Close-out Netting Developments in Romania and Worldwide
By Andreea Toma & Cristina Togan
Since the 1990s, close-out netting has become one of the most important methods used in the financial markets for the reduction of counterparty credit risk, as it allows market participants to reduce their outstanding mutual obligations to a single net exposure in relation to each of their counterparties
How Does Close-out Netting Operate?
Close-out netting is a rather new concept, often seen as a type of set-off which applies upon the default or insolvency of one of the parties. Nonetheless, the following elements characterise and, at the same time, differentiate close-out netting from the classical set-off concept:
- it operates either by declaration by one party when a pre-defined event occurs (in particular the default or insolvency of the counterparty) or automatically when such an event occurs
- it extends to a number of financial contracts between the parties that are contractually included in a netting agreement
- upon close-out or automatic termination, all covered contracts are terminated and the market value of each such contract is determined in accordance with a pre-defined valuation mechanism
- the sum value of all contracts is aggregated resulting in one single payment obligation i.e. the net amount
- The net amount remains the only obligation to be settled and is generally due immediately after being determined.
Across jurisdictions, close-out netting faced many obstacles as it conflicts with certain mandatory insolvency laws requirements. Nonetheless, legislations have changed since the 1990s to accommodate this new legal concept.
Close-out Netting in Romania
Romania too has implemented various legislative enactments in order to address the effects of close-out netting in the context of insolvency. This was made gradually, by first introducing in 2004 the concepts of bilateral netting in the context of the insolvency of Romanian credit and financial institutions and of close-out netting in case of financial collateral arrangements entered into between eligible counterparties.
Further amendments to the insolvency legislation were introduced in 2006 in order to make bilateral netting applicable in case of insolvency of entities previously not covered by such regime, and most notably in case of ordinary corporations.
According to Romanian netting legislation, bilateral netting entails (i) termination of a qualified financial contract (i.e. any contract covering operations with derivative financial instruments) / acceleration of a payment or performance of an obligation or exercise of a right under one or several qualified financial contracts, (ii) calculation/estimation of the close-out/market/replacement value, (iii) conversion on the basis of bilateral netting agreement into a single currency, and (iv) determination of a net value by operation of set-off. Furthermore, bilateral netting is an exception to cherry picking and voidable preference through (i) the recognition of bilateral netting as basis of registration of the creditor’s claim against the debtor in the context of the latter’s insolvency, (ii) the recognition of the single net amount, obligation or entitlement, (iii) the fact that no authority may preclude termination or acceleration of qualified financial contracts, and (iv) the inability of the insolvency official or court to void or undo the transactions or the bilateral netting performed on the basis of a qualified financial contract, except for fraud.
Reformation of Romanian Netting Legislation – Insolvency Code Project
Although the main netting principles were implemented in Romanian legislation, further clarifications were deemed necessary in order to secure a clear and unfettered netting regime in both pre-insolvency and insolvency stages.
The reformation of Romanian netting legislation was constantly supported by the International Swaps and Derivatives Association (ISDA), especially lately, in the context of the new Romanian Insolvency Code project, which is meant to encompass and correlate all pre-insolvency and insolvency pieces of legislation.
The draft pre-insolvency and insolvency bill was made available by the Romanian Ministry of Justice on its website for public consultation last September. ISDA was pleased to observe that all its initial proposals seeking to clarify and improve the existing close-out netting regime have been addressed by the draft bill, notably by the incorporation of repo, reverse repo or securities lending agreements in the definition of the qualified financial contract and the specific exemption for bilateral netting operations from the principles according to which, as at the date of the opening of the insolvency proceedings, all on-going agreements are deemed maintained and any contractual clauses providing for the termination of on-going contracts by reason of opening of insolvency proceedings are null and void.
Furthermore, in line with the UNIDROIT Principles on the Operation of Close-out Netting Provisions, the draft bill clearly sets forth as one of its fundamental principles the need of reducing credit risk and systemic risk associated with financial derivatives transactions by recognising the enforceability of close-out netting provisions in the context of the counterparty's pre-insolvency and insolvency, having as a consequence the reduction of the credit risk to a net amount due between the parties, or even to zero where collateral has been transferred to cover the net exposure.
