The ISDA 2014 Resolution Stay Protocol, published on November 12, 2014, by the International Swaps and Derivatives Association, Inc. (ISDA),1 represents a significant shift in the terms of the over-the-counter derivatives market. It will require adhering parties to relinquish termination rights that have long been part of bankruptcy “safe harbors” for derivatives contracts under bankruptcy and insolvency regimes in many jurisdictions. While buy-side market participants are not required to adhere to the Protocol at this time, future regulations will likely have the effect of compelling market participants to agree to its terms. This change will impact institutional investors, hedge funds, mutual funds, sovereign wealth funds, and other buy-side market participants who enter into over-the-counter derivatives transactions with financial institutions.
Among the key features of the Protocol are the following:
- Special Resolution Regimes. In the wake of the 2008 financial crisis, regulators in several jurisdictions have adopted “special resolution regimes,” which are designed to enable regulators to direct an orderly resolution of a distressed financial institution, including the institution’s derivatives transactions. These regimes, including Title II of the U.S. Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, generally impose a one or two business day stay on the exercise of default rights (such as termination rights and rights to net collateral), to give the receiver or regulatory body time to transfer the failing or failed financial institution’s rights and obligations to another entity. Following such a transfer, the non-defaulting party’s right to exercise default rights as a result of its counterparty entering the proceedings is eliminated. The cross-border enforceability of these special resolution regimes is unclear under current law. The Protocol seeks to provide clarity, by introducing the provisions from certain eligible regimes by contract to ISDA Master Agreements and related credit support arrangements. In effect, Protocol adherents will agree to be bound by the special resolution regimes, even in situations where they might not otherwise apply.
- U.S. Bankruptcy Code Proceedings. Particularly troubling is that the Protocol includes provisions requiring an adhering party to agree to limit (and in certain cases, eliminate) its rights to exercise remedies under ISDA Master Agreements and related credit support arrangements when an affiliate of its counterparty, such as a bank holding company, enters U.S. Bankruptcy Code or certain other U.S. insolvency proceedings. Coupled with the anticipated regulatory pressure to compel all market participants to adhere to the Protocol, these provisions will have the practical effect of amending and limiting long-standing “safe harbor” protections for derivatives contracts under the U.S. Bankruptcy Code and other U.S. law, without action by Congress.
- Timing. The special resolution regime section of the Protocol becomes effective on January 1, 2015, for ISDA Master Agreements between voluntary adherents to the Protocol who are financial institutions covered by an eligible special resolution regime. The provisions of the Protocol that relate to proceedings under the U.S. Bankruptcy Code and other U.S. insolvency regimes (other than special resolution regimes) apply only after U.S. regulations enter into force limiting the ability of financial institutions to enter into derivatives transactions under ISDA Master Agreements that do not include provisions like those in the Protocol. Those regulations are expected to be adopted by the Federal Reserve and other U.S. regulators in the next couple of years. So far, eighteen major global banks have voluntarily adhered to the Protocol. Buy-side entities are not expected to adhere at this time. The Protocol by its terms anticipates that regulators in various jurisdictions will adopt regulations in the coming years that will prohibit financial institutions from entering into derivatives transactions with counterparties who have not adhered to the terms of the Protocol or otherwise agreed to similar terms.
A more detailed explanation of the changes to ISDA Master Agreements and related credit support arrangements made by the Protocol is included in Annex A to this Alert.
Background: From the 2008 Financial Crisis to the Protocol
Following the financial crisis in 2008 and widespread concerns about taxpayer support of financial institutions that are deemed to be “too big to fail,” many jurisdictions adopted special resolution regimes. These special resolution regimes generally give regulators sweeping powers in the event a systemically important financial institution becomes distressed, with the goal of stabilizing or liquidating a failing or failed institution without severe disruption to the financial system or losses to taxpayers.2
One of the key issues regulators have sought to address in implementing special resolution regimes is termination rights in respect of a failing or failed financial institution’s derivatives contracts. The special resolution regimes seek to address this issue by imposing a temporary pause—or “stay”—on the ability of counterparties to exercise direct default or cross-default rights. A temporary stay is designed to give regulators time, among other things, to oversee the transfer of derivatives contracts to a more financially sound entity or to take other actions to preserve the financial institution’s contracts. Termination of derivatives contracts and the resulting capital calls made on Lehman Brothers were widely viewed as complicating the firm’s resolution. Since that time, regulators have sought to implement measures to avoid wholesale terminations of a financial institution’s derivatives contracts by its counterparties during a time of severe financial stress.
