On November 12, 2015, the International Swaps and Derivatives Association, Inc. (ISDA) announced the publication and launch of the ISDA 2015 Universal Resolution Stay Protocol (the 2015 Protocol). Eighteen of the largest banking organizations worldwide (the G-18)1 and three other large international banking organizations (together with future adherents to the 2015 Protocol, the 2015 Protocol Adherents)2 adhered to it upon publication. The ISDA 2014 Resolution Stay Protocol (the Original Protocol) was published in November 20143 and the G-184 adhered to it upon publication in connection with regulatory efforts to reduce risks associated with "too-big-to-fail" institutions.5 The Original Protocol is being replaced by the 2015 Protocol and by an additional protocol expected in 2016. As a consequence, buy-side market participants will face a unique set of legal and practical challenges in the coming year, and their sell-side counterparties will face related challenges of their own.
The Original Protocol came into effect on January 1, 2015, and was intended to help ensure, via short-term stay mechanisms, the preservation of swap transactions of any G-18 organization that became subject to certain resolution or reorganization proceedings. Two important limitations of the Original Protocol were acknowledged at its inception, and they are now the reason for its replacement:
The Original Protocol applied only to swap transactions under ISDA master agreements—and not to repurchase agreements or other security financing transactions (SFTs) such as securities lending.
The Original Protocol applied principally to transactions between G-18 institutions—and not to transactions of G-18 institutions with other market participants, such as buy-side counterparties.
These limitations are being addressed by the new ISDA protocols and by related legislative and regulatory initiatives in FSB jurisdictions.
The purpose of this Sidley Update is to provide a broad overview of the current ISDA resolution stay protocol mechanisms and to anticipate further protocol developments that will affect the buy-side and sell-side alike. This Update is not intended to be a detailed guide to either of those topics: the full complexity of the Original Protocol and of the 2015 Protocol—to which adherence is expected principally by the world’s largest banking organizations—is beyond the scope of this Update; and the protocol that is expected in 2016—to which broader market adherence is expected—must still be finalized, and in any case it will likely prove complex in its own right.
New ISDA Resolution Stay Protocols
Effective January 1, 2016, the 2015 Protocol will replace the Original Protocol for those institutions that have adhered to both.6 Although it is expected that additional banking organizations will also adhere to the 2015 Protocol, including other firms that the FSB has designated as global systemically important banks (GSIBs),7 it is not expected that other market participants, such as buy-side firms, will adhere to the 2015 Protocol.8
More significant for such market participants will be a second protocol, the ISDA Resolution Stay Jurisdictional Modular Protocol (the Jurisdictional Modular Protocol or JMP), which ISDA is expected to publish in 2016.9 The JMP will be developed in response to anticipated legislation and regulations (collectively, Anticipated Regulations) in various jurisdictions, including the United States and other major FSB countries.10
Anticipated Regulations will be imposed not only on 2015 Protocol Adherents, but also, in some FSB jurisdictions (as discussed below), on other banking organizations that are subject to national resolution regimes (collectively, Covered Banking Organizations). Anticipated Regulations are expected to require Covered Banking Organizations to amend existing agreements that govern derivative transactions and SFTs—i.e., ISDA master agreements and various SFT trading agreements—as a condition to continuing to trade under those agreements.11 The regulations are also expected to require that new agreements to which Covered Banking Organizations are party contain analogous provisions. Although Anticipated Regulations will directly bind Covered Banking Organizations (and not their counterparties), the regulatory consequence of the Anticipated Regulations will be requests by Covered Banking Organizations that their counterparties adhere to the JMP for purposes of amending existing trading agreements. However, as suggested below, it remains to be seen whether the JMP will effect amendments to agreements only to the extent expressly required by Anticipated Regulations or whether, in fact, the JMP goes further than Anticipated Regulations require.
