No Stay of Termination Without Legislation: Investors Oppose Proposed ISDA Stay Protocol Regarding Derivatives Contracts

[1]In late 2014, at the request of and in coordination with the global Financial Stability Board (FSB),[2] the International Swaps and Derivatives Association (ISDA) developed the ISDA Resolution Stay Protocol, which “will impose a stay on cross-default and early-termination rights within standard ISDA derivatives contracts between G-18 firms in the event one of them is subject to resolution action in its jurisdiction. The stay is intended to give regulators time to facilitate an orderly resolution of a troubled bank.”[3] The Stay Protocol was officially published by ISDA on Nov. 4, 2014, and 18 global banks[4] have agreed to adhere to the Stay Protocol, § 1 of which went into effect on Jan. 1, 2015.

Section 2 of the Stay Protocol, which will not go into effect until appropriate regulations are promulgated, has caused an uproar in the investment community because § 2 requires counterparties to derivatives contracts to stay their right to immediately terminate a derivatives contract in the event that an affiliate of the other party to the contract commences a U.S. bankruptcy proceeding. As discussed below, the Stay Protocol in effect unofficially amends the U.S. Bankruptcy Code to add an “exception to a codified exception to the automatic stay.” This article discusses the automatic stay exceptions afforded certain financial market participants, the ISDA’s new Stay Protocol and current investor opposition to the Stay Protocol.

Automatic Stay Exception for Derivatives and Other Qualified Financial Contracts

The filing of a bankruptcy petition triggers an automatic stay on, among other acts, acts by creditors’ to enforce their rights under pre-petition agreements.[5] The purpose of the automatic stay is to maintain the status quo and provide the bankrupt debtor with enough time and opportunity to formulate a reorganization or liquidation plan.

Congress has specifically provided that the automatic stay is inapplicable to certain creditor acts. Non-defaulting counterparties to qualified financial contracts such as swap agreements, repurchase agreements, commodities contracts, and futures contracts are not stayed from exercising their rights to terminate, liquidate or accelerate the agreements during the pendency of a debtor’s bankruptcy.[6] Further, these counterparties are not stayed from offsetting or netting out any termination value, payment amount or other transfer obligation.[7] Section 2 of the Stay Protocol requires counterparties to derivatives contracts to waive their early termination rights.

Section 2 of the Stay Protocol

An ISDA master agreement generally allows a non-defaulting party to the agreement to, among other things, terminate a derivatives transaction, net or set off amounts owed and exercise rights against collateral, in the event of the insolvency (default) of the counterparty to the agreement (and, in some instances, the insolvency of the affiliate or guarantor of the counterparty). Section 2 of the Stay Protocol, which does not go into effect until regulators promulgate regulations regarding the Stay Protocol, limits non-defaulting parties’ cross-default rights in the event of the bankruptcy or insolvency of an affiliate of a counterparty that is a systemically important financial institution (SIFI).[8]

In the event that an affiliate of a SIFI files for bankruptcy protection, non-defaulting counterparties to derivatives contracts are required to wait 48 hours before exercising termination and other close-out rights. [9] The 48-hour automatic stay stay is intended to prevent a “run on the bank” and reduce systemic risk.[10] ISDA touts the new Stay Protocol as necessary to “facilitate an orderly resolution of a troubled bank”:

The [Stay Protocol’s] aim is to ensure [that] cross-border derivatives trades are captured by statutory stays on cross-default and early termination rights in the event a bank counterparty enters into resolution. These stays are intended to give regulators time to facilitate an orderly resolution of a troubled bank.

The Protocol also incorporates certain restrictions on creditor contractual rights that would apply when a U.S. financial holding company becomes subject to U.S. bankruptcy proceedings. This includes a stay on cross-default rights that would restrict the counterparty of a non-bankrupt affiliate of an insolvent U.S. financial holding company from immediately terminating its derivatives contracts with that affiliate. A non-defaulting party’s right to terminate derivatives trades with a direct counterparty that is under insolvency proceedings is unaffected by the Protocol.[11]

However, the problem with the Stay Protocol is that it, in effect, amends the U.S. Bankruptcy Code without proper legislation by Congress.

Buy-Side Market Participants Oppose Proposed Stay Protocol

Although 18 major global banks have agreed to adhere to the Stay Protocol, buy-side market participants oppose the Stay Protocol given that it strips them of their rights under the Bankruptcy Code to immediately terminate a derivatives contract and reclaim assets in the event of bankruptcy. On Nov. 4, 2014, six asset-management-related associations (including the Managed Funds Association, Alternative Investment Management Association Limited and the American Council of Life Insurers) wrote a letter to the FSB opposing the Stay Protocol.[12] It is expected that by the end of 2015, the FSB will promulgate regulations related to the Stay Protocol.[13] The new regulations will essentially compel participants in the global derivatives market to agree to adhere to the Stay Protocol[14] because the expected “regulations [will] require, at least, G-SIFIs [(globally SIFIs)] and certain of their related entities to cease trading with any counterparty unless such counterparty has agreed to the suspension of their early termination rights during a resolution action in an FSB member jurisdiction or a U.S. insolvency proceeding.”[15]

Hedge fund managers and other asset managers owe fiduciary duties to their investors. It is the associations’ position that if the asset managers voluntarily waive their rights to immediately terminate derivatives contracts and reclaim investors’ assets, they would be in violation of their fiduciary obligations to investors:

[Our] members have fiduciary duties to their investors. Therefore, [they] have an affirmative duty to act in good faith and in the best interests of their investors. Because early termination rights ultimately can protect investors, our members’ fiduciary duties prevent them from voluntarily waiving these rights. Specifically, early termination rights protect a counterparty and its investors by ensuring that, when the counterparty transacts with a financial institution (e.g., a G-SIFI) or its related entities (such financial institutions and related entities, together “Applicable Entities”), in the event of the Applicable Entity’s default, the counterparty may be able to mitigate its exposure by recovering their investors’ assets.[16]

These associations oppose any unofficial and official amendment to their termination rights under the Bankruptcy Code. However, they argue that to the extent that the FSB wants to move forward with a stay of their early termination rights, the FSB should petition Congress to formally amend the Bankruptcy Code to allow for such a stay.

Conclusion

Given buy-side participants such as hedge fund managers are opposing the new Stay Protocol that would strip the participants of the rights afforded to them by Congress under the Bankruptcy Code, it is uncertain whether the Stay Protocol will go into effect in the U.S. Bankruptcy and insolvency practitioners that advise hedge funds and other asset-management firms should continue to monitor actions by the FSB and U.S. regulators to see if regulators will move forward with promulgating regulations implementing the Stay Protocol.