On May 3, 2016, the Board of Governors of the Federal Reserve System (the “Board”) approved a proposal (the “Proposal”) that, if adopted, would impose restrictions on the terms of certain common financial contracts of systemically important banks in order to prevent the immediate termination of the contracts if a covered banking entity enters bankruptcy or a resolution process. 81 Fed. Reg. 29169 (May 11, 2016). Among other things, the Proposal would significantly limit default rights of buy-side counterparties to over-the-counter swaps, repurchase and reverse repurchase agreements, securities lending and borrowing transactions, commodity contracts, and forward agreements with covered banking entities. The Proposal is subject to public comment until August 5, 2016.


The Proposal is part of a continuing effort by regulators in the aftermath of the financial crisis to facilitate the orderly resolution—for instance, through bankruptcy or the special resolution process created by the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”)—of distressed major financial institutions and to mitigate potential systemic risks to the financial markets and the economy as a whole. Specifically, the Board noted the Proposal is intended to prevent the destabilizing effects caused by the mass, rapid termination of the various financial contracts, including derivatives, used by large, interconnected systemically important banks.

The Proposal is intended to address the Board’s concerns in two broad ways. First, the Proposal seeks to minimize the potential that courts in foreign jurisdictions would disregard U.S. statutory provisions that stay the rights of counterparties to terminate their contracts when a failed financial firm enters a resolution proceeding under one of the special resolution regimes, such as the Federal Deposit Insurance Act (the “FDIA”) and the Dodd-Frank Act. Second, the Proposal seeks to prevent counterparties of solvent affiliates of a failed entity from terminating their contracts with the solvent affiliate based solely on the failed entity’s resolution. Notably, however, this aspect of the Proposal would eliminate certain common default rights, which buy-side counterparties have traditionally been permitted to exercise outside of the restrictions of the bankruptcy process.

The Proposal

Under the Proposal, any U.S. top-tier bank holding company identified by the Board as a global systemically important banking institution (“GSIB”), any subsidiary of a U.S. GSIB (other than national banks and federal savings associations),1 and the U.S. operations of any foreign GSIB (other than national banks and federal savings associations) (collectively, “covered entities”)2 would be subject to two primary sets of restrictions regarding the terms of their non-cleared “qualified financial contracts” (“QFCs”).3 For this purpose, the term QFC has the same meaning as in section 210(c)(8)(D) of Title II of the Dodd-Frank Act, which includes swaps, repurchase and reverse repurchase transactions, securities lending and borrowing transactions, commodity contracts, and forward agreements. The Proposal would apply to any “covered QFC,” generally defined as any QFC that a covered entity enters into, executes, or otherwise becomes party to.

First, a covered entity would be required to ensure that QFCs to which it is party, including QFCs entered into outside the U.S., explicitly provide that any default rights and restrictions on the transfer of the QFCs are limited to the same extent as they would be under the Dodd-Frank Act and the FDIA, if the QFCs were governed by U.S. law. These special resolution regimes generally impose a temporary stay on the exercise of default rights tied to a firm’s entry into resolution so that the firm’s QFCs may be transferred to another, solvent financial entity.           If a firm’s QFCs are successfully transferred, non-defaulting counterparties may no longer exercise default rights in respect of the firm’s entry into resolution.4 By requiring covered entities to adhere specifically to the special resolution regimes in their QFCs, the Board seeks to ensure that these stay and transfer provisions are enforced in foreign jurisdictions.

Second, a covered entity generally would be prohibited from entering into QFCs that would allow the exercise of cross-default rights—meaning default rights related, directly or indirectly, to the entry into resolution of an affiliate of the direct party—against it. Covered entities would also be prohibited from entering into QFCs that would restrict the transfer of a “credit enhancement” supporting the QFC (such as a guarantee) from the covered entity’s affiliate to a transferee upon the entry into resolution of the affiliate. However, the Proposal includes several exceptions intended, among other things, to clarify that the prohibitions would apply only to cross-default rights (and not direct default rights against a direct party to a QFC), and to allow counterparties to continue to exercise cross-default rights in scenarios outside of an orderly resolution of a GSIB.

