Background

Earlier this month, Mark Carney, the Governor of the Bank of England together with Dr. Elke König, the President of BaFin, Martin Gruenberg, the Chairman of the US FDIC and Patrick Raaflaub, the CEO of the Swiss Financial Market Supervisory Authority wrote a letter to the International Swaps and Derivatives Association (ISDA) voicing their collective concerns that (notwithstanding numerous regulatory changes) there is still the need to manage systemic risk in the investment banking system.

Although the letter is short in length, its message is strong and has the derivative industry paying close attention. The letter focused on:

risk of disorderly termination of derivative contacts, particularly in a cross-border resolution context, arising out of the exercise of termination rights following the commencement of an insolvency or resolution action”.

The letter concluded that:

“we believe that it is essential for standard ISDA documentation to provide for a short-term suspension of early termination rights and other remedies on the basis of commencement of any insolvency or resolution proceeding or exercise of resolution power...”.

The rationale for the suggestion that a short-term suspension be included in standard ISDA documentation is to allow derivative contracts to remain in effect while an appropriate solution to the insolvency of the counterparty is found, which could include transfer of the derivative contact (and associated guarantee obligations) to a third party on an expedited basis or the bail-out of the failing counterparty through, for example, the write-down of liabilities or the conversion of liabilities into equity.

What does this mean?

Generally, ISDA documentation gives the non-defaulting party the option to (i) close-out open transactions immediately, (ii) wait or (iii) suspend payments when the defaulting party is insolvent (see Section 2(a)(iii) and Lomas and others v JFB Firth Rixson Inc and others [2012] EWCA Civ 419 (3 April 2012)).

If the suspension period suggested in the letter were to be incorporated into the ISDA documentation, one of the issues that could arise would be that any positions which are “open” at the time the defaulting party became insolvent would be exposed to market movements and the non-defaulting party would not be able to crystallise its exposure at the time of insolvency, potentially being faced with a different risk situation once it is actually able to terminate some time later. This effectively means that the non-defaulting party could lose its own fundamental freedom and rights all of which could have a variety of legal and commercial consequences for both the defaulting and the non-defaulting party.

What next?

As there is no specific or concrete detail in the letter as to how the short-term suspension should be implemented and in what form (for example, there is no recommendation as to how long the delay or suspension of early termination rights should be or what other remedies should be suspended), there will be an extensive consultation period, debate and dialogue between supervisors and regulators around the world in order to achieve an appropriate solution that will contribute to efficient markets and address the concerns set out in the letter. We suspect that this is just the beginning.