The Federal Reserve Board (“FRB”) has issued a proposed rulemaking to require “global systemically important banking organizations” (“GSIBs”) and their subsidiaries to limit their counterparties’ rights to terminate and liquidate uncleared derivatives and other agreements under certain conditions if the GSIB or its subsidiary enters into a bankruptcy or resolution process.  The proposal is intended to facilitate the orderly resolution of GSIBs and avoid cascading failures that could destabilize the global financial system.

  • Rationale for Proposed Rule. The FRB believes this rulemaking is necessary to help assure that foreign regulators will recognize such limitations on termination rights in contracts involving non-US parties within their respective jurisdictions. The FRB also seeks to apply these limitations to all Qualified Financial Contracts (defined below) of the GSIB—not just those involving other GSIBs as generally is the case today. The proposal also includes provisions intended to help ensure that if subsidiaries of a GSIB are otherwise able to meet their obligations, they are not forced to enter resolution merely due to the failure of the GSIB or another subsidiary of the GSIB.
  • Qualified Financial Contracts. The proposal would apply to Qualified Financial Contracts (“QFCs”) which, among others, includes securities, commodity contracts, forward contracts, repurchase agreements, and swaps. The proposal would not apply to cleared swaps, but the FRB is considering whether to propose a separate rule addressing cleared trades.
  • Covered Entities. The proposal would apply to QFCs entered into by: (i) the 8 US banks that the FRB has determined to be GSIBs, including their foreign operations, (ii) the US operations of 22 foreign GSIBs, (iii) any subsidiary of a US GSIB and (iv) any US subsidiary, branch or agency of a foreign GSIB (collectively, “Covered Entities”).
  • Stay of Termination Rights and Related Restrictions.
    • First, the proposal would require a Covered Entity to include provisions in QFCs that, upon the initiation of a resolution under the special resolution regimes with respect to the Covered Entity, would prohibit its counterparties from terminating the contract for 48 hours or blocking the transfer of any credit enhancement applicable to the QFC (or associated obligations or collateral). The 48-hour stay is intended to give regulators time to conduct an orderly resolution of the institution, including transferring the covered transactions to a solvent affiliate of the GSIB or a third party. Counterparties would be able to exercise their contractual rights after the stay expires, but not upon notice that a QFC has been transferred to another financial institution (including a “bridge” entity). While Title II of the Dodd-Frank Act already mandates these restrictions in connection with the Orderly Liquidation Authority, the proposed rule would insure consistency between the Orderly Liquidation Authority and the Federal Deposit Insurance Act, and encourage consistent treatment of the QFC by a non-US court.
    • Second, the proposal would prohibit counterparties of a Covered Entity from exercising default rights due to the initiation of any bankruptcy or resolution proceeding with respect to an affiliate of the Covered Entity, except as described below, and would prohibit restrictions on the transfer of a credit enhancement from the Covered Entity’s affiliate to a transferee due to the affiliate’s entry into resolution.
  • Creditor Protections. The FRB has included several exceptions to protect the financial interests of counterparties to Covered Entities and reduce their desire to “run” during the lead-up to a resolution or bankruptcy proceeding. Among others, those protections include:
    • A counterparty could exercise its contractual rights upon the entry by the “direct party” (i.e., the Covered Entity that is party to the QFC, as opposed to an affiliate) into a bankruptcy other than a resolution proceeding under a US or foreign special resolution regime;
    • A counterparty could exercise its default rights based on the failure of the direct party, a credit support provider affiliate, or a transferee assuming a credit enhancement to satisfy the transferee’s obligations thereunder;
    • A counterparty could exercise its default rights if the direct party fails to satisfy its payment or delivery obligations under another contract between the direct party and the counterparty;
    • Additional protections for counterparties that have received a credit enhancement from a Covered Entity affiliate of the Covered Entity, including the ability to exercise default rights against the direct party after a 48-hour stay in certain specified circumstances.
  • Compliance with Resolution Stay Protocol. The changes set forth in the proposed rule have generally been implemented between GSIBs by ISDA’s 2015 Resolution Stay Protocol, which was developed by ISDA in coordination with the FRB, other US bank regulators, and foreign regulators.  The FRB has proposed that Covered Entities could satisfy their obligations under the rule if their QFCs are amended through the Resolution Stay Protocol. ISDAs 2015 Resolution Stay Protocol is no longer open for adherence, but ISDA has recently published an additional protocol. The FRB has not yet opined as to whether Covered Entities could comply with the proposed rule by adhering to this additional protocol.
  • Compliance Deadlines. As proposed, the rule would become effective on the first day of the calendar quarter that begins at least one year after the issuance of the final rule (“Effective Date”). Covered Entities would be required to amend their pre-existing trades on or after the date following the Effective Date on which they enter into new trades with the applicable counterparty or its affiliate.
  • Rule Text and Comment Due Date. The text of the proposed rulemaking is available here.  Comments are due by August 5, 2016.