The Banking Bill is still passing through Parliament and is currently in the committee stage in the House of Commons. Clause 43, which gives the Treasury the power to protect security interests and set-off and netting arrangements in a partial property transfer, was considered in the public bill committee on 12 November, and no amendments were tabled. Firms and companies need to consider the draft order to understand how the Bill might affect their set-off, netting and security arrangements with UK banks, and the resulting impact on their capital and reporting requirements.

On 6 November 2008, HM Treasury published for consultation "Special Resolution Regime: Safeguards For Partial Property Transfers". The consultation includes:

  • a draft Safeguards Order which seeks to safeguard the rights of creditors of a bank subject to a partial property transfer; 
  • draft No Creditor Worse Off Regulations which aim to ensure no creditor of a residual bank is in a worse position following a partial property transfer than that creditor would have been in had the whole bank been wound up; and 
  • a draft Code of Practice to provide guidance on how the tripartite authorities will use the special resolution regime powers in the Banking Act.

This article focuses on the proposed Safeguards Order.

How does the current proposal differ from previous proposals to protect set-off and netting?

The draft Safeguard Order now presented for responses by 9 January 2009 is a big improvement on previous proposals to protect set-off and netting. The qualified financial contract proposal In its July 2008 consultation paper "Financial stability and depositor protection: Special resolution regime", HM Treasury, drawing on US experience, proposed to protect certain qualifying financial contracts from cherry picking in a partial property transfer. However, this approach has some drawbacks:

  • defining "qualifying financial contracts" would have been hard; and 
  • existing set-off and netting arrangements including non-QFC contracts currently being accounted for on a net basis would have been undermined.

The industry master netting agreement proposal Another approach considered by HM Treasury, which it intends not to take forward, is to protect set-off and netting under widely recognised industry master netting agreements but not contracts written under any other custom-made netting agreements. Stakeholders identified that this approach, too, is fraught with difficulties of definition.

  • Drawing the line between industry standard and bespoke agreements would have been challenging. There any many netting agreements currently in place between counterparties that are slightly different from the industry standard documents. Parties would have had to consider whether those agreements qualify for the protection. 
  • Many master agreements, such as ISDA's 2002 Standard Agreement, include set-off clauses that allow parties to set off against the net amount calculated and payable on close-out, liabilities under other agreements. So set-off rights included in master agreements such as ISDA would have been protected, but the same set-off clause in a nonindustry standard document would not have been protected. This goes against the general English law principle of preferring substance over form.

Consequences of the previous proposals Both the qualified financial contract and industry master netting agreements approaches would have been an enormous departure from the current law. To say that netting works, English lawyers have always been able to rely on insolvency set-off, covering the full range of dealings between mutual parties, rather than a bespoke netting law, as in so many other jurisdictions.

Unchanged, those approaches would have also presented difficulties for exchange traded contracts. The Government would have had to make clear that contracts traded on, or cleared by, recognised investment exchanges and clearing houses, protected under the Companies Act 1989, could not be cherry picked in a partial property bank transfer. The same goes for contracts protected under the Settlement Finality Directive.

Without clear protection from cherry picking for netting and set-off rights, exposures which may currently be accounted for on a net basis for regulatory capital and reporting purposes would have to be dealt with on a gross basis. This would have potentially made it more expensive to deal with UK banks.

The new proposal

HM Treasury has taken on board these points. It has helpfully adopted blanket protection for all set-off and netting arrangements subject to certain carve-outs:

  • contracts governed by foreign law; 
  • debt securities issued by the failed bank, such as bonds, medium-term notes and commercial paper; 
  • claims crucial to the preservation of banking continuity, such as retail deposits, mortgages; and other loans and liabilities other than financial contracts in the ordinary course of business, such as trade debts and litigation claims; and 
  • an ability to transfer only claims on a bank, but not only liabilities. The idea is that this would benefit counterparties who would be able to enforce that claim against the solvent new bank without waiting for recovery in the remaining bank.

Unfortunately, however, the draft Safeguard Order is not consistent with the consultation paper. For example, excluded rights includes rights relating to all deposits within the meaning of Article 5 of the Regulated Activities Order. These deposits do not just include retail deposits as contemplated in the consultation. Deposits placed with the bank by any company which is not itself a bank, or a company in the bank's group, are also excluded from the safeguard.

If kept in this form, the effect of the Safeguard Order would be that:

  • UK banks could not take into account deposits made by corporate customers in working out a net exposure to those customers for regulatory capital purposes; and 
  • Companies may not, under relevant accounting rules, be able to include the deposit in a net amount for the purposes of their balance sheets.

When considering the impact of these provisions, parties should carefully distinguish netting and set-off. For example, the carve-out for foreign law contracts applies to rights and liabilities which are foreign property. This carve-out should not catch individual "theoretical debts" (as they are referred to in the Banking Bill) under an English law governed close-out netting arrangement. It will of course catch a foreign law governed master agreement.

Proposed protection for collateral

The proposed protection for collateral remains much stronger than the proposed protection for set-off and netting. Liabilities will only be transferred to a new bank with the related collateral.

But the new draft clarifies that title transfer security is not included. Those arrangements should be covered by the set-off and netting protections.

Proposed protection for structured finance arrangements

The consultation paper does not include drafting to protect structured finance arrangements, and HM Treasury has asked for comments as to what should be included.

Remedy

The draft Safeguards Order includes a right for creditors to notify the Bank of England if they believe a partial property transfer order breaches the safeguards. The current proposal is that the Bank has to respond to such a notice within 30 days, but that seems long in the context of volatile markets.