By Joseph W. Aaker
Clients who have engaged in Qualified Financial Contracts (QFCs)—which include derivatives, repurchase agreements and securities lending—with large financial institutions may have received, or may soon receive, a notice requesting that they adhere to the ISDA 2018 U.S. Resolution Stay Protocol (the Resolution Stay Protocol). This request relates to the phase-in of new regulatory requirements applicable to those regulated financial institutions, and the effect of adherence is that clients would waive certain contractual rights that they may otherwise have in a counterparty default scenario. We’ve set forth below an explanation of the background of why this requirement is being implemented and what it means in practice for market participants who are users of these financial products.
The Resolution Stay Protocol is designed to meet the requirements of rules promulgated by regulators in the U.S. and other jurisdictions setting certain requirements for QFCs entered into by their supervised financial institutions. While these regulations apply to the regulated financial institutions rather than end users, the regulations prohibit the regulated financial institution from continuing to trade under non-compliant documentation, and therefore end users who engage in QFCs with these financial institutions are faced with the choice of adhering or foregoing any further trading with entities subject to these rules. While the rules delay phase-in until January 1, 2020 for non-financial entities and small financial institutions, the structure of the phase-in will result in most covered financial institutions seeking adherence for counterparties contemplating any QFC transaction on or after January 1, 2019.
The Resolution Stay Protocol generally amends the contractual relationship with respect to QFC transactions between adhering parties in two ways.
- Opt In - First, the Resolution Stay Protocol “opts in” to limitations on contractual remedies that exist under designated insolvency laws (including, for U.S. institutions, bank insolvency under the Federal Deposit Insurance Act and systemically-important financial institution insolvency under the Orderly Liquidation Authority created by the Dodd-Frank Act), and thereby inhibits the ability of a creditor in another jurisdiction to argue that its exercise of remedies should be allowed notwithstanding insolvency law applicable to the failed financial institution. This portion is intended to address legal uncertainty related to cross-border transactions and should be of limited relevance for trading activity between two U.S. entities.
- Related Party Defaults and Transfers - Second, and of more practical impact for U.S.-centered activity, the Resolution Stay Protocol limits the exercise of contractual default rights that may arise against a counterparty based on an affiliate of that counterparty entering into resolution proceedings pursuant to those designated insolvency laws, to the same extent as would be provided by the insolvency regime applicable to that affiliate. Agreements relating to QFCs commonly include provisions specifying an Event of Default to occur upon an insolvency event relating to specified affiliates of the counterparty, or to affiliates that may be acting as credit support providers, and these types of provisions would be limited by the operation of the Resolution Stay Protocol. However, this does not limit the direct default rights that a party may have if the counterparty itself were to enter insolvency proceedings or otherwise default under the QFC. This portion of the Resolution Stay Protocol also allows a transfer of credit enhancement obligations to a transferee, notwithstanding any restriction on transfer in the QFC or the credit support enhancement, also to the same extent as provided in the applicable insolvency regime.
These provisions are designed to facilitate a resolution model common under the identified insolvency regimes where a regulator is appointed as receiver for an insolvent parent company and seeks to preserve value and limit disruption by maintaining the ongoing operations of solvent subsidiaries for sale or orderly wind-down. Therefore the limitations required under the applicable rules, and implemented in the Resolution Stay Protocol, operate to stop counterparties from terminating ongoing transactions with those otherwise solvent subsidiaries so that the regulator can recapitalize or liquidate the parent entity while protecting the operations of solvent subsidiaries.
The Resolution Stay Protocol is complex in its applicability and operation. Clients with additional questions related to the matters discussed in this alert should reach out to Joseph Aaker, Kraig Kohring, Casandra Carpenter or their regular Polsinelli contact.