For buy-side market participants, the resulting challenges will concern understanding the complex international regulatory context and the resulting protocol-driven contractual paradigm. Additionally, for asset managers and investment managers representing buy-side clients, there will be the challenge of communicating the terms and consequences to their clients, investors and accounts. Moreover, buy-side firms may not be presented an ISDA protocol fait accompli. In light of their fiduciary and other responsibilities, this may pose a unique challenge for buy-side asset managers, who may need to explore non-protocol means of amending agreements that would satisfy the bank counterparties’ regulatory obligations, though such alternatives may prove unattractive or difficult to pursue in practice. Thus, buy-side decision-making about coming regulatory changes, and related ISDA protocol efforts, will in some instances be nuanced, and will in most instances be complex, particularly with respect to communicating options and consequences both within a firm and with a firm’s clients.
For the sell-side—by which we generally mean Covered Banking Organizations—the challenges will involve educating counterparties and encouraging them to act before regulatory deadlines take effect. In some circumstances, the challenges may arise as counterparties request alternative (non-protocol) approaches (in the manner noted above)—that is, ad hoc documentation amendments that meet regulatory requirements but that do not do so solely via the JMP and which may, therefore, attract regulatory attention.
Before discussing the JMP in greater detail, we turn to the Original Protocol and the 2015 Protocol, whose terms and mechanisms provide important background for discussion of the JMP.
Original Protocol and 2015 Protocol
The key substantive portions12 of the Original Protocol and the 2015 Protocol are similar. In each case they are set forth in a protocol "Attachment" that has two distinct elements, one directed at large organizations subject to resolution regimes in a variety of FSB jurisdictions (including the United States),13 and one directed only at large banking organizations subject to certain insolvency laws in the United States. The Attachments under the two protocols are quite similar (with the exception of the addition of SFTs to the 2015 Protocol); and because the Original Protocol is now being replaced by the 2015 Protocol, we will focus on the latter.
Both elements of the 2015 Protocol’s Attachment operate to amend, as between two adhering parties, existing ISDA master agreements and a range of agreements governing SFTs; those latter agreements are listed in the 2015 Protocol’s Securities Financing Transaction Annex (the SFT Annex).14 The ISDA master agreements and SFT Annex agreements (together with any agreements that in the future may be incorporated into the 2015 Protocol via its "Other Agreement Annex") are collectively referred to as Covered Agreements. In contrast, the Original Protocol addressed only ISDA master agreements.15
Both elements of the Attachment limit the availability of certain termination and other rights in the context of resolution and reorganization proceedings. In other words, each of the two elements of the Attachment amends existing Covered Agreements between adhering parties in order to help ensure that, if one 2015 Protocol Adherent becomes subject to certain resolution or reorganization proceedings in its home jurisdiction, the termination and close-out rights of other 2015 Protocol Adherents will be subject to certain limitations. As discussed below, the first of these elements may be thought of as a choice of law provision applicable to cross-border transactions (irrespective of the FSB jurisdiction of the resolution proceedings), and the second as an override of certain cross-default provisions applicable only in the context of certain U.S. insolvency proceedings (irrespective of the presence of a cross-border transaction). Both elements are subject to certain opt-out provisions intended to ensure the protection of creditor rights.16
The first section of the Attachment (Section 1) operates as a choice of law clause for cross-border Covered Agreements—i.e., those where an adhering party subject to the resolution regime in a relevant FSB jurisdiction17 enters into agreements governed by the law of a jurisdiction other than its own. For example, consider a large UK banking organization that becomes subject to UK resolution proceedings where the relevant UK bank regulator imposes, under the applicable UK resolution regime, a short-term stay on the exercise of termination rights by the ISDA master agreement counterparties of the UK banking organization. For those master agreements of the UK banking organization governed by English law, the UK stay would be enforceable without application of choice of law principles. However, a conflict-of-law issue could arise where, for example, a master agreement is governed by New York law and the counterparty in question is a bank in the United States. In this example, Section 1 makes moot whether a New York court would enforce the UK stay: having adhered to the 2015 Protocol, the U.S. bank counterparty would have agreed contractually to the effectiveness of the stay as though the master agreement were governed by English law. Although a New York court may well have enforced the UK stay in any case (on the basis of New York conflicts of law principles), Section 1 removes any doubt.
