A Series of Fortunate Events
Until very recently, the Russian legal system did not contain a regulatory framework for OTC derivatives and repo transactions. Such guidance as existed was limited to certain narrow issues1. The resulting uncertainty concerning the legal status of such instruments limited the development of this segment of the Russian financial markets.
In March 2009, the Russian federal government introduced a bill into the State Duma (the lower chamber of the Russian parliament) that was primarily designed to make significant changes to the Tax Code of the Russian Federation (the Tax Code) with respect to taxation of derivative instruments and repo transactions. In order for the proposed changes to become operational, the draft bill, along with specific tax amendments, proposed to define “derivative instruments” and “repo transactions” as well as certain other key concepts directly in the Tax Code. The Commission on Taxation of the State Duma concluded that introduction of such general definitions and concepts directly in the Tax Code was inappropriate, and the bill was reworked so that general definitions and provisions would be introduced into other existing laws dealing with various aspects of the financial markets2 and the amendments to the Tax Code would be limited only to specific issues regarding taxation.
The bill, in its amended form, was signed into law on 25 November 2009, and most of the amendments (the Amendments) took effect on 1 January 2010. This Client Alert is intended to provide an overview of the Amendments, which almost by accident spawned a more general (albeit in some respects still incomplete) regulatory framework for OTC derivatives and repo transactions in Russia3.
Regulation of Derivative Instruments
Article 2 of the Securities Market Law was amended to introduce the definition of a derivative instrument4. The definition significantly extends the list of underlying assets set forth in Article 1062 of the Civil Code and expressly covers various options, total return swaps, credit derivatives, transactions linked to indices, as well as derivatives linked to statistical and environmental data. Any forward transactions (with a settlement of T+3 or longer) will also be covered by the definition, but only if the contract specifies that they should be treated as a derivative instrument. The reference to instruments linked to “changes in prices for derivatives” allows us to conclude that margin posting arrangements (in the form of cash or securities) should also be covered by the new definition.
Pursuant to Article 1062 of the Civil Code, the new derivative instruments introduced by the aforementioned definition will, like the instruments expressly listed in Article 1062, be enforceable but only to the extent that at least one of the parties to the relevant instrument is a bank or a professional participant of the securities market. While Article 1062 does not expressly provide whether the terms “bank” and “professional participant of the securities market” capture any, or only Russian, entities, it is arguable that the enforceability protection applies solely to transactions with, or between, Russian banks and Russian professional participants of the securities market holding relevant licences issued by the Central Bank of Russia or the FSFM, as applicable. Accordingly, the Amendments have not mitigated the existing risk of unenforceability of cash-settled derivatives between foreign financial institutions and Russian corporates.
Local Broker Requirement
Prior to the Amendments, the Securities Market Law established certain restrictions with respect to dealing in foreign financial instruments by Russian entities who do not qualify as QIs. For the purposes of the Securities Market Law, QIs are divided into two categories—QIs by operation of law5 and QIs by recognition6.
The Amendments introduced a new Article 51.4.7 which provides that QIs by recognition may enter into derivative instruments “that are intended for QIs” only through Russian brokers licenced by the FSFM. The impact of this new requirement will be different in the cross-border and the domestic context.
As regards cross-border instruments, pursuant to Article 51.1.13 of the Securities Market Law, foreign financial instruments not recognised as foreign securities (i.e., any derivative with a foreign counterparty) can only be offered to QIs. Therefore, offering of such instruments will automatically fall within the restrictions established by Article 51.4.7. Accordingly, once the Amendments come into effect, foreign financial organisations will only be able to enter directly into derivative transactions with QIs by operation of law and will need to engage Russian brokers to enter into any derivative transactions with QIs by recognition. Exceptions to this rule may be established by federal law or by regulation of the FSFM, but as of yet no such exceptions have been provided.
Local derivative transactions between two Russian counterparties will fall into two categories. Transactions that will be included in the FSFM list of financial instruments “intended for QIs” will have to be entered through Russian brokers if one of the counterparties is a QI by recognition. Transactions that will not be covered by such list will not require the use of a Russian broker. Since the Amendments do not clarify whether the aforementioned rule would be applicable to both parties to an agreement involving a QI by recognition, the reference to “entering through brokers” could be construed as a requirement that in the instances where parties need to use a Russian broker, both parties need to be entering into the transaction using Russian brokers.
The new Article 51.4.6 of the Securities Market Law introduced the following limitation on trading in credit derivatives:
- when a credit instrument is entered into on exchange, the seller of protection must be a QI (either by operation of law or by recognition) and the buyer must be a legal entity. The Amendments do not clarify whether the reference to “exchange” should be limited to a Russian exchange. The law is also not clear on what constitutes “entering on exchange” (i.e., whether the instruments only need to be admitted to trading on the exchange, or also included in one of the exchange’s quotation lists).
