Mitigating Insolvency Risks in Derivatives Transactions
Derivatives have become an increasingly common way for companies to manage financial risk. Associated with their use, however, is the risk of default by the counterparty, and in particular default arising from the counterparty’s insolvency. In this article, we briefly explain the nature of derivatives, examine the insolvency risks, and review the safeguards against such risks, namely close-out netting and collateralization.
Market participants enter into over-the-counter derivative transactions for three reasons. First, they are commonly used to reduce various risks in a particular business. Second, market speculators use derivatives in order to attempt to capitalize on changes in market rates or prices. Finally, derivatives are often used to obtain more desirable financing terms.
The International Swap Dealers Association (ISDA) master agreement has become the standard contract for derivatives transactions. The ISDA agreement governs, under a single ‘umbrella,’ all the derivatives transactions that take place between the counterparties. Note that upon the occurrence of a prescribed event of default, the party that is not in default may unilaterally terminate the ISDA agreement.
The ISDA agreement defines eight events of default, including "bankruptcy." Upon the occurrence of a defined event of default, each ISDA transaction may be terminated, "marked-to-market" and netted against other transaction values in order to determine the payment obligation due to the party in credit. Collateralization of transactions permits the creditor to access security that has been taken, if the debtor is unable to satisfy the payment obligation. These arrangements ensure the ability to offset the debt against that of an insolvent counterparty and, if secured, to essentially be treated as a preferred creditor.
The governing law of an insolvency is that of the jurisdiction where the debtor or its assets are located. Unfortunately, liquidators have been known to interpret the ISDA agreement by enforcing transactions profitable to a domestic insolvent party while rejecting those requiring payment to a foreign counterparty. As a result, market participants are increasingly seeking assurances from hosting jurisdictions that their contractual rights will be respected upon the occurrence of a bankruptcy event of default.
In Canada, trustees in bankruptcy may repudiate certain contracts of a bankrupt while continuing to acknowledge others. It is arguable that each derivatives transaction covered by the ISDA agreement is a separate agreement and that a trustee in bankruptcy could potentially uphold some of them and disclaim others. Nevertheless, the prevailing view is that a trustee must decide to accept or reject the ISDA agreement in its entirety and may not unbundle transactions covered by it. In Canada, therefore, it is acknowledged that a trustee in bankruptcy is bound by the close-out netting provisions.
The close-out netting provisions in the ISDA agreement allow the non-defaulting party to calculate a single settlement amount and offset its payment obligations against the defaulting party’s corresponding obligations. Trustees and receivers are thereby prevented from ‘cherry-picking’ individual contracts.
In the absence of legislated protection, however, the ability of a non-defaulting party to manage its exposure to an insolvent counter-party by entering into new off-setting contracts or by having the debtor post additional collateral is severely restricted.
While the "eligible financial contracts" provisions in Canadian insolvency legislation recognize close-out netting, those statutes do not allow a secured creditor to exercise rights against the collateral previously pledged by an insolvent debtor. Canada’s derivatives market would benefit from the explicit protection of creditor access to collateral that is provided in the U.S.
Although domestic regulation is not yet fully modernized, ISDA’s Canadian regional committee plans to "increase its work on collateral law reform and insolvency law reform … by encouraging Industry Canada to look at improvements to the various bankruptcy and insolvency statutes." It is anticipated that revised provisions clarifying the status of market participants’ collateral arrangements will be introduced this year.
The above summarizes Martin Marcone’s longer article that appeared in two parts in the October and December 2006 issues of the National Banking Law Review. At the time, Mr. Marcone was an associate lawyer in our Ottawa office, but is now Counsel with the Law Branch of Finance Canada.