On 31 August 2012, the Spanish Government approved the Royal Decree-Law 24/2012 on the restructuring and dissolution of credit entities (Real Decreto-Ley 24/2012, de 31 de Agosto, de reestructuración y resolución de entidades de crédito) (hereinafter, RDL 24/2012) by which the agreement reached in the Memorandum of Understanding on the Financial Sector Policy Conditionality (the MoU) entered into in July 2012 between the Kingdom of Spain and the Eurogroup was implemented.
Pursuant to RDL 24/2012 the Spanish government adopted the first set of legislative amendments for the restoring and strengthening of the Spanish banks. In particular, the main objectives of the RDL 24/2012 are the following:
- the identification of individual bank capital needs through a comprehensive asset quality review of the banking sector and a bank-by-bank stress test, based on that asset quality;
- recapitalization, restructuring and/or resolution of weak banks; - financial assistance provided by the FROB (Fund for Orderly Bank Restructuring) through different instruments; and
- reinforcement of the resolutions powers of the FROB.
The purpose of this brief newsletter is precisely to analyse certain provisions of RDL 24/2012 which under certain circumstances may affect the ordinary performance of derivative instruments based in the strengthening of resolution powers of the FROB.
Articles 65 and 68 of RDL 24/2012
Chapter V of Section II of RDL 24/2012 extends the faculties, powers and liabilities of the FROB in order to implement the reorganisation and resolutions measures and instruments contemplated in the RDL 24/2012. Due to such extension and reinforcement of faculties, and despite the nature of such faculties is yet to be determined, it may be stated that the FROB becomes a banking authority.
Article 65 of the RDL 24/2012 establishes that in relation to transactions subject to section 2º of Chapter II of Title I of Royal Decree Law 5/2005 of 11 March, on urgent reforms to encourage, among other, productivity and improve public procurement (“Real Decreto-Ley 5/2005 de 11 de Marzo, de reformas urgentes para el impulso a la productividad y para la mejora de la contratación pública” RDL 5/2005), the entering into any action of early termination or intervention in relation to a Spanish financial entity shall not imply as an event of default and shall not entitle any counterparty of the relevant transaction or agreement to terminate the relevant contract or take enforcement action or setoff of any rights or obligations related to such transactions or agreements, unless if finally the transaction or agreement is not transmitted to the purchaser or bridge bank.
Moreover, article 68 entitles the FROB, on the context of an early intervention, restructuring and/or resolution measure to suspend the right of the counterparties to early terminate and close out a contractual netting agreement or master agreement ("acuerdo de compensación contractual"). In particular, article 68.3 declares as follows:
“The FROB may, through an administrative act, suspend the right of counterparties to early terminate, close-out, request the enforcement or set-off a financial transaction and a master agreement pursuant to section 2º of Chapter II of Title I of Royal Decree Law 5/2005 of 11 March, as a consequence of entering into any action of early intervention, restructuring or orderly resolution, for a maximum period which runs from the date of the publication of the exercise of the suspension right until 17:00 of the next business day. If within that period, the assets and liabilities of the relevant financial transaction and/or master agreement have been transferred to a third party, the relevant counterparties may not exercise their termination, close-out, set-off or enforcement right if the assets and liabilities have been transferred in accordance with in the relevant resolution instrument. Not withstanding the above, the counterparties shall not be prevented from enforcing termination rights as a result of other events of default under the relevant transaction or master agreements, either arising before or after the implementation of the relevant measure”.
The first conclusion that may be drawn is that this particular provision overrides, at least to a certain extent, the existing protections to derivative transactions set out by RDL 5/2005.
Special regime for derivative transactions under RDL 5/2005
A derivatives transaction agreement allows a non-defaulting party to terminate all transactions upon its counterparty’s default and to calculate its gain or loss on a net basis. The principal legal issues with respect to enforceability of these rights and remedies arise under the governing law of the agreement 3 and the insolvency laws of the counterparty’s jurisdiction. The insolvency laws of counterparty’s jurisdiction may override the termination and close-out provisions even though they are generally enforceable under the governing law of the agreement. The Spanish insolvency legislation (Law 22/2003, of 9 July, of Insolvency or “Spanish Insolvency Act”), as opposed to other jurisdictions which tend to be friendlier to the creditor, enables the insolvency representative the right to continue executory contacts that are favourable to the debtor or to terminate those unfavourable to the debtor (action which is usually referred to as "cherry-picking"). Close out netting is a significant problem in jurisdictions which restricts the right to exercisecontractual terms of termination and which permit an insolvency representative to cherry-pick. This is why in these jurisdictions special laws for derivatives have been issued in order to provide certainty to the enforcement of a derivative transaction.
