By Liu Zhigang and Lv Yinghao of King & Wood’s Finance Group
I. Background Introduction
On October 12, 2007, the National Association of Financial Market Institutional Investors ("NAFMII"), a self-regulatory body newly formed in late August of 2007 for Chinese inter-bank market players and operating under the direction of the People’s Bank of China ("PBOC"), was authorized by PBOC to release the standardized Master Agreement and its supplemental documents including the Schedule, the Performance Collateral Annex and the Definitions(1) (collectively the "Master Agreement and Supplements"). The Master Agreement and Supplements are intended to serve as a uniform documentation basis for the inter-bank market participants in financial derivatives transactions amongst them.
Just like the renowned ISDA Master Agreement series ("ISDA Documents"), the Master Agreement and Supplements can be used for a wide range of derivatives transactions: interest derivatives, bond derivatives, currency derivatives, credit derivatives and other derivatives not prohibited by Chinese law. In a total of nineteen articles, the Master Agreement addresses almost all provisions that might be necessary when entering into a derivatives transaction in the domestic market, such as: performance methods for payment or delivery obligations, detailed definitions for events of default and termination events, remedies available in event of defaults, mechanisms for early termination date designation, determination of contractual currency and termination currency, calculation formulae for early termination payments, dispute resolutions, etc.. Also, the Supplements help tailor these transaction documents to more specific needs of most traders.
II. Prominent Features of the Master Agreement
Industry users and practitioners with experience in ISDA Documents may easily identify in the Master Agreements and Supplements traces of the ISDA Documents, such as the silent agreement scheme, netting, and calculation of close-out amounts.
A. "Single Agreement" Scheme When two parties intend to enter into a series of transactions for different derivatives products, they must first sign one Master Agreement, one Security Agreement and one Schedule. The variety of different products and the specifics entailed by such variety will be reflected in each Confirmation exchanged between the parties under each transaction. Together with all such Confirmations, the Master Agreement, the Security Agreement and the Schedule will constitute just one single agreement to govern all such transactions.(2)
The Master Agreement heavily borrows from the ISDA Documents on the netting concept. "Netting" is important because it is expected to significantly reduce administrative costs associated with cash or securities transfers and to minimize one’s exposure to the credit risk of the other. Under the Master Agreement, the parties can choose "netting" not only within one transaction but across different transactions if they so specify in the Schedule.(3) In addition, in the event of an early termination, all obligations of the parties under all relevant transactions governed by one Master Agreement would be netted off despite their different natures and designated contractual currencies — a process called "close-out netting"(4) — so that one’s credit failure would result in minimum loss for its counterparty.
C. Calculation of Close-out Amounts
As is true with the 2002 ISDA Master Agreement, under the Master Agreement where a close-out netting is needed in the event of early terminations, the final amount due from one to the other hinges upon the amount of the "replacement cost", or the fair market value, of the terminated transactions determined based on factors including third-party quotations, open market data and one’s usual practices, which combined are expected to produce a more objective result.(5)
While the ISDA Documents have had undeniable impact on the drafting of the Master Agreement, the latter is presented in a more succinct manner to accommodate the unique situation of the Chinese market. For example, most tax-related provisions, including tax representations and tax-based termination events, have been taken out of the text under the assumption that the Master Agreement would be used mostly for domestic rather than cross-border dealings and the tax implications would thus remain substantially the same for all parties. Another example would be that transfer of obligations between different offices as required by the ISDA Documents to avoid illegality or other termination events is not seen in the Master Agreement because such transactions in domestic transactions under a unified Chinese legal system are not necessary.
III. Potential Soft Spots
Though the Master Agreement is worthy of all the applause it has received since its very recent birth, some matters should be considered, such as the validity of netting in bankruptcy situations, the uncertainties around assignments, and choosing between alternatives for documentation.