Section 1 is desirable from a regulatory perspective because the presence of doubt regarding the enforceability of resolution stays could vex a regulator trying to resolve a globally interconnected banking organization in a short period of time. Doubt may be problematic because successful resolution is likely to require a high degree of certainty regarding the stability of the organization’s assets and liabilities when they are allocated or otherwise addressed through the exercise of applicable regulatory resolution powers.
The second section of the Attachment (Section 2) operates principally to override certain cross-default rights and certain transfer limitations under Covered Agreements where one of the adherents has an affiliated credit enhancement provider that is subject to Chapter 11 reorganization proceedings under the U.S. Bankruptcy Code or to resolution by the U.S. Federal Deposit Insurance Corporation (FDIC) under the U.S. Federal Deposit Insurance Act (FDIA).18 Consider, for example, the operating subsidiary of a large U.S. bank holding company where the latter files for Chapter 11 protection at a time when the former has trades under ISDA master agreements guaranteed by the holding company. In this circumstance, Section 2 would operate, in effect, to subject such cross-default rights to a short (e.g. two-day) temporary stay.19
Note that Section 2, unlike Section 1, does not simply ensure the cross-border enforceability of existing statutory resolution or reorganization powers. It introduces, via contract, powers that are entirely absent from the Bankruptcy Code and the FDIA in the first place—powers that reach affiliates of the entity subject to reorganization under the Bankruptcy Code or resolution under the FDIA. In effect, Section 2 bridges part of the gap between reorganization powers under the Bankruptcy Code and the FDIA, on one hand, and the greater powers under the orderly liquidation authority (OLA) created by Title II of the Dodd-Frank Act (as applied to failing financial institutions that threaten financial stability), on the other. While Title II reaches affiliates of an entity subject to OLA proceedings, neither the Bankruptcy Code (with respect, for example, to a holding company not deemed systemically significant enough to warrant OLA resolution) nor the FDIA (with respect to FDIC-insured institutions, which are expressly carved out of OLA jurisdiction) reaches affiliates. Section 2 addresses this limitation in part by contractually limiting the exercise of certain cross-default rights of counterparties of affiliates of either a company subject to Bankruptcy Code reorganization or a depository institution subject to FDIA resolution. Note, however, that Section 2 does not limit termination rights arising from direct defaults; for example, if the operating subsidiary in the example above were to fail to make a payment or were itself to become subject to Chapter 11 proceedings, resulting termination rights would not be stayed by Section 2.
Section 2 is desirable from a U.S. bank regulatory perspective because it would permit a short period of time during which a bankruptcy court (for a bank holding company subject to reorganization under Chapter 11) or the FDIC (for an FDIC-insured depository institution subject to resolution under the FDIA) would not be concerned with the consequence of cross-default terminations of ISDA master agreements at the level of operating affiliates.
One important caveat regarding Section 2: Unlike Section 1 of the Original Protocol’s Attachment, Section 2 did not become effective on January 1, 2015; indeed it is not yet in effect. Its effectiveness was conditioned on the adoption by U.S. regulators of related regulations. At this point, it is expected that when U.S. regulators propose and then finalize the U.S. version of Anticipated Regulations related to the JMP, they will propose and finalize regulations related to Section 2 of the Attachment as well.