In Spain the special legal framework is established under RDL 5/2005, which implemented in Spain the EU Financial Collateral Directive 2002. The scope of RDL 5/2005 covers those financial transactions carried out under a master agreement. Article 5 of RDL 5/2005 defines a master agreement as such agreement that envisages the creation of one single legal obligation which covers all the financial transactions included in such agreement and by virtue of which, where there is an early termination, the parties will only have the right to claim the net amount resulting from the liquidation of such transactions. In particular, RDL 5/2005 recognises the following exceptions to the Spanish Insolvency Act in order to provide enforceability to the provisions of close-out under a master agreement.
- Recognition and enforcement of ipso facto clauses:
The Spanish Insolvency Act does not recognise the provisions which allow the parties to terminate or close out an agreement upon the insolvency declaration. However, article 16 of RDL 5/2005 provides that the termination rights of transactions under a master agreement will not be affected, restricted or limited by the declaration of insolvency of one of the parties. In particular, it establishes that:
“the declaration of an early termination, termination, enforcement of equivalent effect of financial transactions entered into in the context of a master netting agreement or in relation thereto may not be limited, restricted or affected in any way by the opening of an insolvency procedure or an administrative liquidation procedure”
Exception to the general insolvency rule in relation to set-off:
Contractual set-off is valid and effective under Spanish law. However, in an insolvency, Spanish insolvency rules provided that set-off is only effective if the relevant "conditions are met before the opening of the insolvency proceedings". This means that the reciprocal claims must have become due before the commencement of the insolvency proceeding.
However, RDL 5/2005 establishes a more flexible regime providing that the net sum of an early terminated transaction entered into under it calculated in accordance with the provisions of such agreement, will be included as a claim or, as applicable, as a debt, in the estate of the insolvency party.
Implications of RDL 24/10 on the special regime for derivative transactions
As already outlined, section 3 of article 68 of RDL 24/2012 pretends to override the safe harbour provisions set out in RDL 5/2005 by way of entitling the FROB to suspend the right of counterparties to early terminate and close-out a master agreement upon a restructuring and/or resolution event.
However, at this point we must treat separately those master agreements governed by Spanish law to those where the law of the relevant transaction is other than the Spanish law (such as those based in the International Swaps and Derivatives Association” or ISDA). While RDL 24/2012 shall be applicable to the Spanish law governed derivative contracts (as those based in the “Contrato Marco de Operaciones Financiaeras” or CMOF) as a special regime that suspends at least temporarily the eneral regulatory framework applicable to derivative transactions, on the contrary, for those governed by other than the Spanish law, such as the ISDA based transactions which are governed by the laws of the State of New York or UK law, in our view RDL 24/2012 in principle shall not be applicable to such transactions since under the laws of the contract the counterparty may in theory still be able to laim early termination.
In this regard, there are certain issues to consider:
i. Insolvency legislation:
RDL 24/2012 RDL 24/2012 implies an exceptional piece of legislation within the Spanish insolvency regulation in relation to financial entities following previous precedents such as the Law 6/2005 of 22 April on the reorganisation and winding-up of credit entities.
The measures set out under RDL 24/2012, in particular the so-called resolution measure, are conceived legally as a special winding up administrative process conducted by the FROB aside from an insolvency procedure subject to the Spanish Insolvency Act. As a result, such restructuring and resolution measures:
- do not require the declaration of a formal insolvency procedure;
- the Fifth Additional Provision (“Disposición Adicional Quinta”) of RDL 24/2012 xpressly states that the obligation to file for insolvency shall not apply to any credidntity which is subjected to a resolution measure;
- once opened a restructuring or resolution process, Spanish courts may not accept the request of insolvency filed by or against the insolvent entity and any actions undertaken in a insolvency process shall be null and void. Should a request for insolvency be filed in relation to any financial entity, the court in charge of the case 5 must notify the FROB who shall confirm within 14 days whether or not it intends to open a restructuring or resolution process in the near future, in which case the court shall dismiss the insolvency application, all pursuant to the Fifth Additional Provision of RDL 24/2012; and
- the Sixth Additional Disposition of RDL 24/2012 provides protection to any restructuring measures adopted by the FROB in case of a future insolvency process of the entity, granting immunity to such measures against any claw-back actions exercised pursuant to Article 71 of the Insolvency Spanish Act 22/2003 of 9 July.
ii. Recapitalization, restructuring and/or resolution events may be considered as an Event of Default under the ISDA Master Agreement and the CMOF ("Contrato Marco de Operaciones Financiaeras").