For purposes of the Proposal’s restrictions, default rights are broadly defined to include such common rights as setoff, liquidation of collateral, suspension of performance by a non-defaulting party, acceleration of a defaulting party’s obligations, alteration of a defaulting party’s collateral or margin obligations, and termination. Covered default rights would not include such day-to-day functional provisions as same-day payment netting and contractual margin requirements that arise solely from a change in value of collateral or the amount of an economic exposure.

Finally, in case of a legal dispute as to a party’s right to exercise a default right under a QFC with a covered entity, the Proposal would require a QFC to provide that, after an affiliate of the direct party has entered a resolution proceeding: (a) the party seeking to exercise the default right bears the burden of proof that the right is indeed permitted by the QFC and (b) the party seeking to exercise the default right must meet a “clear and convincing evidence” standard, a similar standard, or a more demanding standard.

Alternative Compliance and Conforming Changes

The Proposal provides that a covered entity could comply with the proposed requirements to the extent its QFCs are amended by the current International Swaps and Derivatives Association (“ISDA”) 2015 Universal Resolution Stay Protocol (the “Protocol”). Notably, as the Board highlights in the Proposal, the Protocol is actually somewhat narrower in certain of its provisions (including the scope of its stay and transfer provisions) than the Proposal. The Board also notes that a jurisdictional module for the U.S. that is substantively identical to the Protocol in all respects aside from exempting QFCs between adherents that are not covered entities or covered banks would be consistent with the proposed requirements.

The Proposal provides a mechanism for covered entities to request approval for QFCs containing additional creditor protections beyond those that would otherwise be permissible thereunder. A covered entity making such a request would have to provide an analysis of the relevant contractual terms in light of all facts and circumstances related to the proposal, including such factors as the potential impact of the requested creditor protections on GSIB resilience and resolvability, adoption on an industry-wide basis, coverage of existing and future transactions, coverage of one or multiple QFCs, coverage of some or all covered entities, and impact on creditor protections specific to supported parties. A covered entity would also need to submit a legal opinion stating that the requested terms would be valid and enforceable under the applicable law of the relevant jurisdictions, along with any additional relevant information requested by the Board. Once approved, enhanced creditor protections could be used by other covered entities.

Finally, the Proposal would amend several definitions, including the definition of “qualifying master netting agreement,” to maintain the existing treatment for these contracts under the Board’s regulatory net capital and liquidity rules.


The requirements of the Proposal would take effect on the first day of the first calendar quarter that begins at least one year after issuance of the final rule (the “Effective Date”). A covered entity would be required to ensure that its QFCs entered into on or after the Effective Date comply with the rule’s requirements.

However, a covered entity would not be required to conform a preexisting QFC if that covered entity and its affiliates do not enter into any new QFCs with the same counterparty or its affiliates on or after the effective date. If the same parties (or their affiliates) do enter into a new QFC, they would have to bring preexisting QFCs into compliance no later than the first date on or after the effective date they enter into the new QFC.

Potential Impact

The restrictions in the Proposal would generally prevent buy-side counterparties from exercising default rights in respect of an affiliate (including a parent entity or guarantor) of a covered entity counterparty entering resolution or bankruptcy proceedings. Contractual restrictions on the transfer of a guaranty or other credit enhancement provided by an affiliate upon entry into resolution would be similarly prohibited. Moreover, the stay and transfer provisions of the U.S. special resolution regimes would be more likely to be enforced for financial contracts entered outside the U.S. However, the possibility of alternative compliance with the Proposal through the Protocol suggests the Board is open to slightly less restrictive provisions when weighed against the possibility of broad-based industry compliance. Indeed, the extent of the impact of these rules when finalized will largely depend upon whether a buy-side counterparty decides to adhere to an industry-wide protocol or to amend its agreements on a bilateral basis to conform to the requirements.