- when a credit instrument is entered into over-the-counter, the seller must be a credit organisation, a broker or a dealer and the buyer must be a legal entity. While the wording of the Amendments does not specify whether the reference to a credit organization, a broker or a dealer covers any, or only Russian, entities, it is arguably limited to Russian entities holding the relevant licences.
Prior to the Amendments, it was unclear whether Russian banks could enter into commodity derivatives. This lack of clarity resulted from the prohibition in Article 5 of the Law On Banks and Banking Activity that expressly prohibited banks from engaging in commodity trading. That provision has now been amended to clarify that, although Russian banks are expressly prohibited from trading in commodities, they can enter into cash-settled commodity derivatives.
The principal rules for exchange trading remain unchanged — i.e., derivatives may still be traded on an exchange on the basis of specifications (i.e., internal regulations of the exchange setting forth standard terms of particular instruments) registered with the FSFM, subject to certain limitations with respect to the classes of securities and indices that may be referenced as underlying assets of exchange-traded derivative instruments, as well as commodities that may be traded on a commodity exchange.
The only significant change introduced by the Amendments is the adoption of new Article 51.4.1 of the Securities Market Law which now requires a central counterparty clearing house for any derivative transactions entered on an exchange7. The current trading rules of the RTS Stock Exchange already provide for such requirement. MICEX trading rules will need to be amended to introduce a central clearing house.
Regulation of Repo Transactions
The definition of a repo transaction introduced by the new Article 51.3 of the Securities Market Law is quite extensive and deals with most of the key terms of a repo transaction, including the range of securities that can be the subject of a repo transaction8, the procedure for determination of dates and prices for the purchase and repurchase of securities, substitution, margining, early termination, etc.
There is no requirement to use brokers on repo transactions entered into by legal entities. An individual can enter into a repo transaction, but it can only do so through a broker unless the other party is itself a broker, dealer, depositary, investment manager, clearing house or a credit organization. Again, while the Amendments do not clarify as to how the reference to such entities should be construed, it is arguably limited to Russian entities holding relevant licences.
Prior to the adoption of the Amendments, there existed a risk of recharacterisation of a repo transaction as a secured loan as customarily repo transactions provided for certain restrictions on the right of the buyer to dispose of securities, requirements to transfer distributions on the underlying securities to the seller, arrangements regarding voting rights with respect to the underlying securities, etc. The Amendments have dealt with this issue by expressly permitting the parties to restrict the right of the buyer to dispose of purchased securities and providing that such restrictions should be registered in the securities account of the buyer opened with a registrar or a custodian9. Since this requirement appears to contemplate registration only by Russian registrars and custodians holding relevant licences issued by the FSFM (as regulation of activities of foreign registrars and custodians is outside the scope of the Securities Market Law), it is not clear that this requirement could be complied with on transactions involving a repo of foreign securities.
Pursuant to Article 51.3.13 of the Securities Market Law, the buyer shall have an obligation to pass on any distributions on purchased securities to the seller (by way of cash payments or a pro rata decrease of the repurchase price).
While the Amendments do not address the question of voting rights arrangements and it therefore remains unclear as to whether passing of voting rights back to the seller would affect the characterisation of a repo transaction, the clarity established with respect to the right of disposal of securities and transfer of distributions should significantly reduce the risk of recharacterisation of repurchase transactions as a secured loan.
Master Agreement and Liquidation Netting Concepts
The Amendments provide for the possibility to enter into derivative and repo transactions on the basis of master agreements, including those that incorporate by reference standard terms published in the mass media or on the Internet. This provision is presumably intended to cover, inter alia, transactions that may be entered into under the Standard Russian Derivatives Documentation published in the summer of 200910, as well as any other standard documentation that may be developed in the future. While such reference in itself has not changed the existing situation (since the possibility to enter into a master agreement is already set forth in the Civil Code), it may be viewed as sign of recognition of the use of master agreements in the context of derivative and repo transactions.
The Amendments also specify that master agreements may establish a procedure for termination of transactions thereunder and calculation of termination amounts. This provision appears to be intended to capture the concept of liquidation netting that is currently being considered by the Russian parliament and is expected to introduce significant changes to the Russian bankruptcy legislation allowing liquidation netting under master agreements in the context of insolvency proceedings. However, until the rules specifically addressing liquidation netting are adopted, it is unclear whether and how the corresponding references in the Amendments will operate.