Addressing these issues in a cross-border context has proven challenging. Whether and how the different rules apply in the case of a global financial institution with counterparties in (and contracts governed by the laws of) multiple jurisdictions is complex and uncertain under current law.3 As a result, some counterparties of a failing or failed financial institution may be able to terminate derivatives contracts with the financial institution, while others may not, depending on each party’s jurisdiction (and the governing law of the contract). As regulators grappled with these issues, they have called upon ISDA, the primary trade association for the over-the-counter derivatives market, to implement a contractual solution.
The Protocol addresses the cross-border problem by contractually binding all adherents to the resolution laws governing a financial institution that enters an eligible special resolution regime, including any stays on the exercise of default remedies. Since special resolution regimes generally override the exercise of termination rights based on direct defaults or cross-defaults, the effect of the Protocol is to impose a contractual stay on termination of the financial institution’s derivatives contracts by counterparties once the financial institution enters a special resolution regime, no matter where the financial institution or its counterparty is located (or the governing law of the contract). In addition, if the financial institution’s rights and obligations under a derivatives contract are transferred to a successor as part of the resolution process, the right of the non-defaulting party to exercise termination rights as a result of its original counterparty’s entering resolution proceedings is eliminated.
The Protocol also incorporates provisions relating to a proceeding under the U.S. Bankruptcy Code, including restrictions on creditor rights that otherwise would apply in a U.S. Bankruptcy Code proceeding. These include the removal of any ability to exercise cross-default rights because an affiliate of a financial institution counterparty that is listed as a “specified entity” in an ISDA Master Agreement enters a U.S. Bankruptcy Code proceeding. The Protocol also limits the ability of a non-defaulting party to exercise remedies in the event that a guarantor of a financial institution’s obligations under an ISDA Master Agreement enters U.S. Bankruptcy Code proceedings. Unlike the rules applicable to an eligible special resolution proceeding, the Protocol does not limit a non-defaulting counterparty’s right to terminate derivatives transactions in the event that its direct counterparty enters U.S. Bankruptcy Code proceedings—although, in fact, it seems likely that most major U.S. swap dealers will be subject to special resolution proceedings.4
Implications of the Protocol and Considerations for the Buy Side
As noted above, eighteen major global banks have voluntarily adhered to the Protocol, which is to become effective with respect to those banks and eligible special resolution regimes on January 1, 2015. It is expected that regulators will adopt regulations in 2015 and beyond that will prohibit financial institutions from entering into derivatives transactions with counterparties who have not agreed to terms like those in the Protocol. Regulations will have the effect of requiring more entities—including members of the buy side—to give up termination rights (i.e., adhere to the Protocol) in order to continue trading with financial institutions in these jurisdictions. Adherence to the Protocol will cause an adhering party to agree to these terms for all of its outstanding derivatives contracts under ISDA Master Agreements with other adhering parties.
While members of the buy side are not required to adhere to the Protocol at this time, they should begin thinking about the Protocol and its potential effect on their derivatives trading. Members of the buy side should understand the extent to which their financial institution counterparties are potentially within the scope of eligible special resolution regimes and the effect such proceedings would have on the terms of their ISDA Master Agreements, depending on the jurisdictions of the counterparties and any “specified entities” or guarantor entities of such counterparties, to determine how the Protocol would apply.
Notably, the Protocol is limited to ISDA Master Agreements and related credit support arrangements. Other types of trades, such as repurchase agreements, securities lending transactions, and derivatives that are not traded under an ISDA Master Agreement are not directly covered by the Protocol. It is not clear if and when these types of transactions might become subject to a similar industry-wide solution.