Further Protocol Evolution: The Jurisdictional Module Protocol (JMP)
The Original Protocol is being replaced by the 2015 Protocol, effective January 1, 2016, principally in order to extend the former’s scope to a greater range of Covered Agreements (i.e., agreements governing SFTs, as well as ISDA master agreements). The JMP, which is expected to be published in 2016, will likely cover just as broad a range of agreements and transactions (if not broader); moreover, its target will be not just Covered Banking Organizations, but their counterparties (including all buy-side firms). In connection with the publication of the 2015 Protocol, ISDA noted in general terms that:
"The operative provisions of the ISDA Jurisdictional Modular Protocol are aimed at achieving an outcome substantially similar to the outcome under Section 1 of the ISDA 2015 Universal Protocol, which results in counterparties to financial institutions consenting to be subject to and "opting in" to stays on or overrides of certain termination rights under [special resolutions regimes], notwithstanding the governing law of their agreements."20
However, as noted above, the JMP is expected to respond, on a direct jurisdiction-by-jurisdiction basis, to Anticipated Regulations that impose new national restrictions on Covered Banking Organizations, requiring them to amend a variety of trading agreements (e.g., swap and SFT agreements) with non-bank counterparties. Already, the UK Prudential Regulatory Authority (UK PRA) has published its related final rules (the UK Regulations),21 and the German Legislature has enacted a related statutory amendment to its resolution regime (the German Regulations).22
Modularity: How Will the JMP Operate? The JMP is dubbed "modular" because a separate portion of the JMP is expected to address the Anticipated Regulations in each given jurisdiction, and thus the JMP will effectively operate via modular mechanisms.23 Each separate jurisdictional element, or module, of the JMP is expected to comprise protocol provisions that are unique to the jurisdiction in question and to permit Covered Banking Organizations subject to that jurisdiction’s Anticipated Regulations to comply with the new requirements by having their counterparties adhere.
It seems likely—particularly given the potential for differences, in both substance and timing, among Anticipated Regulations in various FSB jurisdictions—that the JMP will be open to adherence on a jurisdiction-by-jurisdiction basis. In other words, it will likely have mechanisms that permit adherents to choose those jurisdictional “modules” of the JMP to which they agree to be bound, rather than adhering universally across all FSB jurisdictions (in the manner of the Original Protocol and the 2015 Protocol).24
Adherents: Which Parties Will the JMP Affect? 2015 Protocol Adherents are also expected to be Covered Banking Organizations and thus to adhere to the JMP. One way to think about 2015 Protocol Adherents becoming subject to both the 2015 Protocol and the JMP is that the 2015 Protocol may not address, in one or more (or perhaps all) relevant FSB jurisdictions the specific requirements under Anticipated Regulations. This is because the primary purpose of the 2015 Protocol was to extend the Original Protocol to SFTs, not to operate as a means of satisfying future regulatory requirements. Moreover, the 2015 Protocol was finalized at a time when only one FSB jurisdiction had finalized its Anticipated Regulations—the German Regulations were final when ISDA published the 2015 Protocol, but the UK Regulations were published in final form only a day later—and thus it is simply not possible to know whether the 2015 Protocol’s terms will serve to meet requirements yet to be determined.
In contrast, non-Covered Banking Organizations—i.e., market participants that will not be directly subject to Anticipated Regulations—are generally expected to adhere to the JMP (and not the 2015 Protocol).25 Note, however, that adherence to the 2015 Protocol is not restricted to 2015 Protocol Adherents—i.e., its express terms do not limit its operation to banking organizations that adhere at the behest of their respective banking regulators.26 Thus, it is at least feasible for a 2015 Protocol Adherent to request non-bank counterparties to adhere to the 2015 Protocol pending availability of the JMP. Whether such requests are made and, if made, to which counterparties they are directed, will depend on a number of jurisdiction-specific factors.27 Any such requests would not, however, alter the guiding principle that the 2015 Protocol is not intended for buy-side adherence.28
Transaction Coverage: Which Agreements Will Be Subject to the JMP? The JMP is generally expected to cover a range of agreements that is similar to Covered Agreements under the 2015 Protocol. This is underscored by the ISDA statement quoted above regarding the JMP "achieving an outcome substantially similar" to Section 1 of 2015 Protocol Attachment. However, the German Regulations and UK Regulations, given the agreements they respectively target, demonstrate that the coverage of Anticipated Regulations will vary from the 2015 Protocol and, moreover, may vary to different degrees from jurisdiction to jurisdiction.29 Thus, although it may be possible for the JMP to list SFT master agreements in a manner similar to the SFT Annex, any such list is likely to be inadequate. Each jurisdiction-specific set of terms under the JMP will likely need to cross-reference, in one fashion or another, the respective jurisdiction’s Anticipated Regulations for purposes of defining the agreements covered.
