Marc Benzler, Habib Motani and Gareth Old 16/17 September 2014
Introduction 2
Introduction Developments in Europe and the US Europe overall and specific German issues Major heads of change Dodd Frank/EMIR Resolution Margin Securities Financing Transactions Certain Disclosure Requirements in Germany 3
EMIR/Dodd-Frank 4
EMIR/Dodd Frank Timely confirmations Reporting Portfolio reconciliation and compression Dispute resolution Daily valuation Margining 5
Bank Resolutions 6
Bank Resolutions (1) New crisis management tools for regulators to resolve failing banks Europe BRRD Resolution tools sale of business bridge bank asset separation bail-in US OLA 7
Bank Resolutions (2) BRRD includes power for resolution authority to suspend payments and deliveries (Article 69) to restrict enforcement of security (Article 70) to suspend termination rights (Article 71) until midnight on the business day following publication of notice Also resolution action itself not to be event of default (Article 68) Regulators are looking at what could interfere with the effective implementation of resolution actions Section 2(a)(iii) Resolution Default Protocol 8
Section 2(a)(iii) On occurrence of event of default or potential event of default, non-defaulting party can suspend its own performance Cases regarding timely use of this right and time limit on its use Regulators want to see it used within a given time period or lost Section 2(a)(iii) Amendment Agreement What should the time limit be? - [90] days 9
ISDA Resolution Default Protocol Suspensions or stays intended to cover not only the entity in resolution but also certain affiliates Say you have: NY Law ISDA with US sub of a European parent European parent is credit support provider European parent goes into resolution Article 71(2) resolution authority to have power to suspend termination rights of parties to contracts with the subsidiary How? 10
ISDA Resolution Default Protocol Adhering party agrees to opt-in to the resolution regime applicable to the counterparty and each related entity So your ability to terminate is subject to resolution regime of entity in resolution US Bankruptcy Code: expected regulations requiring giving up cross default rights when certain entities become subject to ordinary insolvency Adhering party agrees not to exercise certain cross default rights if related entity becomes subject to certain insolvency regimes, including US Bankruptcy Code Some conditions relating to credit support 11
Margin for Uncleared Derivatives 12
US Swap Margin Requirements Required by Dodd-Frank Act, following G20 declaration Originally proposed May 2011 Re-proposed September 2014 following BCBS-IOSCO recommendations Five regulators involved: Federal Reserve, FDIC, OCC, SEC and CFTC Expected implementation timetable late 2015/early 2016 Additional provisions for exchange traded derivatives 13
US Swap Margin who has to post? Counterparties to a covered swap entity Covered Swap Entity is an swap entity regulated by a US prudential regulator Swap entity is any entity that meets definition of SD, SBSD, MSP or MSBSP Financial end-users bank, regulated financial entity, investment company, securitization issuer, investment pool (including REITs) Anyone else if covered swap entity considers appropriate 14
US Swap Margin Thresholds for Financial End-Users Initial margin (IM) or independent amounts must be posted to and collected from a covered swap entity if the Financial End- User is above two thresholds USD 3 billion (US) in total notional; and USD 65 million in required IM Variation margin (VM), or market-to-market collateral must be posted and collected Minimum transfer amount $650,000 15
US Swap Margin When and what to post Margin is required under any swap except physically settled FX forwards and swaps (but see Fed supervisory guidance) No frontloading, but all outstanding swaps under a Master Netting Agreement will be subject to margin requirements after effective date VM: Must be in cash No haircuts apply Collected at least daily IM: Cash, gold, Treasuries, certain securities Any IM collected from a covered swap entity is subject to segregation requirements (even if IM is not required by rule) IM posted to a covered swap entity is not required to be segregated Can only be netted in broad categories (agricultural commodities, energy commodities, metals and other commodities, credit, equity, currency and rates) 16
US Swap Margin Documentation Documentation covering requirement for IM and VM, valuation, eligible collateral, dispute resolution Custody/segregation requirements (especially for IM received from covered swap entity) Master netting agreement only means of netting VM covered swap entity must have well-founded basis that agreement is enforceable in bankruptcy 17
