International Swaps and Derivatives Association, Inc. (“ISDA”) recently published the updated Legal memorandum on enforceability of close-out netting of privately negotiated derivatives transactions under ISDA Master Agreements in the PRC (“2017 Netting Memo”) and the new Memorandum of law on enforceability under PRC law of close-out netting of privately negotiated derivatives transactions under the ISDA Master Agreements against a PRC State Counterparty (“Sovereign Netting Memo”), both issued by King & Wood Mallesons (“KWM”). This article summarises the key points[1].
In response to increasing industry focus on the netting analysis against Chinese counterparties under the mandatory margining requirements for un-cleared OTC derivatives, ISDA mandated KWM to update our 2014 China netting memorandum. The update captures recent regulatory and judicial developments in China. The 2017 Netting Memo includes further information on the bankruptcy regime that applies specifically to Chinese financial institutions. This assists ISDA members’ ability to effectively terminate and close-out outstanding trades under an ISDA Master Agreement with a bankruptcy Chinese Counterparty.
The 2017 Netting Memo and the Sovereign Netting Memo are available on the ISDA website (member log-in required).
Has there been a change in PRC laws on close-out netting position since 2014?
No. The key PRC laws relevant to the determination of close-out netting have not changed since 2014. But recent developments give market participants more insights as to whether netting is available in China.
Snapshot of our legal advice under the 2017 Netting Memo
The key points and legal analysis on close-out netting against an enterprise incorporated as a legal person in the PRC (“Chinese Counterparty”) under PRC law are:
1.termination right suspended – the right of a party to terminate the Transactions outstanding under an ISDA Master Agreement against a Chinese Counterparty will be suspended upon the commencement of a bankruptcy proceeding against that party;
2.when bankruptcy commences – a bankruptcy proceeding commences from the time when a PRC court accepts a bankruptcy petition (not at the time of the filing of the petition itself);
3.cherry-picking rights – the PRC Enterprise Bankruptcy Law (“Bankruptcy Law”) provides the administrator of an insolvent entity the power to determine whether to terminate or continue with performance of executory contracts[2] (generally referred to as the “administrator’s cherry-picking rights”) after the commencement of a bankruptcy proceeding;
4.when ISDA transactions are terminated – close-out netting[3] is not a legal concept expressly recognised under PRC law, nor is it expressly addressed under the Bankruptcy Law. To address the risks associated with the administrator’s cherry picking rights in the context of ISDA Transactions, KWM recommends the adoption of a mechanism to facilitate an effective termination of ISDA Transactions prior to the commencement of a bankruptcy proceeding against a Chinese Counterparty. We recommend this be achieved by:
(a) the selection of Automatic Early Termination in respect of a Chinese Counterparty so that the termination of the ISDA Master Agreement is triggered by reference to an event occurring before the bankruptcy proceeding commences. We believe the selection of Automatic Early Termination should be enforceable in a bankruptcy proceeding against a Chinese Counterparty under PRC law on the basis that:
- there is certainty on the occurrence of the specified bankruptcy event triggering the Automatic Early Termination;
- there is certainty on the timing of the occurrence of the Early Termination Date; and
- the Early Termination Date occurs, or is deemed to have occurred, prior
to the commencement of the bankruptcy proceeding in respect of the Chinese Counterparty;
(b) removing the retrospective effect of the “15 days/ 30 days” grace period provided for a bankruptcy event under section 5(a)(vii)(4) and section 6(a) of the ISDA Master Agreement; and
(c) the Non-defaulting Party serving the statement of Early Termination Amount on the Chinese Counterparty to complete the process of close-out netting prior to the commencement of the bankruptcy proceeding;
5.completion of close-out netting process before a court’s acceptance of a bankruptcy petition – the close-out netting provisions under the ISDA Master Agreement should not be subject to the administrator’s cherry-picking rights if the Early Termination Date occurs, or is deemed to have occurred, prior to the commencement of a bankruptcy proceeding against a Chinese Counterparty and the statement of Early Termination Amount is then served on the Chinese Counterparty; and
6.completion of close-out netting process after the commencement of a bankruptcy proceeding – the statutory set-off provisions under the Bankruptcy Law are likely to apply to determine the amounts due between the parties under an ISDA Master Agreement if the statement of Early Termination Amount is not served on a Chinese Counterparty before the commencement of the proceedings. Those provisions should achieve the same economic effect as close-out netting, although the process of asserting set-off rights and an administrator’s right of challenge may cause delay and uncertainty in completing the statutory set-off procedure.
The 2017 Netting Memo also includes the following information:
1.in-depth analysis of bankruptcy procedures applicable to financial institutions – a more comprehensive explanation of the process, formalities and timing requirements for the commencement of bankruptcy proceedings under the Bankruptcy Law.
