8 th DICJ Round Table March 25, 2015 Resolution of SIFIs and Handling of Derivative Transactions Under Japanese Law: Past, Present, and Future Akihiro Wani Ito & Mitomi (Registered Associated Offices of Morrison & Foerster LLP) mofo.com
I. Close-out Netting and Japanese Law a. What is close-out netting? A calculation procedure of derivative transactions when a party to the transactions goes into insolvency proceedings. a procedure by which, upon occurrence of a Close-out Event (i.e., the filing of a petition with a court to commence the insolvency proceeding) with respect to a party to the Specified Financial Transactions (i.e., derivative transactions) entered into under a Master Agreement and regardless of both parties intentions, the value at such occurrence of each of the Specified Financial Transactions under the Master Agreement shall be computed in accordance with the provisions of Ministerial Ordinance of the Prime Minister s Office, and the aggregate net balance shall become a single claim or obligation arising between the parties. (Article 2, paragraph 6, the Netting Act, as defined below.) 2
In short, the close-out netting procedure is the mechanism to evaluate the present value of the outstanding payment obligations of the parties under the derivative transactions such as swaps and options and the net such value of all the obligations so that one single payment obligation will be created. This unwinding procedure is not specific to derivative transactions but is widely used to liquidate the repurchase (repo) or securities lending transactions between the parties. In Japan, the enforceability of the close-out netting of derivative transactions has been recognized as market practice since rather earlier stage when 1987 Master Agreement (Interest Rate and Currency Exchange Agreement) was introduced, based on the set-off provision of the Civil Code or Article 61 of the former Bankruptcy Code (i.e., mandatory set-off provision of listed products in case of the commencement of insolvency proceedings). Now Japan has statutory provisions recognizing the enforceability of the close-out netting: The Act on Close-out Netting of Specified Financial Transactions by Financial Institutions, etc. (the Netting Act ) Article 58 of the Bankruptcy Code 3
b. Automatic Early Termination (the AET) Under the Japanese system the close-out netting is designed to be automatically triggered upon the occurrence of the insolvency of a party. The AET seems to have been imported from Germany a long time ago and the use of the AET is an established practice in commercial transactions in Japan. Issue: The AET may trigger the systemic risks in case of the insolvency of the large financial institutions (SIFIs). 4
II. Prehistory Crisis of Financial Institutions in the late 90 s a. A time of chaos and confusion: The Bank of Japan s Special Loan to insolvent financial institutions was the only tool to prevent the systemic risks. After the grant of the loan by the Bank of Japan, such failing institutions were liquidated according to the procedures of the Commercial Code by discharging their obligations fully. There was no special legislation to take care of the insolvency of the financial institutions. cf. http://www.bis.org/publ/bppdf/bispap06.pdf 5
1. Sanyo Securities Co., Ltd. (November 3, 1997) One of the up-and-coming securities companies at that time. The freezing order issued by a court upon the filing of the application for the commencement of the corporate reorganization proceedings did not exclude the repayment of loans by Sanyo Securities borrowed in the short-term money market; this caused defaults. 6
2. The Hokkaido Takushoku Bank, Ltd. (November 15, 1997) The Hokkaido Takushoku Bank, then one of the city s major banks which had incurred severe losses due to non-performing loans (NPLs) linked to real estate investments, became unable to raise enough funds for its operation in the short-term money market due to the default by Sanyo Securities. Special insolvency proceedings for banks had yet to be legislated. The systemic risk was the biggest concern for the regulators. The Hokkaido Takushoku Bank transferred its business to the Hokuyo Bank Ltd., a regional bank, and Chuo Trust Bank (now Sumitomo Mitsui Trust Bank, Limited) and the Bank of Japan granted special loans to the Hokkaido Takushoku Bank. 7
3. Yamaichi Securities Co., Ltd. (November 24, 1997) Yamaichi Securities, which was one of the Big Four securities companies in Japan at the time, incurred heavy losses due to undisclosed off-balance transactions and could not obtain enough funding from its main bank, and therefore entered into voluntary dissolution procedures, which finally changed into bankruptcy proceedings. 8
