16 Aug 2011

Close-out netting contracts: Government consults on proposed reforms

by Louise McCoach

Currently it’s unclear when a party can exercise a contractual right to close out a netting contract with an ADI in statutory management.

Close-out netting provisions are a common feature of derivatives documentation. They are typically relied upon by parties to reduce their credit risk to each other under their derivatives exposures. The more legal certainty there is over the enforceability of close-out netting provisions in any particular jurisdiction, the more confidence potential counterparties will have in their ability to manage their credit risk under derivatives exposures with entities based in that jurisdiction.

There has traditionally been a relatively robust view on the enforceability of close-out netting provisions under Australian law. Since the enactment of the Payment Systems and Netting Act 1998 (PSN Act), this view has been even more robust where those provisions form part of a "close-out netting contract" for the purposes of the PSN Act. The standard ISDA Master Agreements published by the International Swaps and Derivatives Association are a good example of derivatives documentation that would ordinarily qualify as a "close-out netting contract" for the purposes of the PSN Act.

Following amendments to the Banking Act 1959 in 2008, there has been some uncertainty in relation to the enforceability of close-out provisions that form part of a close-out netting contract with an authorised deposit-taking institution (ADI). Treasury has acknowledged that this uncertainty has the potential to "impede the efficiency of the financial markets in Australia and to create difficulties for ADIs and other Australian entities entering into currency and interest rate contracts" and that "these difficulties could be heightened if market confidence was fragile".

As a result of equivalent amendments made to the Insurance Act 1973 and the Life Insurance Act 1995, similar uncertainties exist for counterparties to close-out netting contracts with an insurer.

Treasury has released a discussion paper and exposure draft of the Financial Sector Legislation Amendment (Close-out Netting Contracts) Bill 2011 in an attempt to deal with this uncertainty.

Why is there uncertainty?

The recent uncertainty affecting ADI counterparties stems from an inconsistency between the Banking Act and the PSN Act, which arose as a result of an amendment to section 15C of the Banking Act as part of a package of amendments made by the Financial System Legislation Amendment (Financial Claims Scheme and Other Measures) Act 2008 (Cth) (FSLA Act) to facilitate the introduction of a Financial Claims Scheme in Australia.

The amendments relate to APRA's power to appoint a statutory manager to an ADI under section 13A of the Banking Act. If APRA were to exercise its power under section 13A, this is likely to trigger an event of default under an ISDA Master Agreement or other close-out netting contract, allowing the non-defaulting party to terminate the hedging arrangements governed by the contract. This could be problematic for a statutory manager, especially given that statutory management is intended to be a flexible mechanism for crisis resolution.

To ensure that statutory managers have sufficient flexibility and time to implement a resolution without automatically triggering an event of default, the FSLA Act amended section 15C to provide that the assumption of control by a statutory manager does not, in itself, give a counterparty grounds to accelerate debt or close out a contract with an ADI.

The amended section 15C is potentially inconsistent with section 14(2) of the PSN Act, which gives statutory recognition to the enforceability of close-out netting contracts notwithstanding the appointment of an external administrator to a party to that contract. Although, the PSN Act is expressed to prevail despite any other law, it is unclear whether section 14(2) of the PSN Act necessarily overrides the inconsistent provisions in section 15C, especially as they were enacted after the PSN Act came into force.

In the absence of clearer evidence of Parliament's intentions, the tension between the PSN Act and the Banking Act has created uncertainty in relation to the rights of counterparties to close-out netting contracts with ADIs.

There are similar issues caused by the recent amendments to the Insurance Act and the Life Insurance Act, with equivalent implications for counterparties to close-out netting contracts with insurers.

What is Treasury’s proposed solution?

Treasury’s discussion paper seeks to propose a solution which strikes an appropriate balance between achieving legal certainty, on the one hand, and maintaining the existing protection for depositors and insurance policy holders, on the other hand.

To this end, the solution adopts a staged approach to the enforcement of a party’s rights under a close-out netting contract with an ADI, with the aim of creating a short window of time within which a stay-of-action prevents close-out from occurring and enables the authorities to determine whether to provide continuity to the contracts or to allow them to be terminated:

  • initially, section 15C will apply to prevent a counterparty from exercising its close-out rights merely upon the appointment of a statutory manager. This prohibition will apply for a defined period (the current proposal is for 48 hours after the statutory manager takes control), unless the statutory manager gives notice within that period that the ADI will not meet its liabilities under the contract. Once that notice is given, the counterparty will be able to exercise its close-out netting rights in accordance with contractual terms;
  • after the defined period, section 15C will cease to apply and the counterparty will be able to exercise its contractual close-out netting rights unless the statutory manager gives notice that liabilities under the contract will continue to be met as and when they become due and payable (in which case section 15C will continue to apply).

An equivalent solution has been proposed for close-out netting contracts with insurers.

Industry concerns with Treasury’s proposed solution

While the legislative inconsistency is a well-known problem, the proposed solution has raised some concerns within the derivatives industry.

In particular, the stay on close-out netting rights for a defined period could expose the counterparty to a risk of being overhedged if it chooses to replace hedges during the defined period (before it can close-out the hedges with the ADI or insurer) in circumstances where the statutory manager or judicial manager subsequently determines that the hedges should continue after the defined period. Even if this determination is not made, the counterparty still runs the risk of paying more to re-hedge than the price of close-out after the defined period.

The defined period also exposes the counterparty to a risk that any payments made by the ADI or insurer to the counterparty during the defined period are subsequently held to be voidable preferences and clawed back. As a result, the counterparty could lose both its ability to protect its position by exercising its right to close-out as well as the payments it has received after the appointment of the statutory or judicial manager.

Although the current proposal is for the defined period to run for 48 hours, Treasury has sought feedback on whether this period should be extended. The industry's response so far has been to recommend that the defined period be kept as short as possible to avoid exacerbating the potential problems referred to above.

The submissions on the exposure draft have noted a number of other shortcomings with the proposed solution, including a lack of clarity over its application to derivatives involving the delivery of property (as opposed to the payment of money). It also fails to address a similar inconsistency that applies to market netting contracts and approved netting arrangements.

Whether the solution strikes an appropriate balance between the potentially competing objectives of legal certainty and depositor/policy holder protection, remains to be seen. If the balance is not struck correctly, there is a possibility that the uncertainty which the solution is seeking to address will be outweighed by other problems that the solution creates. In particular, the stay on close-out rights for a defined period may result in counterparties perceiving Australian ADIs and insurers as a riskier proposition, leading to higher regulatory capital charges for their related exposures and corresponding pricing adjustments.

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Clayton Utz communications are intended to provide commentary and general information. They should not be relied upon as legal advice. Formal legal advice should be sought in particular transactions or on matters of interest arising from this communication. Persons listed may not be admitted in all States and Territories.