Although the draft bill marks progress for the Romanian netting regime, further amendment and clarification proposals were sent by ISDA during public consultation to the attention of the Romanian Ministry of Justice, with a view to (i) enhancing legal certainty regarding other types of developed products/financial contracts (i.e. buy/sell-back and sell/buy-back transactions), (ii) ensuring the enforceability of close-out netting in the context of pre-insolvency arrangements, in line with the fundamental principle mentioned above, (iii) harmonising the safe-harbour regime for all types of counterparties, and (iv) ensuring a consistent cross-border insolvency treatment in line with European legislation.
According to a recent statement of the Government, the draft bill will be presented to the Romanian Parliament before the end of 2013.
Close-out netting Worldwide - UNIDROIT Harmonisation Efforts
In a diversity of legal regimes, national insolvency laws include several restrictions to the operation of close-out netting. Therefore, harmonisation of netting legislation through an international instrument has become a priority.
In 2010, the General Assembly of UNIDROIT decided that works should be started for the development of an international instrument on netting. UNIDROIT Committee of Governmental Experts was convened in 2012 and 2013 to discuss the principles of the enforceability of close-out netting provisions, the second meeting of which we had the honour to attend.
In May 2013, UNIDROIT Governing Council adopted the Principles on the Operation of Close-out Netting Provisions. Whilst the first 4 Principles deal with the scope of the principles and the definitions of “close-out netting provision”, “eligible party” and “eligible obligation”, Principles 5 to 8 detail the elements which should be taken over by the law of each implementing State in relation to a close-out netting provision, as follows:
- the operation of close-out netting should not be dependent on the performance of any formal act other than the requirement that a close-out netting provision be evidenced in writing or any legally equivalent form (Principle 5)
- a close-out netting provision should be enforceable in accordance with its terms (Principle 6)
- upon the commencement of an insolvency proceeding or in the context of a resolution regime in relation to a party to a close-out netting provision: (i) the operation of close-out netting should not be stayed, (ii) demanding performance of obligations from the other party, while rejecting performance of any obligation owed to the other party should not be possible, (iii) avoidance of the close-out netting provision on the basis of inconsistency with the principle of equal treatment of creditors should not be possible, (iv) subject to fraud, operation of close-out netting should not be restricted on grounds that it was entered into in a prescribed period before the commencement of the proceedings (Principle 7 and the core principle)
- close-out netting principles should apply without prejudice to a stay or other measure which the law of the implementing State, subject to appropriate safeguards, may provide for in the context of resolution regimes for financial institutions (Principle 8).
Due to its beneficial effects on the stability of the financial system, close-out netting is strongly supported worldwide. Moreover, in the context of recent regulatory developments, supervisory authorities, including the Financial Stability Board recognise the need for financial institutions to rely on the enforceability of close-out netting. Hence a harmonisedclose-out netting regime will work to the benefit of all market participants across financial markets. As for Romania, in the context of an increasing number of derivatives transactions, a full implementation of UNIDROIT Principles in Romanian legislation will create legal certainty and be as well an incentive for investors and financial institutions to confidently enter into financial transactions with Romanian counterparties.
Andreea Toma is a Partner with Gide Loyrette Nouel Bucharest and member of the Bucharest Bar. She holds a law degree from Bucharest University School of Law and an LL.M. in International Business Law from Budapest Central European University. She joined Gide Bucharest in 2000. She specialises in banking and finance and has advised IFIs, banks and financial institutions on a broad range of transactions with an emphasis on acquisitions, real estate and project finance. She also has extensive experience in mergers and acquisitions having acted for sellers and purchasers on a wide range of domestic and cross-border deals.
The Banking & Finance practice of Gide Bucharest offers high expertise in advising banks, investors and borrowers on national and cross-border financing transactions. Main areas of expertise cover acquisition, real estate and project finance, derivatives, capital markets, and regulatory issues.
Andreea Toma can be contacted via e-mail at firstname.lastname@example.org or phone at +40 (0)21 223 03 10
Cristina Togan is a Senior Associate with Gide Bucharest and member of the Bucharest Bar. She holds a Masters Degree in European Economics and Finance from Bucharest Academy of Economic Studies and a law degree from Bucharest University School of Law. Prior to joining Gide in 2007, she has worked for six years as in-house lawyer with three leading multinational banks. She specialises in financing deals, corporate banking, derivatives and regulatory issues and has assisted IFIs, banks and financial institutions on a broad range of financing transactions.
Gide Bucharest is the legal adviser to the International Swaps and Derivatives Association (ISDA) for Romania and regularly assists ISDA and its members on derivatives issues.
Cristina Togan can be contacted via e-mail at email@example.com or phone at +40 (0)21 223 03 10