b. The emergence of the Financial Rehabilitation Act (the FRA) This Act passed the Diet just one week, before the Long-Term Credit Bank of Japan (LTCB) failed. The Act introduced, among other measures to rescue the troubled large banks, temporary nationalization where the failing bank is nationalized by the Government of Japan and all the existing shareholders may be divested of their shares without any compensation. However, under the Act, the claims of the creditors such as bondholders and loan lenders were left untouched. The Act also introduced the procedures of capital injection by the government to a not-yet-insolvent bank and the grant of the financial assistance to failing or already insolvent banks in an amount exceeding the pay-out costs. 9
c. FRA Days 1. LTCB (October 23, 1998) LTCB was one of Japan s major banks and had a wide range of domestic and international operations. Due to the increase of NPLs and failures of attempts to merge with other financial institutions, LTCB was temporarily nationalized under the FRA, the government injected JPY 11,700,000,000,000, and the ultimate final loss is said to be approximately JPY 5,000,000,000,000. LTCB is now rehabilitated as Shinsei Bank, Limited. 10
2. The Nippon Credit Bank, Limited. (December 13, 1998) The Nippon Credit Bank, Limited (NCB), which had domestic and international operations, also suffered from NPLs and loans to non-bank institutions. After an investigation by the FSA, a JPY 270,000,000,000 deficit was found and the bank became temporarily nationalized pursuant to the FRA. The government injected JPY 5,400,000,000,000, and the ultimate final loss is said to be approximately JPY 3,800,000,000,000. NCB is now rehabilitated as Aozora Bank, Ltd. 11
c. What did we do in the LTCB case? A small case study 1. AET under the ISDA Master Agreement Under Japanese practice, the AET of transactions upon filing for the commencement of insolvency proceedings, such as bankruptcy proceedings or corporate reorganization proceedings, has been generally adopted. The documentation of the ISDA Master Agreement follows such practices and Automatic Early Termination is generally chosen with regard to a Bankruptcy event (Section 5(a)(viii)). If the Temporary Nationalization under the FRA could be characterized as a Bankruptcy event, then AET of derivative transactions would take place. Judging by the size of the LTCB, the systemic risk was easily envisaged. 12
The issues 1) Although 1992 ISDA Master Agreement was already published, 1987 ISDA Master Agreement was prevalent in the market. 2) 1987 ISDA Master Agreement adopts the AET broadly. 3) How to argue that the AET was not triggered? i) Do the procedures under the FRA constitute a Bankruptcy under the ISDA Master Agreement? Issue: At least the current management would be ousted, although the creditors rights will not be affected. ii) Implied waiver by the Non-defaulting Party of the AET followed by implied consent by the Defaulting Party to continue the Transactions. Issue: Too artificial. After a long discussion, ISDA Tokyo recommended approach (ii). 13
2. ISDA ISDA identified the problems of AET from an early stage when the draft FRA was discussed in the Diet. A big meeting for ISDA s members called Tokyo Update was scheduled to take place in Tokyo on October 22, 1998, just one day before the expected commencement of the Temporary Nationalization, and ISDA decided to use the meeting as a place to address the market so as not to trigger the AET clause of the ISDA Master Agreement. 14
3. The Bank of Japan (the BoJ) The BoJ was also aware of the problems with the AET. Almost one week before the Tokyo Update, the BoJ and ISDA agreed to work together to improve the situation. The BoJ confirmed that the safety net of deposit insurance would be maintained, and that the BoJ would make every effort to avoid systemic risks. 15
4. Japanese Bankers Association On October 20, meeting of the Derivative Working Group was held which the BoJ, the Financial Supervisory Agency (not the Financial Services Agency yet), and the Ministry of Finance attended and at which they announced their intention not to allow the financial institutions to trigger the AET, in order to avoid any systemic risk. 16