ESAs Consultation Paper on Margin for Uncleared Derivatives (April 2014) Origin and Timing Scope: IM Principles: Other Principles: Based on BCBS- IOSCO Final Framework Initial start date: 1 December 2015. Phase-in over 3 year period Rules will apply to new trades only Covered entities: FC s and NFC+s Must collect margin from all their counterparties except NFC-, exempt entities and covered bond issuers But including all non- EU counterparties (subject to 8bn threshold) Two-way exchange of IM with a segregation requirement IM to cover full potential future exposure Using standardised approach or approved internal models No rehypothecation of IM VM collected at least on a daily basis starting from business day following execution of contract Can agree bilaterally to a minimum transfer amount of up to EUR 500,000 VM applies to physically settled FX swaps and forwards (and principal on currency swaps). Parties can agree no IM for these Appears to prohibit cross-product margining (IM models may count risk offsets within a netting set / same underlying class) 18
Germany 19
Developments in German law governed derivatives documentation Clearing Framework Agreement (Clearing-Rahmenvereinbarung) Governs the relationship between CM and Client (Rulebook prevails in any event) Additional provisions for exchange traded derivatives Eurex-Annex Modifies the CRV with respect to the Individual Clearing Model LCH-Annex Modifies the CRV with respect to LCH including the Clearing House Prescribed Language Central Counterparty Annex to German Master Agreement for Financial Derivatives Transactions Addresses submission to clearing of DRV governed transactions and de-clearing EMIR-Annex Assists in maintaining EMIR compliance, in particular risk management for non-cleared derivatives Developments regarding investment funds Exchange traded derivatives are now also covered by the exemption for netting, set-off and margin 20
BGH judgment of 15 November 2012 on insolvency-related termination rights (1) Summary According to Germany's Federal Supreme Court (Bundesgerichtshof, "BGH"), early termination provisions which exclude the ʺcherry-pickingʺ right of a German insolvency representative in respect of mutual contracts under section 103 of the German Insolvency Code (Insolvenzordnung, ʺInsOʺ) are void under section 119 InsO While the judgment concerned a contract for the supply of energy, the BGH's decision has wider implications which generally affect early termination provisions and in particular closeout netting The BGH dismissed the payment claim in its judgment of 15 November 2012 Insolvency-related termination clauses restricting the insolvency representative's cherrypicking right (section 103 InsO) are invalid (section 119 InsO) Insolvency-related termination clauses are termination rights based on: (1) a stoppage of payments (Zahlungseinstellung), (2) the filing of an application for the opening of insolvency proceedings or (3) the opening of insolvency proceedings According to the BGH, this would not apply if the contractual termination clause corresponds to a statutory exemption which provides for an early termination upon a party's insolvency The judgment does not apply to termination clauses which are based on defaults in general such as a failure to deliver or perform or breach of contract 21
BGH judgment of 15 November 2012 on insolvency-related termination rights (2) Impact of the statutory close-out netting provision under section 104 InsO Section 104 InsO is mandatory law and prevails over contractual arrangements While the BGH did not mention section 104 InsO, we understand that section 104 InsO as a statutory netting provision qualifies as a statutory exemption and any contractual early termination and netting agreements which include transactions covered by section 104 InsO should not be void under section 119 InsO As a consequence, not only the timing of the early termination right is decisive but also whether or not the relevant transactions subject to the contractual netting agreement qualify either as fixed date transactions (Fixgeschäft) or financial transactions (Finanzleistungen), both terms as referred to in section 104 para. 1 or para. 2 InsO respectively If based on the application of section 104 InsO, contractual netting agreements are enforceable in an insolvency, the valuation of the terminated transactions should also be determined as agreed between the parties If not, section 104 para. 3 InsO applies which provides for generic principles for valuation and calculation at the relevant market or exchange price on any date within 5 working days upon the opening of insolvency proceedings determined by the parties. Where parties fail to reach an agreement on the date, the prices applicable on the second working day following the opening of insolvency proceedings prevail To summarise, no changes to documentation required (but legal assessment whether in or out of scope of section 104 InsO is essential) 22
