Companies are being, or have been, approached by US banks and/or their affiliates with which they have derivatives contracts or other qualified financial contracts (QFCs) and asked to amend those agreements to cover a situation where the bank or its affiliates might be put into a receivership situation. The reason why they are getting these requests is because US regulators are requiring that the agreements be amended.
As a result of the 2008 financial crisis, US federal banking and other financial services regulators saw the need to address in more detail the concept of risk to the US financial system of certain activities and products.
Prior to the crisis and currently, under federal banking law, if a bank that carries federal deposit insurance is closed and put into receivership under the Federal Deposit Insurance Act (“FDIA”), a counterparty to a QFC with the bank cannot exercise an immediate right to terminate the QFC. The Federal Deposit Insurance Corporation (FDIC) as receiver generally has about 48 hours to transfer the QFC to another financial institution.
One of the many new laws coming out of the major US Dodd-Frank regulatory reform legislation signed into law in 2010 is the Orderly Liquidation Authority (OLA), which, under certain circumstances, would allow the FDIC to be the receiver of a systemically important financial company (such as a large bank holding company), and resolve it in accordance with the provisions in the OLA. The OLA is based on the statutory provisions for liquidating an FDIC-insured bank, including the 48 hour stay.
The regulation refers to the FDIA and OLA and the regulations promulgated thereunder jointly as a “U.S. special resolution regime.”
US Federal Regulations
In 2017, the US Federal bank regulators each promulgated a regulation (the Federal Reserve Board regulation can be accessed here, the Federal Deposit Insurance Corporation (“FDIC”) regulation here and the Office of the Comptroller of the Currency (“OCC”) here), requiring, subject to certain limited exceptions, certain entities, including large banks and systemically important bank holding companies and their subsidiaries (collectively, “covered institution”), to revise any QFCs that provide default rights by a counterparty or restrictions on transfer of a QFC from the covered institution(“in-scope QFCs”). Specific language must be added to the in-scope QFC:
(1) In the event the [covered institution] becomes subject to a proceeding under a U.S. special resolution regime, the transfer of the covered QFC (and any interest and obligation in or under, and any property securing, the covered QFC) from the [covered institution] will be effective to the same extent as the transfer would be effective under the U.S. special resolution regime if the covered QFC (and any interest and obligation in or under, and any property securing, the covered QFC) were governed by the laws of the United States or a state of the United States; and
(2) In the event the [covered institution] or an affiliate of the [covered institution] becomes subject to a proceeding under a U.S. special resolution regime, default rights with respect to the covered QFC that may be exercised against the [covered institution] are permitted to be exercised to no greater extent than the default rights could be exercised under the U.S. special resolution regime if the covered QFC were governed by the laws of the United States or a state of the United States.
In other words, the FDIC would have the 48 hour stay to transfer the QFC. A “covered QFC” is one that is entered into on or after January 1, 2019, or an existing QFC that is required to be conformed as discussed below.
ISDA Resolution Stay Protocol
ISDA developed a Resolution Stay Protocol prior to finalization of the US Federal mandatory stay regulations. The Protocol imposes by contract a stay on cross-default and early termination rights within standard ISDA derivatives contracts in the event certain financial companies become subject to a resolution action. A Regulation Tomorrow blog post run at the time of its adoption can be accessed here. Under the regulation, if the banks’ counterparties adopt this Resolution Stay Protocol, that generally should be deemed compliance with the regulations.
Which In-Scope QFCs need to be conformed?
For a covered institution that was a covered institution (i) on November 13, 2017, for entities subject to the Federal Reserve Board regulation, and (ii) on January 1, 2018, for entities subject to the OCC or FDIC regulations, the covered institution must conform any in-scope QFCs into which it enters on or after January 1, 2019.
These covered entities also must conform any in-scope QFC existing on January 1, 2019, if the covered institution (or an affiliate that is also a covered entity) enters into another QFC with the same counterparty or its consolidated affiliate on or after January 1, 2019.
The regulations also address its applicability for those covered institutions that become covered institutions after the relevant November 2017 or January 2018 dates.
There are staggered compliance dates with respect to the initial applicability of the requirement to conform existing in-scope QFCs, depending upon the nature of the counterparty, such as whether or not it is another bank or a financial or nonfinancial counterparty.