It is interesting to analyse whether the implementation of recapitalization, restructuring and resolution measures by the FROB as described in RDL 24/2012 may trigger an Event of Default under the ISDA Master Agreement or under the CMOF.
a. Restructuring Credit Event
Section 4.7 of the 2003 ISDA Credit Derivatives Definition includes among the Credit Events the so-called "Restructuring Credit Event" that implies the restructuring of all or a part of the debts of an entity that negatively affects its solvency.
In particular, it will constitute a "Restructuring Credit Event":
- a reduction of the rate amount of interest or principal (including any standstill period or waiver;)
- a postponement or other deferral of such obligations;
- a change in the ranking in the priority of payment of any obligations, causing he subordination of such obligation;
- a change in the currency.
The 2003 ISDA Credit Derivatives Definition requires for the "Restructuring Credit Event" to be notified to the other counterparty previously to declare the Event of Default as opposed to a failure to pay or deliver or bankruptcy which operates with immediate effects.
b. General assignment, arrangement or composition with or for the benefit of its creditors
Section 5(a) (viii) (3) of the ISDA Master Agreement includes as an event of default under bankruptcy those general assignment, arrangement or composition with or for the benefit of its 6 creditors. The concept "with or for the benefit of its creditors" has been interpreted in the sense that such measures have to be carried out with or for the benefit of all of the creditors of the entity and not exclusively related to a certain type of creditors exclusively. Based on this interpretation, an agreement reached for the benefit of certain creditors -financial institutions - will not constitute an event of default.
In the context of CMOF, Clause 9.7.2 incorporates such actions as an event of default in the following terms "request o been requested by a third party, as the case may be, the insolvency declaration or any other similar proceeding or of equivalent effects, or turn to its creditors to, in any way, restructure its debt.
c. Merger Without Assumption
Section 5(a)(viii) of the ISDA Agreement includes as an event of default those corporate restructurings (the party consolidates or amalgamates with, or merges with or into, or transfers all or substantially all its assets to, or reorganises, reincorporates or reconstitutes into or as, another entity) were the resulting entity fails to assume all the obligations of the other entity. On the CMOF a similar provision is included under section 9.9 (Disminución de la Solvencia Económica).
Based on the above, each restructuring and /or resolution measure established by RDL 24/2012 shall need to be analysed on an individual basis in order to determine whether it would constitute or not an Event of Default under the relevant master agreement.
In our view, should it be a Spanish law governed agreement such as a CMOF-based transaction, the right of the counterparty to early terminate and close-out upon such events shall be suspended by virtue to RDL 24/2012 despite the occurrence of an Event of Default as defined under the Spanish law master agreement. On the other hand, for those based in a foreign governing law, RDL 24/2012 shall not prevent in principle the counterparty to early terminate and close-out upon a restructuring and/or resolution event as those to be undertaken by the FROB, always provided that such events trigger a specific Event of Default as defined under the foreign based master agreement.
It must also be outlined that even if the specific event does not fall within the Event of Default definitions described above and other defined in the master agreement, the parties may have specified additional termination events, e.g., Change of Control or ratings downgrading provisions that may be triggered upon restructuring and/or resolution actions such as those implemented by RDL 24/2012.
The above considerations are based in the assumption of declaring an early termination/enforcement of a foreign governed contract before a foreign court. However, even if the governing law of the master agreement is other than Spanish law, should the non-Spanish counterparty intend to enforce the Early Termination Event before a Spanish Court with the intention, for instance, of pursuing any assets in Spain, in our view it cannot be discarded the risk that an Spanish court may choose to apply RDL 24/2012 on the basis that it's an exceptional rule based in a matter of public policy.
By way of example we consider interesting to refer to previous similar events:
- Fannie Mae and Freddie Mac (September 2008): Government sponsored enterprises that entered into conservatorship on September 2008 following its collapse. Based on the 2003 ISDA Credit Derivatives Definitions, they considered that the appointment of a conservator trigger one of the event included under clause 4.2 (f) Bankruptcy.
- The take over of Fortis Bank, initially by the governments of the Benelux and finally by BNP Paribas, was not considered an event of default, on the basis that the investment money used to take over Fortis Bank did not modify its creditworthiness.