See the diagram below for the key steps of a bankruptcy proceeding (including the timing factors) against a Chinese Counterparty starting from the filing of a bankruptcy petition to the termination of the bankruptcy proceeding in China;
2.requirements of regulator’s consent in a bankruptcy proceeding against a Chinese financial institution – Chinese commercial banks, securities companies and insurance companies are subject to specific bankruptcy rules under the Bankruptcy Law.
The consent of the relevant PRC regulator[4] is expressly stated to be a requirement of a court’s acceptance of bankruptcy proceedings against a Chinese securities company and insurance company.
There are currently no regulations or rules prescribing the procedures for a bankruptcy proceeding against a Chinese commercial bank. The China Banking Regulatory Commission (“CBRC”)’s consent is only stated to be a pre-requisite to a bankruptcy court order (but not necessarily to the institution of the bankruptcy proceeding) against a Chinese commercial bank.
The involvement of a Chinese regulator in a bankruptcy proceeding against a Chinese financial institution increases the likelihood that the non-defaulting party will have time to serve its termination notice prior to the commencement of bankruptcy proceedings against a Chinese financial institution;
3.further regulatory support on “close-out netting” in China since 2014 – the Shanghai Clearing House was approved by China’s central bank, PBOC, to clear RMB interest rate swaps as the central counterparty in January 2014. Its standard IRS clearing agreement contains provisions for single agreement, early termination and close-out netting. This development demonstrates further PBOC support for the adoption of close-out netting in China; and
4.a recent PRC court case supporting “single agreement” concept in a non-bankruptcy scenario – a Shanghai court in 2015[5] upheld the validity and effectiveness of early termination provisions under an industry prescribed form of a master agreement, including the close-out of all outstanding transactions following an event of default by the defaulting party. In upholding the validity of the relevant provisions, the PRC court implicitly recognised and accepted the single agreement clause of the master agreement and applied close-out netting. However, the case did not involve the application of the Bankruptcy Law as neither party to the dispute was bankrupt. But the decision indicates judicial support for the “single agreement” concept.
What is the scope of Sovereign Netting Memo and its coverage?
KWM responds to ISDA members’ request that we expand our netting analysis to cover PRC sovereign entities. KWM issued the Sovereign Netting Memo to cover English and New York law governed ISDA Master Agreements entered into with the People’s Bank of China, the State Administration of Foreign Exchange or the Ministry of Finance (each a “PRC State Counterparty”).
The Sovereign Netting Memo confirms the enforceability of close-out netting against the PRC State Counterparties under PRC law on the basis that:
- the Bankruptcy Law does not apply to a PRC State Counterparty and that the PRC courts do not have statutory power or jurisdiction to accept or process bankruptcy petitions against a PRC State Counterparty; and
- accordingly, the close-out netting is enforceable as a matter of contract against a PRC State Counterparty pursuant to the governing law of the relevant ISDA Master Agreement.
When dealing with a PRC State Counterparty, participants must consider sovereign immunity issues under the relevant governing law, and the jurisdiction to which the parties submit for the purpose of enforcement.
Closing remarks
The PRC government is drafting rules and regulations to implement the Financial Stability Board’s Key Attributes of Effective Resolution Regimes for Financial Institutions, but the timing of their implementation has not been announced. Our analysis on the special bankruptcy rules applicable to Chinese financial institutions will be revisited when the rules and regulations are published.
We encourage derivatives market participants to continue monitoring closely the PRC regulatory and judicial developments with respect to close-out netting issues in China.
KWM thanks ISDA and its participants for their support in the publication of the 2017 Netting Memo and the Sovereign Netting Memo.
Key steps involved in a bankruptcy proceeding against a Chinese Counterparty
[1] In this article, capitalised terms have the meanings provided in the relevant ISDA Master Agreement.
[2] The cherry-picking rights of an administrator apply to contracts with outstanding obligations to be performed by both parties.
[3] Close-out netting is a process comprised of three steps commenced by the Non-defaulting Party (or automatically upon the trigger of an Automatic Early Termination) under an ISDA Master Agreement following the occurrence of an Event of Default, namely: (i) termination of all Transactions under the ISDA Master Agreement; (ii) valuation of the terminated Transactions; and (iii) determination of one single net amount payable under the ISDA Master Agreement.
[4] China Securities Regulatory Commission is the regulator for Chinese securities companies, whilst China Insurance Regulatory Commission is the regulator for Chinese insurance companies.
[5] The decision of the Shanghai Pudong New Area People’s Court in Citibank (China) Limited v Shanghai Global International Trading Co. Ltd. concerning financial derivative product transaction disputes, issued on 12 August 2015.