in the private banking sector.
Model terms and master agreements
Pursuant to the amendments to the Federal Law No. 39-FZ “On Securities Market” dated 22 April 1996 (the “Securities Market Law”), if parties intend to conclude a set of repo and/or derivative transactions and/or other transactions in respect of securities or foreign currency, they can do this on the basis of a master agreement incorporating by reference the model terms adopted by the self-regulatory organisations of the professional participants of the securities market and disclosed in press or Internet (the “Model Terms”).
The Model Terms must comply with the requirements of Article 51.5 of the amended Securities Market Law. In particular, they must set out: (i) terms and procedure for termination of some or all transactions entered into on the basis of the master agreement, including the termination at the request of a party due to non-performance or undue performance of the other party; (ii) terms and procedure for termination of all transactions entered into on the basis of the master agreement in case of bankruptcy of one of the parties. The Model Terms and any amendments to them are subject to approval by the Federal Service for Financial Markets (the “FSFM”), Russian financial markets regulator.
If one of the parties to the repo and/or derivative agreement and/or other agreement in respect of securities or foreign currency or the master agreement of such agreement is a foreign entity, the amended Securities Market Law permits the parties to incorporate by reference certain model terms developed by international industry bodies included in the list to be approved by the FSFM (the “eligible foreign organisations”). We expect that the FSFM will include the International Swaps and Derivatives Association (the “ISDA”), the International Capital Market Association (the “ICMA”) and the International Securities Lending Association (the “ISLA”) in the list of eligible foreign organisations.
The amended Securities Market Law also provides that the parties to the OTC repo and/or derivative agreement and/or other agreements in respect of securities or foreign currency and parties to the other transactions concluded pursuant to the master agreements must inform selfregulatory organisations, clearing organisations or the stock exchanges of the conclusion of such agreements. Self-regulatory organisations, clearing organisations or the stock exchanges must keep a register of these agreements and submit it to the FSFM.
Although the FSFM has yet to elaborate the requirements as to the frequency of reporting and the scope of information that the market participants must disclose to the repository, we do not believe that commercial terms of the transactions will be subject to mandatory disclosure. However, there is a concern that any potential requirement to register the detailed terms of transactions, including proprietary economic terms and formulas, is something that most parties would be keen to avoid. It is also not clear whether the reporting requirements would extend to one or both parties and, should such obligations apply to both, how the duplicate reporting would be accommodated.
The Clearing Law introduced new definitions of clearing, clearing activity and clearing organisation.
According to the previous version of the Securities Market Law, clearing referred to an activity involving: (i) calculation of mutual obligations arising under the securities transactions and preparation of accounting documents relating thereto; (ii) set-off of the obligations upon delivery of the securities; and (iii) performance of settlements under the securities transactions. This definition limited clearing operations only to securities transactions and provided that the obligations under such transactions could only be set‑off, which was problematic under the Russian bankruptcy laws that prohibit set-off against the bankrupt’s estate.
The Clearing Law expanded this definition by providing that clearing is the activity relating to (i) calculation of outstanding obligations under the agreements, including obligations resulting from netting and (ii) preparation of the documents (information) based on which such obligations are performed and/or terminated. The Clearing Law also specifically recognised the concept of netting defining it as full or partial termination of obligations admitted to clearing by set-off or any other means provided by the Rules (as defined below).
The Clearing Law outlines general requirements for clearing organisations and the central counterparty (the “CCP”) which we discuss in more detail below. Other amendments introduced to the Russian legislation in connection with the Clearing Law (mainly, amendments to the Securities Market Law) contain corresponding clarifications.
Pursuant to the Clearing Law, the clearing organisation is a Russian legal entity having a license to perform clearing activity and the charter capital of which amounts to at least RUR 100 million.
The Clearing Law limits the ability of the following persons to control more than 5% in the clearing organisation, either directly or indirectly, independently or jointly with any other persons on the basis of the fiduciary management agreement, commission agreement, shareholders’ agreement or any other agreement in respect of stakes in the clearing organisation: (i) legal entities incorporated in the states or territories with preferential tax treatment and/or which do not require the disclosure of the financial operations (the offshore zones) included in the list approved by the Ministry of Finance of the Russian Federation;3 (ii) legal entities whose licenses for the provision of certain financial activities have been revoked as a result of violation of law; and (iii) individuals who committed certain violations in the economic sphere.