If the JMP follows the pattern set by Original Protocol and the 2015 Protocol, it will amend only agreements that are in effect on or prior to the respective adherence date between two adherents.30 New agreements between adherents, by contrast, would need to include, from the outset, terms required by applicable Anticipated Regulations, rather than being subject to amendment or modification via protocol (though such required terms may operate via incorporation by reference from the JMP to the new agreement).31
One distinction between the JMP and the 2015 Protocol is worth keeping in mind as consideration is given to the range of agreements that the JMP eventually covers: The 2015 Protocol responds (as the Original Protocol responded before it) to expectations of national banking regulators in the exercise of various supervisory powers in respect of the G-18 and other 2015 Protocol Adherents—i.e., the exercise of supervisory authority in the absence of express authority under what we have termed "Anticipated Regulations." For example, in the United States, the Federal Reserve and FDIC indicated during the summer of 2014 that they would not accept the "living will" submissions of large U.S. bank holding companies (under Title 1 of Dodd-Frank) unless those organizations amended "on an industry-wide and firm-specific basis, financial contracts to provide for a stay of certain early termination rights of external counterparties triggered by insolvency proceedings."32 Adherence to the Original Protocol by G-18 organizations in the United States was the result; adherence to the 2015 Protocol by such organizations is a direct offshoot.33
By contrast, the JMP will likely respond to express requirements under newly adopted national regulations or legislation—i.e., the Anticipated Regulations, such as the UK Regulations and the German Regulations. Thus each jurisdictional module of the JMP is expected principally to respond to the direct regulations, rather than (as in the case of the Original Protocol and the 2015 Protocol) to more general supervisory demands of regulators. That said, the transaction coverage of a given jurisdictional module—which transactions and agreements it amends—may be broader than is strictly required under their respective jurisdiction’s Anticipated Regulations. In other words, nothing prevents the JMP, in response to expectations of bank regulators in connection with their exercise of supervisory authority,34 from effecting contractual amendments that exceed the amendments expressly required of Covered Banking Organizations under respective Anticipated Regulations. If the terms of the JMP in fact exceed express regulatory requirements, then when a Covered Banking Organization requests a counterparty to adhere to it, the counterparty’s response may be driven by a number of factors, including whether the Covered Banking Organization is willing to engage in the first instance in discussions regarding alternative means of amending trading agreements.
Substance: How Will Agreements Be Affected by the JMP? As discussed above, the JMP is expected to serve principally as a means for banking organizations to comply with requirements imposed under Anticipated Regulations. In turn, Anticipated Regulations are expected to limit the ability of banking organizations to transact with counterparties that do not contractually agree to limitations that, in substance, are akin to limitations effected by the 2015 Protocol among 2015 Protocol Adherents. However, not only are the requirements of Anticipated Regulations yet to be seen (other than in Germany and the United Kingdom), but the responding terms of the JMP are yet to come. How each jurisdictional module of the JPM operates vis-à-vis the Anticipated Regulations for that module’s respective jurisdiction will need to be carefully considered. This will be of particular interest in the United States, inasmuch as Anticipated Regulations in the United States are expected not only to address cross-border matters (in the manner of Section 1 of the 2015 Protocol Attachment), but also to introduce certain U.S.-centric insolvency limitations (in the manner of Section 2 of the 2015 Protocol Attachment).
Timing: When Will the JMP Be Published? While the 2015 Protocol has been finalized and will be effective January 1, 2016 (among 2015 Protocol Adherents), the JMP is to follow at a later date. ISDA will be able to finalize each jurisdictional module only after the Anticipated Regulations for the jurisdiction in question are finalized. Although there remain significant questions regarding the precise timing of respective national regulations, it seems likely that they will be effective in a number of FSB jurisdictions, and that the JMP and related jurisdictional modules will be ready for adherence, during 2016.35
Bank of America
Bank of Tokyo-Mitsubishi
Royal Bank of Scotland