U.S. Resolution Stay Regulations — Final Rules and ISDA Protocol

As regulators in Europe and elsewhere have done, U.S. banking regulators have introduced new regulations designed to facilitate the resolution of a global systemically important bank (GSIB).^[1] The rules issued by the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation and the Office of the Comptroller of the Currency (the Final Rules) will limit certain insolvency-related rights available to trading counterparties of GSIBs and their affiliates under certain financial contracts. The Final Rules complement and supplement existing special resolution regimes under the Federal Deposit Insurance Act (FDIA) or the Orderly Liquidation Authority (OLA) under Dodd-Frank.

The banking regulators felt it was paramount that they be able to preserve the continuity of a GSIB and its subsidiaries (by keeping them out of bankruptcy proceedings and avoiding a run on the bank) in order to effectively manage the resolution process.

The Final Rules effectively require GSIBs (and/or their subsidiaries) to include in their qualifying financial contract (QFC) documentation:

1. A contractual recognition that such QFCs are subject to the FDIA and OLA special resolution regimes where such regimes may not otherwise be applicable because the underlying QFC is not governed by U.S. law, or the counterparty is organized or domiciled or has a principal place of business outside the United States
2. Express limitations on certain termination rights of the counterparty upon the insolvency of a subsidiary of a GSIB
3. Express limitations on the right of a counterparty to restrict the GSIB’s (or its subsidiary’s) right to transfer or assign the QFC or any obligations and/or liabilities thereunder

In order to streamline and expedite the process of amending QFCs to include these limitations, ISDA has published the U.S. Resolution Stay Protocol (the Protocol).

This alert addresses the practical implications of the Final Rules and the relative advantages and disadvantages of adhering to the Protocol as opposed to bilaterally amending each QFC.

Scope of the U.S. Resolution Regime

Covered Entities

The Final Rules apply to banking groups that have been identified as GSIBs, and within such groups, covered entities (Covered Entities) include:

1. With respect to U.S. GSIBs, all U.S. and non-U.S. subsidiaries
2. With respect to non-U.S. GSIBs, all U.S. subsidiaries, branches and agencies

In-Scope QFCs and Compliance Date

QFCs encompass a broad range of financial transactions and include swap agreements, repurchase agreements, securities contracts (including contracts for the purchase or sale of equity and debt securities or mortgage loans, securities lending and borrowing transactions, and margin loans), forward contracts and commodities contracts, together with related master agreements and credit support agreements. Such QFCs are in-scope for the Final Rules if:

1. The counterparty is a Covered Entity
2. The QFC contains default rights or the ability to limit transfer obligations post-insolvency
3. A transaction or trade under the QFC is entered into on or after Jan. 1, 2019

If a QFC is entered into on or after Jan. 1, 2019, then, notwithstanding (3) above, all QFCs with a Covered Entity in the same group become subject to the Final Rules (i.e. the Final Rules have retroactive effect in such cases). This is somewhat different from similar regimes in, for example, Europe, where it is possible to grandfather legacy trading agreements, provided no new trades are entered into on such agreements after the compliance date. The U.S. regime on the other hand, mandates limitation of insolvency-related rights on a relationship level, rather than with respect to individual trading agreements.

Out-of-Scope QFCs

The Final Rules exclude the following contracts that could otherwise be viewed as QFCs based on the scope of the rules:

1. Any QFC to which a central counterparty (CCP) is a party or to which both parties are financial market utilities (i.e., parties operating multilateral trading facilities for the purposes of clearing, settling or transferring payments and deliveries). Only QFCs between financial market utilities related to their activities as financial market utilities (i.e., not including agreements related to investment, market-making, brokerage, etc.) are out-of scope
2. Investment advisory contracts with retail customers that do not provide for express Default Rights or Transfer Restrictions (each as defined below)
3. Warrants issued prior to Nov. 13, 2017 evidencing rights to subscribe for or acquire the securities of a Covered Entity

The regulators also reserved the right to provide additional exemptions.

Impacted Rights

Default Rights Following Covered Entity’s Entry into FDIA or OLA Proceedings

The Final Rules provide that where a Covered Entity or any of its affiliates is subject to FDIA or OLA resolution proceedings, a counterparty to a QFC may exercise default rights and enforce transfer restrictions only to the extent permitted under the FDIA or OLA special resolution regimes.

Cross-Default Rights Following Affiliate of Covered Entity Becoming Subject to US or non-US Insolvency Proceedings

The Final Rules also prohibit Covered Entities from entering into QFCs providing a counterparty with the following rights, in each case where those rights arise as a direct or indirect result of an affiliate of the Covered Entity becoming subject to U.S. or non-U.S. resolution or insolvency proceedings:

1. Accelerate, liquidate or terminate a QFC or transactions thereunder, exercise set-off or netting, exercise collateral remedies (e.g., foreclosure), suspend or delay performance, or modify the obligations of either party, or any similar rights
2. request additional collateral under the QFC (increased initial margin requirements, margin as a result of credit rating downgrades, etc.) (together with (1), Default Rights)
3. Prohibit the transfer of any credit enhancements provided by the affiliate of the Covered Entity (Transfer Restrictions)