5. On October 23, the day of the Temporary Nationalization i. An interview with the ISDA s General Counsel, welcoming the application of the Temporary Nationalization to LTCB to stabilize the market concerns, was released. ii. iii. iv. The comments by the Governor of the BoJ trying to stabilize market concerns were released. The comments by the President of the Japanese Bankers Association welcoming the application of the Temporary Nationalization of LTCB were released. The Prime Minister released his comments trying to stabilize market concerns upon application of the Temporary Nationalization. v. The Financial Supervisory Agency held a session for non-japanese financial institutions in Tokyo to explain the Temporary Nationalization of LTCB and to encourage them to avoid early termination of the ISDA Master Agreement with LTCB. vi. No termination of the ISDA Master Agreements with LTCB took place and no systemic risk took place. 17
6. The Day After The FRA was incorporated into the current Deposit Insurance Act (the DIA) in 2000. Japan has not experienced insolvency proceedings with respect to a large financial institution like LTCB, which institution could cause the systemic risk only by its insolvency. Further, Japanese financial market was relatively calm even during the Lehman Shock: Lehman Japanese entity was subject to the Civil Rehabilitation Proceedings, but its impact was not uncontrollable by market players. So the stay of the AET/Close-out Netting from the viewpoint of the prevention of the systemic risk was rarely discussed. 18
III. 2013 Amendments to the DIA Based on 2008 G20 Pittsburgh Protocol a. Countermeasures learned from Lehman crisis 1. Introduction of new tools to prevent systemic risks caused by derivative transactions which are provided in the Financial Instruments and Exchange Act Central Counterparty (CCP) Repository Swap Execution Facility (Electronic Trading Platform) 2. Recovery and Resolution Plan Key Attributes of Effective Resolution Regimes for Financial Intitutions by the Financial Stability Board (October 2011, updated 15 October 2014, endorsed by the G20 at Cannes, the Key Attributes ) 19
b. Amendments to the DIA The DIA was amended in 2013 to reflect the recommendations of the Key Attributes. Adoption of Recovery and Resolution Plan In addition to banks, the DIA covers financial instruments business operators (securities companies), insurance companies, and Japanese branches of foreign banks, securities companies and insurers, financial holding companies, etc., experiencing difficulties. CCPs are not covered. The Prime Minister may take any necessary measures to recover or resolve a troubled financial institution. The Prime Minister has the authority to suspend the application of any termination provisions of certain financial agreements (including the AET of the ISDA Master Agreement) (the Stay ), together with the application of the close-out netting provisions under the Netting Act, the Bankruptcy Code, the Corporate Reorganization Act, and the Civil Rehabilitation Act for a period the Prime Minister so designates. The Stay order will be issued before a troubled financial institution goes into an insolvency proceeding. 20
If there were an event of default not related to the recovery and resolution of a troubled financial institution, such as Failure to Pay or Deliver, the counterparty could still close out the Transactions in accordance with the relevant close-out netting provisions. However such events of default caused as the result of the Stay order are also subject to the Stay effect of the same order. The Stay is designed to enable a troubled financial institution to transfer its assets to an acquiring financial institution or to a bridge financial institution, both of which must be solvent financial institutions. Therefore, when the Stay period expires, such Transactions of the troubled financial institution will have been transferred to the acquiring financial institution or the bridge financial institution, which will continue to perform the obligations under the Transactions. So there is no room to argue that an Event of Default or the AET has taken place when the Stay period expires. The amendments to the DIA will not affect the enforceability of the close-out netting under Japanese law. The DIA does not provide any limit on the length of the Stay period, but the FSA says that it will make its best efforts to limit the period to up to two Business Days in Japan. 21
IV. ISDA 2014 Resolution Stay Protocol a. Purpose Stay effect by the resolution authority in one jurisdiction cannot become automatically enforceable in other jurisdictions in a crossborder resolution. Why not achieve the cross-border application through the private agreement between the parties to the ISDA Master? b. Protocol Adherence is required. http://assets.isda.org/media/8253b540-25/958e4aed.pdf/ 22