In addition, the Clearing Law restricts some of the activities of clearing organisations, particularly those that may lead to substantial financial losses, to guarantee the performance of obligations by the clearing organisations towards market participants. The Clearing Law prohibits the clearing organisations from carrying out: (i) production activities; (ii) trading and insurance activities; (iii) securities registrar’s activities; (iv) management of the investment funds, mutual investment funds and non-state pension funds; (v) activities of the specialised depository of the investment funds, mutual investment funds and non-state pension funds; and (vi) activities of the joint stock investment fund and non‑state pension funds.
At the same time, the Clearing Law expressly states that, subject to certain limitations, clearing organisations may act as (i) CCP; (ii) stock exchange; (iii) broker; (iv) dealer; (v) depositary; and (vi) asset manager. In addition, clearing organisations have the right to dispose of their own funds without any limitations, including by entering into securities and derivative transactions.
Pursuant to Section 2 of the Clearing Law, the clearing organisation must adopt the Rules of clearing setting forth the eligibility requirements for parties to clearing activities, the terms of access to the clearing system, the rules and terms of the clearing process, the rights and obligations of the parties to clearing activities and the collateral which is eligible for use as security for the performance of obligations that have been admitted to clearing. The Rules and any amendments to them are subject to registration by the FSFM.
The FSFM will also have to promulgate regulations under the Rules. As of the date of this memorandum no drafts of such regulations are publicly available.
To become eligible for clearing activities the parties must enter into a clearing agreement with the clearing organisation by adhering to the agreement whose terms are set out in the Rules of the relevant clearing organization.
Prior to the passage of the Clearing Law, Russian law did not recognize the concept of CCP. However, as a matter of practice, since 2007, two of Russia’s largest stock exchanges, MICEX and RTS, have been providing through their affiliated companies (CJSC JSCB “National Clearing Centre” and CJSC “Clearing Centre RTS”) services relating to conclusion and performance of transactions on the stock exchanges. The Clearing Law has formalised the CCP’s status.
Pursuant to the Clearing Law, the CCP is a Russian entity satisfying certain requirements. Either a clearing organisation or a credit organisation that the FSFM has certified can perform functions of the CCP. The Clearing Law sets out certain restrictions relating to the activities of the CCP. For example, a credit organisation performing the CCP’s functions does not have the right to attract deposits from individuals.
Under the Clearing Law, the CCP must be a party to all agreements obligations under which are included into the clearing pool. The Rules will have to specify the list of obligations that the clearing pool will include. Prior to promulgation of the Rules, it is difficult to define the full scope of agreements to which the CCP must be a party.
The amended Securities Market Law provides that the CCP must be a party to exchange traded derivative transactions and vests the FSFM with the right to determine whether the CCP should also be a party to the OTC derivative agreements. At the same time, repo transactions do not fall within the definition of the derivative transactions and, therefore, CCP does not need to be a party to repo transactions.
The Rules may limit the CCP’s liability for the performance by the parties to the respective agreements or undue performance of their obligations that have been admitted to the clearing pool. In this case, if the amount of claims of the parties to clearing exceeds limits of the CCP’s liability, these claims will be satisfied in the order of priority set out in the Rules. In addition, unless the Rules provide otherwise, the claims that the CCP has not satisfied will be deemed discharged.
New currency control rules
The amendments were also made to the Federal Law No.173-FZ “On Currency Regulation and Currency Control” dated 10 December 2003 (the “Currency Law”) to make it consistent with the new provisions of the Clearing Law.
The previous version of the Currency Law, as a general rule, prohibited currency operations, including settlements in foreign currency, between Russian residents. Prior to promulgation of the amendments to the Currency Law Russian parties structured agreements with the involvement of a Russian licensed bank or used other structures to be able to make payments under the transactions. Currently, the Currency Law does not restrict Russian residents from entering into the following transactions relating to currency operations: (i) provision or repayment of the clearing collateral; (ii) settlements upon the results of clearing; (iii) performance or termination of the derivative transaction providing, however, that one of the parties thereto is either a Russian licensed bank or a professional participant of the securities market; and (iv) provision of services by agents to their principals in respect of conclusion and performance of the agreements obligations under which are subject to clearing.
Entry into force
The Clearing Law and the majority of related amendments to other legislative acts, such as the Securities Market Law, the Currency Law and banking legislation, come into force on 1 January 2012.