Finally, we must underline that the special measures established under RDL 24/2012 shall not modify the nature and consequences of a payment default (other than those contractual described above) as a non payment is ultimately a matter of fact and its significance cannot be re-categorised by an exceptional piece of administrative regulation. Although the legal right to request the insolvency declaration of a credit entity may be restricted pursuant to RDL 24/2012 as mentioned above, the non defaulting party will always be entitled to file a claim in the local or foreign relevant civil or commercial procedure before the competent courts in order to obtain a satisfactory recovery of all amounts due and payable under the contract.
iii. Clearing of derivative transactions
The effectiveness of the suspension faculties of the FROB recognized RDL 24/2012 may also prove problematic from a clearing perspective, as the power of the FROB to suspend the right of counterparties to early terminate and close-out a master agreement upon a restructuring and/or resolution event may be in conflict with the general regime of clearing and settlement of clearing transactions pursuant to the rule books of a clearing house upon an event of default.
In this regards, upon the occurrence of any of the following events: (i) failure to pay or deliver or (ii) failure to pay initial margin, variation margin, intra-day margins or any additional margin, a clearing house is entitled to discretionarily take any of the following measures:
- to buy, borrow or sell securities form the account of the defaulting clearing member so as to ensure the performance of the transactions registered in the name of the defaulting clearing member;
- to settle any Open Position registered in the name of the defaulting clearing member through a payment in cash;
- to declare one or more of the obligations of the defaulting clearing member to be due and payable immediately, convert the delivery obligations of the defaulting clearing member into payment obligations on the basis of the settlement price in the valuation date, and set off all the reciprocal payment obligations of the defaulting clearing member, so that these 8 payment obligations will be deemed satisfied in whole or in part, to the extend of the setoff;
- to transfer to another clearing member the positions registered in the name of the defaulting member, and or
- to liquidate the open positions registered in the name of the defaulting member.
iv. Assets and liabilities transferred to a third party
According to the second paragraph of Article 68 of the RDL 24/2012 “If within that period, the assets and liabilities of the relevant financial transaction and/or master agreement have been transferred to a third party, the relevant counterparties may not exercise their termination, close-out, set-off or enforcement right if the assets and liabilities have been transferred in accordance with in the relevant resolution instrument”.
It is not totally clear the meaning and scope of the above provision given the particularities of assignment of positions under derivative transactions. In the context of a master agreement, positions in contracts are transferred basically by way of cancelation of the previous transaction and novation of the existing contract by way of the new party replacing one of the parties in relation to all its rights and obligations, being therefore the outgoing party totally released from its position. In our view, the wording used by Article 68 of RDL 24/2012 may be misleading as it does not seem to take into account that when dealing with derivatives, as opposed to a mere assignment of credit rights, the assignment of the assets and liabilities of a transaction legally speaking means the an assignment of a contract resulting in the cancellation of the former transaction and entering into a whole new agreement between the “assignee” and the counterparty.
v. Non Payment as an Event of Default
According to the third paragraph of Article 68 of the RDL 24/2012 “Not withstanding the above, the counterparties shall not be prevented from enforcing termination rights as a result of other events of default under the relevant transaction or master agreements, either arising before or after the implementation of the relevant measure”.
Therefore the RDL 24/2012 does not prohibit the termination of an agreement as a consequence of a payment default caused by the intervened entity either before or after the implementation of the entity. Similar principle as contained in the Spanish Insolvency Act 22/2003 of 9 July which does not prevent the early termination as a consequence of a payment default caused by the insolvent debtor, despite that according to Article 61 of the Spanish Insolvency Act the declaration of insolvency of the debtor cannot be an event of default in agreements.
Moreover, the right to claim early termination upon a payment default despite the existence of any restructuring or resolution measures shall apply not only to payments under the master agreement but the same principle may also be extended to the obligations to be fulfilled under the ISDA Support Credit Annex or “CSA”. Under ISDA, all assets provided as Eligible Credit 9 Support in a CSA are legally owned by each “Transferor” and reciprocally transferred between the parties in full legal title becoming absolutely of the property of the relevant “Transferee”. Therefore, failing to transfer the “Return Amount” under the CSA shall legally result, not in the mere breach of a covenant of providing collateral when agreed, but in an actual Failure to Pay under the ISDA master agreement and therefore in an Event Default to all legal effects, and any amount that remains unpaid or undelivered under the CSA shall be taken into account in the termination of the master agreement or any terminated transactions under the master agreement.