A. Validity of "Netting" In Bankruptcy Situations
No Chinese law has explicitly addressed the issue of "netting", and its closest kin under the Chinese legal system is "set-off". Set-off between two parties is allowed(6) under the PRC Contract Law(7) , but if a bankruptcy proceeding is initiated against one of them (which is defined as an event of default under the Master Agreement), the non-defaulting party’s right to set-off will be subject to certain time limits as well as the approval of the bankruptcy administrator.(8) Should the court interpret the "close-out netting" as merely a variation of the "set-off" concept, the bankruptcy administrator could then be entitled under the set-off provisions of the newly promulgated PRC Bankruptcy Law(9) to require those transactions benefiting it (and harming the non-defaulting party) to be resumed and those aggravating its financial position (and to the advantage of the non-defaulting party) to be terminated(10) , which is essentially "cherry-picking" behavior—most derivatives documentations strive to avoid cherry-picking. Furthermore, "close-out netting" could be considered a de facto "preferential repayment" to certain creditors to the detriment of other creditors and could thus be invalidated by the court for its violation of the "pari passu" principle incorporated in the PRC Bankruptcy Law.
B. Uncertainties Around "Assignment"
Unlike in the US or UK where it has been widely used in financial dealings, assignment is not a security form that can be found either in the PRC Security Law(11) or in the recently effected PRC Property Law(12).Consequently, the effect of an "assignment" (13) of this type in the case of a dispute would rest upon the opinions of judiciary authorities. Drafters of the Master Agreement obviously have made a commendable leap toward the internationally prevailing industry practice, but this leap has squarely put them well ahead of Chinese law’s pace of reform. How much impact the uncertainties around this "assignment" concept would have on the use of the Master Agreement is a matter soon to be tested.
C. Choosing Between Alternatives for Documentation
In August 2007 the State Administration of Foreign Exchange ("SAFE") and the China Foreign Exchange Trade System & National Interbank Funding Center ("CFETS") released the RMB-FX Master Agreement, a set of standard documentation to be used for RMB-foreign exchange forwards, RMB-foreign exchange swaps and RMB-foreign exchange currency swaps (the "CFETS Documents").(14) Currently, RMB-foreign exchange related derivatives investors in the domestic market have two options — use either the CFETS Documents or the Master Agreement and Supplements. Where a transaction is not RMB-foreign exchange related, the Master Agreement and Supplements would seem to be a more appropriate basis to start with. For cross-border dealings, of course, ISDA Documents remain an option for many investors. Still, there are chances where the Master Agreement, the CFETS Documents and the ISDA Documents may each be appropriate for a transaction, such as when the deal is about RMB-FX derivatives between a domestic institution and a foreign bank’s branch in China. Since the Master Agreement is governed by Chinese law and, as provided in its Article 19, no change to the choice of governing law is allowed(15) , it is advisable to become acquainted with the ramifications for a specific deal of the considerable discrepancies between Chinese law and UK law or New York law, of which the latter two are the most commonly applicable laws under ISDA Documents, before making a final decision as to how to document a transaction.
In addition to uncertain matters discussed above, uncertainties can also be discerned from other provisions of the Master Agreement, such as uncertainties about the validity of acceleration of debts under Chinese law by virtue of an early termination and uncertainties on the scope of definition for "impracticable"(16) in times of force majeure events as set forth in Item 3 of Article 9.
Notwithstanding all the "yet-to-knows" we have just mentioned, there is at least one certain thing about the Master Agreement — once the detailed transaction rules or guidelines are made clear to the public, this Master Agreement, which is the result of cooperation between the regulators, market participants and intermediaries, will soon prevail among institutional players in China and will remarkably promote the prosperity of the domestic financial derivatives market.
The article was originally written in English, the Chinese version is a translation. This article was first published in the firm’s periodical China Bulletin January Issue, 2008, Vol.31)
(1) National Association of Financial Market Institutional Investors Announcement No.1 of 2007.