However, Default Rights, for the purposes of the Final Rules, do not include rights to:

1. Effectuate intra-day netting and set-off in the ordinary course of the agreement that are intended to reduce the volume of payments between the parties
2. Request additional collateral to reflect exposure resulting from a change in the market value of the collateral

Permitted Default Rights and Creditor Protections

Counterparties retain the right to terminate QFCs as a result of:

1. The Covered Entity itself (as direct party) becoming subject to a resolution or insolvency proceeding
2. A payment or delivery failure by the Covered Entity (as direct party) under the QFC, or another contract between the same parties that gives rise to a default under the covered QFC
3. A payment or delivery failure by an affiliate providing credit enhancement
4. Reasons unrelated to the affiliate being subject to insolvency proceedings (e.g., periodic or optional termination rights)

Also, following the expiration of a stay period (one business day or 48 hours, whichever is longer), counterparties may exercise termination rights based on the resolution of an affiliate providing credit support or enhancement, if certain conditions regarding the provider or the credit enhancement are not satisfied.

A counterparty exercising default rights in those circumstances bears the burden of proof, by clear and convincing evidence, that such exercise is permitted.

Protocol Specifics 

Benefits of the Protocol 

As an incentive for Protocol adherence, the U.S. regulators have permitted the Protocol to include certain creditor protections in excess of what is provided for under the Final Rules. In particular, under the Final Rules, a party exercising Permitted Default Rights (see above) bears the burden of proof, by clear and convincing evidence, that such exercise is permitted. Under the Protocol, however, this burden of proof only applies in instances where a counterparty exercises termination rights that are unrelated to the affiliate becoming subject to insolvency proceedings (i.e., termination rights as a result of a payment or delivery failure are not subject to the heightened burden of proof).  

In addition, the Protocol provides better creditor protections than the Final Rules in instances where the provider of credit enhancement is subject to resolution by expanding the transfer and other conditions required to be satisfied by the Covered Entity in that respect with a view to preserving the value and effectiveness of the credit support. Specifically, the Protocol requires (i) the transfer of credit support obligations to a bridge company, together with all or substantially all assets of the credit support provider, or (ii) where no such transfer occurs, claim by the counterparty under the credit support arrangement to be elevated to administrative priority status.

Also, the scope of covered insolvency regimes under the Final Rules is broader than under the Protocol, as any receivership, insolvency, resolution or similar proceedings, including non-U.S. proceedings, are covered.  The Protocol, conversely, covers insolvency proceedings only under the U.S. Bankruptcy Code, SIPA and FDIA.

Drawbacks of the Protocol

Unlike for non-U.S. jurisdictions, adhering to the Protocol for U.S. regulatory compliance also results in extraterritorial implications. Specifically, by adhering to the Protocol, counterparties will also be adhering to the ISDA jurisdictional modules for France, Germany, Japan, Switzerland and the U.K.

Even though these jurisdictional modules generally track the domestic legislation, some counterparties have taken the view that the domestic legislation permits certain legacy trading agreements to be grandfathered and kept outside of the resolution framework, thereby preserving termination rights. By adhering to the Protocol, those agreements would be subject to the recognition of the stays, as the ISDA jurisdictional modules bring all trading agreements in scope, whether or not such agreements may be grandfathered under the domestic legislation.

Adherence Process

As with other ISDA protocols, adhering to the Protocol can be accomplished on an entity-by-entity or group basis. To the extent an investment manager wishes to adhere to the Protocol on behalf of the funds it manages as a group (i.e., via a single adherence letter), the investment manager can elect to have all of its managed funds adhere and may then exclude certain funds from that general adherence.

In addition, adhering to the Protocol constitutes a universal adherence across all of an entity’s dealer counterparties. While most market participants should expect their U.S. dealer counterparties (including U.S. affiliates of non-U.S. dealers) to be covered by the Final Rules, it should be noted that the Protocol does not permit picking and choosing the dealers to which the Protocol will apply.

Practical Considerations

As with the European resolution regimes, counterparties of Covered Entities will have to decide whether to accept the broader scope of the Protocol or to instead enter into bilateral amendments in order to comply with the regulations in a more limited fashion. However, unlike the protocols and jurisdictional modules for the European regimes, the U.S. Protocol provides additional creditor protections with respect to QFCs covered by the U.S. regulations. Counterparties should therefore consider their trading infrastructure closely to ascertain the benefits and drawbacks of both the U.S. Protocol and bilateral amendment approaches.

^[1] The Financial Stability Board’s current list (dated November 21, 2017) identifies the following institutions as GSIBs: JP Morgan Chase, Bank of America, Citigroup, Deutsche Bank, HSBC, Bank of China, Barclays, BNP Paribas, China Construction Bank, Goldman Sachs, Industrial and Commercial Bank of China Limited, Mitsubishi UFJ FG, Wells Fargo, Agricultural Bank of China, Bank of New York Mellon, Credit Suisse, Groupe Crédit Agricole, ING Bank, Mizuho FG, Morgan Stanley, Nordea, Royal Bank of Canada, Royal Bank of Scotland, Santander, Société Générale, Standard Chartered, State Street, Sumitomo Mitsui FG, UBS, Unicredit Group