The Budget Implementation Act, 2009 (Canada) S.C. 2009, c.2, passed on March 12, 2009, introduced amendments to the financial institution restructuring provisions of the Canada Deposit Insurance Corporation Act (CDIC Act) that will modify the stay exemption for close-out netting and collateral enforcement rights under eligible financial contracts (EFCs) with CDIC member institutions. These provisions are not yet in force and will come into effect by Order-in-Council.
Current close-out protections for EFCs in CDIC Act proceedings
A Canadian bank that is in financial difficulty could be subject to one of two types of order made under section 39.13(1) of the CDIC Act by the federal Cabinet on the recommendation of the Superintendent of Financial Institutions. These are (1) an order vesting the shares of the institution in CDIC and (2) an order appointing CDIC as receiver of the institution. These orders have different effects, but in both cases there is an automatic stay on termination or accelerating payments under contracts by reason only of (i) the federal member institution's insolvency, (ii) a default, before the order was made, by the federal member institution in the performance of its obligations under the agreement, or (iii) the making of the order. With respect to EFCs, however, there is the exemption to allow a counterparty to terminate, net and deal with financial collateral (the EFC exemption).
The amendments will limit the ability to rely on the EFC exemption if a "bridge institution" is to be incorporated and the EFCs are to be assigned to the bridge institution. A bridge institution (described in more detail below) is a financial institution that could be established, when CDIC is appointed receiver of an institution, to take over some or all of the assets and liabilities of the member institution for a temporary period, presumably to facilitate a sale of the institution.
The CDIC Act will permit EFCs to be assigned to a bridge institution. If an order directing the incorporation of a bridge institution is made, then the counterparty cannot close-out an EFC if CDIC either (1) undertakes to guarantee unconditionally the payment of any amount due or that may become due in accordance with the provisions of the EFC by the member institution or (2) undertakes to ensure that all obligations arising from the EFC will be assumed by the bridge institution. The proposed language of this limitation on the EFC exemption is as follows:
(7.1) If an order directing the incorporation of a bridge institution is made, the actions referred to in subsection (7) may not be taken by reason only that the order or an order appointing the Corporation as receiver is made in respect of the federal member institution or that the eligible financial contract is assigned to the bridge institution if the Corporation undertakes to
(a) unconditionally guarantee the payment of any amount due or that may become due - in accordance with the provisions of the eligible financial contract - by the federal member institution; or
(b) ensure that all obligations arising from the eligible financial contract will be assumed by the bridge institution.
Unless and until a bridge institution is incorporated and CDIC makes one of those two undertakings, a party to an EFC is free to rely on the EFC exemption.
It is highly likely that a bridge institution incorporation direction and receivership order will occur at the same time so parties will likely know immediately if the EFC exemption can be relied on or not. Note also that this provision prevents reliance on the EFC exemption only if the EFC is terminated or accelerated by reason only of the making of the order to incorporate the bridge institution, the appointment of CDIC as receiver or the assignment of the EFC to the bridge institution, and not if the contractual trigger is the institution's "insolvency" or a pre-proceeding default by the institution.
The amendments do not include a provision similar to that in the similar U.S. law to the effect that either all transactions with the counterparty or none of them must be assigned. Given that the term "eligible financial contract" is defined in the regulations to include individual transactions as well as any master agreements, a literal reading of subsection (7.1) could suggest that CDIC has the power to assign individual transactions under a master agreement, which in turn raises the spectre of cherry-picking.
However, given that the purpose of the bridge institution provisions is to enhance the financial stability of institutions, this cannot be the intention of the provision. CDIC has confirmed to ISDA that it interprets the provision as applying to the master agreement and the underlying transactions as a single contract.
Recognizing that there is an ambiguity in the language, there is a chance that amendments to the Act will be proposed before the provisions come into effect to clarify that assignment of individual transactions is not permitted.
Implications of assignment to a bridge institution
If CDIC is appointed as receiver of the institution, the Cabinet, on the Finance Minister's recommendation, can also direct the Minister to incorporate an institution designated in the order as a bridge institution. This would be a bank if the insolvent institution was a bank, a trust company if the insolvent institution was a trust company, etc. CDIC as receiver can transfer assets and liabilities of the institution to the bridge institution for such consideration as it determines. CDIC can be selective in determining what assets and liabilities are transferred. The protection that the creditors of the member institution have (if the obligations owed to them are not assumed by the bridge institution) is that the Act requires the consideration set by CDIC for the transferred assets to be "reasonable in the circumstances".
If the EFCs are assigned to the bridge institution, then the parties to those contracts should consider the following. The bridge institution will not be an agent of CDIC or the federal Crown even though all the shares are owned by CDIC and it must act on the direction of CDIC. The bridge institution is intended to be a temporary entity. Its designation as a bridge institution is for two years (subject to possible renewal to a maximum of five years in total). CDIC is required, however, to provide the "financial assistance that a bridge institution needs in order to discharge its obligations . as they become due". Consequently, if CDIC undertakes to have the bridge institution assume the obligations under transferred EFCs (and does not directly guarantee them), there is this assurance that the obligations will be satisfied while the bridge institution exists.