i) Section 1 Special Resolution Regimes (SRR) Adhering parties agree to opt in to the resolution regime applicable to their Counterparty and each Related Entity (Credit Support Provider, Specified Entity, and certain parent entities) of their Counterparty, if the Counterparty or Related Entity becomes subject to proceedings under certain resolution regimes to the same extent as though their ISDA Master Agreement were governed by the laws of that resolution regime. Therefore, a Party s ability to exercise close-out netting is subject to the resolution regime applicable to the entity in resolution, including any stays on the exercise of Direct Defaults or Cross-defaults. 23
Applicable existing Resolution Regimes: France, Germany, Japan, Switzerland, UK and U.S. Protocol-eligible Regimes: Newly created regimes in other FSB jurisdictions provided they meet the requirements under the Protocol: Argentina, Australia, Brazil, Canada, China, Hong Kong, India, Indonesia, Italy, Mexico, Netherlands, Republic of Korea, Russia, Saudi Arabia, Singapore, South Africa, Spain, and Turkey If an Adhearing Party or a Related Entity of an Adhearing Party becomes subject to resolution under an SRR, the Non-defaulting Counterparty may exercise its Default Rights in respect of a Covered ISDA Master Agreement or related credit enhancement to the extent it could do so under the SRR if the ISDA Master Agreement or credit enhancement were governed by the laws of the jurisdiction of the SRR. The transfer of a covered ISDA Master Agreement or related credit enhancement to a successor of the Party in resolution will be effective to the same extent that a transfer would be if the ISDA Master Agreement or Credit Enhancement were governed by the laws of the jurisdiction of the SRR. 24
ii) Section 2 U.S. Insolvency Proceedings U.S. has not yet introduced any regulation to require counterparties of certain banking groups to give up certain Cross-default and Direct Default rights arising because certain entities become subject to proceedings under certain ordinary insolvency proceedings. Under Section 2 of the Protocol, adhering parties agree not to exercise certain Cross-default and Direct Default rights under the ISDA Master Agreement if an Affiliate (including a parent) of their Counterparty becomes subject to certain insolvency regimes, including the U.S. Bankruptcy Code and Federal Deposit Insurance Act. 25
iii) Japanese Annex Section 1(a) (Opt-in to Special Resolution Regimes) will not apply, unless the Japanese Resolution Authority, Prime Minister, or Minister of Financial Services issues a public statement that: (a) the Covered Master Agreement and any related Credit Enhancements, as applicable, will be transferred to a successor; or (b) the duration of any temporary stay on Default Rights imposed by the Japanese Resolution Authority with respect to the Covered Master Agreement and any related Credit Enhancements, as applicable, will not exceed two Business Days in Japan. In Paragraph (b), the Japanese Government commits to limit the Stay period to up to two Business Days, although it is a little bit difficult to read the text in such a way. 26
iv) Stay and Transactions with CCP Under the DIA, the clearing transactions with a CCP will be subject to the Stay. Under the DIA, the Stay will be applied to various transactions referring to or linking to listed products or other products with market prices, and both or any of the parties to such transactions are financial institutions. Therefore, the clearing transactions with a CCP will be subject to the Stay. It appears that the Protocol does not care the clearinghouse transactions, as such transactions are not made under the ISDA Master Agreement. However, this also does not apply to the Japanese CCP for the OTC derivatives transactions (i.e. Japan Securities Clearing Corporation, JSCC), because clearing transactions between a clearinghouse member and JSCC are formed by referring to ISDA Master Agreement. Although JSCC does not adhere the Protocol, if adheres, the Protocol can extend to a case where non-japanese clearinghouse member is subject to an insolvency/resolution proceedings in its home jurisdiction. 27
V. Way Forward The Stay is a temporary measure to avoid the clear and present systemic risks in front of us caused by a failing financial institution. To achieve a successful recovery or resolution procedure, day-to-day monitoring of the financial institutions by the regulators will be necessary ( Inspect, Eject, and Inject ). - End - 28