BGH judgment of 22 March 2011 on CMS Spread Ladder Swaps High disclosure standards to discharge duty of care under an investment advisory agreement Existing knowledge or experience does not permit a conclusion in relation to the customer s willingness to take risks Information on unlimited risks (not to be designated that this is of a theoretical nature but rather that this depends on developments of the spread which may become real and ruinous ) Bank needs to ensure customer s knowledge and information of the risk profile of the relevant product is substantially at the same level as the bank s own knowledge and information Specific disclosure of initial negative market value of swap (also based on a (potential) conflict of interest caused by the bank s hedging activities) No information that the bank entered into the transaction with the intention to make profits need to be provided To summarise, increased requirements for documentation and client related disclosure 23
BGH judgment of 3 June 2014 on disclosure requirements for kick-backs Duty under advisory agreement to disclose any kick-backs paid under displayed distinction fees But until recently unclear whether hidden commissions need to be disclosed as well From 1 August 2014 duty to disclose also hidden commissions under an advisory agreement (a distinction between the various forms of kick-backs is no longer being made) In its reasoning the BGH refers to a multiple of more or less recent regulatory developments aiming at increasing transparency which in the BGH s view establish generally applicable principles Open issues: Only if investment advisor relationship? Regulatory transparency requirement applicable with the relevant relationship? Disclosure requirement also for profit component? BGH clarified that irrespective of its reference to regulatory developments the duties of care under civil law have to be treated separately from regulatory requirements (no breach of contract under civil law if (public law) regulatory requirements are violated) 24
Regulatory Background MiFID requirements Fully implemented but likely not giving rise to investors claims (regulatory provisions serve generally public interests only but see BGH decision of 3 June 2014) Additional requirements (for retail clients) Requirement to keep detailed written records of advice (Beratungsprotokoll) 34 (2a) WpHG Product Information Sheet 31 (3a) WpHG Recommendation of suitable instruments only 31 (4a) WpHG Eligibility requirements for sales persons 34d WpHG Comprehensive disclosure obligation with respect to inducement for third parties if non-fee based investment advisory relationship Fee-based Investment Advice Act No kick-backs etc. from third parties Diversified portfolio of offered instruments Organisational separation from any other activities if also non-fee based investment advisory services are affected Assets Investment Act Information Sheet / Prospectus Requirements Extension of definition financial instruments Enforcement action by BaFin 25
General duties under civil law Investment advisory agreement / relationship May be entered by implicit conduct E.g. bank publishes (or makes statements which are construed as or deemed to be) individual recommendations Applies irrespective of client categorisation under MiFID Duty of care Investor-related advice Know your customer (financial situation, investment profits, personal knowledge and experience) Object-related advice Specific risks and characteristics of the investment Examples: Verification of sales material Monitoring of financial news Information duty regarding legal requirements / limitations 26
Securities Financing Transactions 27
Securities Financing Transactions (1) FSB Policy Framework for addressing shadow banking risks in securities lending and repos (August 2013) European Commission Proposed Regulation on reporting and transparency of securities financing transactions (January 2014) What are SFTs? securities lending and borrowing transactions repos and reverse repos buy sell backs and sell buy backs transactions having an equivalent economic effect Reporting to trade repositories Disclosure to fund investors in fund manager reports prospectuses: policies, criteria, limits etc 28
Securities Financing Transactions (2) Rehypothecation written agreement prior consent risk disclosure collateral to be transferred to an account in the name of the receiving counterparty 29
Contacts Marc Benzler Partner, Frankfurt T: +49 697 199 3304 E: marc.benzler @cliffordchance.com Habib Motani Partner, London T: +44 20 7006 1718 E: habib.motani @cliffordchance.com Gareth Old Partner, New York T: +1 212 878 8539 E: gareth.old @cliffordchance.com 30
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