(2) Paragraph 2, article 2 of the Master Agreement:
An agreement on a financial derivative transaction between the Parties is formed by: 1. Master Agreement for Financial Derivative Transactions on China Inter-Bank Market and the Performance Collateral Annex being its Schedule (the "Master Agreement"); 2. Supplemental Agreement to Master Agreement for Financial Derivative Transactions on China Inter-Bank Market (the "Supplemental Agreement to Master Agreement", if any); 3. Supplemental Agreement to Performance Collateral Annex (if any); 4. All effective agreements on a specific transaction (including without limitation the relevant Confirmation, collectively the "Effective Agreements"). The four documents above shall form a single and entire agreement (the "Agreement") between the Parties. Unless otherwise agreed, the non-performance by a Party of any of its obligations under this Agreement shall constitute the non-performance by such Party of the entire Agreement.
(3) Paragraph 4 , article 5 of the Master Agreement provides "Performance of Payment Obligations under the Same Transaction"; Article 5, paragraph 5 of the Master Agreement provides "Performance of Payment Obligations under Two or More Transactions".
(4) See item 3, paragraph 1, Article 8 of the Master Agreement; item 3, paragraph 3, Article 11 of the Master Agreement.
(5) See paragraph 2, article 8 of the Master Agreement.
(6) Article 99 of the PRC Contract Law: "If each party owes a matured obligation to the other, and the subject matters of their obligations are of the same type and quality, either party may offset his obligation against that of the other party, unless the law or the nature of the contract does not permit such setoff." Article 100 of the PRC Contract Law: "If each party owes an obligation to the other, but the subject matters of their obligations are not of the same type or quality, they may still offset their obligations after reaching a consensus through consultations."
(7) Adopted at the Second Session of the Ninth National People’s Congress on March 15, 1999, and effective as of 1 October 1999.
(8) Article 40 of the PRC Bankruptcy Law:
If a creditor owes a debt to the debtor before the bankruptcy application is accepted, it may request the administrator to offset it. However, no offsetting may be made in any of the following circumstances: 1.the debtor of the debtor acquires a claim of another party against the debtor after the bankruptcy application has been accepted; 2.the creditor becomes indebted to the debtor when it already knows the fact of the inability of the debtor to discharge debts as they fall due or the bankruptcy application, unless the creditor becomes indebted by operation of law or for a reason that occurred more than one year prior to the bankruptcy application; or 3.the debtor of the debtor becomes indebted to the debtor when it already knows the fact of the inability of the debtor to discharge debts as they fall due or the bankruptcy application, unless the debtor of the debtor becomes indebted by operation of law or for a reason that occurred more than one year prior to the bankruptcy application.
(9) Adopted at the 23rd Session of the Standing Committee of the 10th National People’s Congress on 27 August 2006, and effective as of 1 June 2007.
(10) Article 18 of the PRC Bankruptcy Law:
After the people’s court has accepted the bankruptcy application, the administrator shall have the right to decide the dissolution or continued performance of any contract established prior to the acceptance of the bankruptcy application and not fully performed by both the debtor and the counterparty upon notice to the counterparty. If the administrator fails to notify the counterparty within two months of the acceptance of the bankruptcy application or fails to reply within 30 days of receipt of the counterparty’s demand, the contract shall be deemed dissolved. If the administrator decides to continue to perform the contract, the counterparty shall do so but it has the right to demand the administrator to provide security. If the administrator fails to provide security, the contract shall be deemed dissolved.
(11) Adopted at the 14th Session of the Standing Committee of the 8th National People’s Congress and promulgated on 30 June 1995. Effective as of 1 October 1995.
(12) Adopted at the 5th Session of the 10th National People’s Congress of the People’s Republic of China on 16 March 2007 and effective as of 1 October 2007.
(13) The Security Agreement provides the "assignment security for performance".
(14) China Foreign Exchange Trade System & National Interbank Funding Center, No.187 of 2007.
(15) See Article 19 of the Master Agreement.
(16) See paragraph 3, article 9 of the Master Agreement.