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Derivatives – regulatory driven changes to documentation
Marc Benzler, Habib Motani and Gareth Old
16/17 September 2014
Clifford Chance
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
Introduction
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Timely confirmations
Reporting
Portfolio reconciliation and compression
Dispute resolution
Daily valuation
Margining
EMIR/Dodd Frank
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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
Bank Resolutions (1)
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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
Bank Resolutions (2)
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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
Section 2(a)(iii)
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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?
ISDA Resolution Default Protocol
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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
ISDA Resolution Default Protocol
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Margin for Uncleared Derivatives
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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
US Swap Margin Requirements
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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
US Swap Margin – who has to post?
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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
US Swap Margin – Thresholds for
Financial End-Users
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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)
US Swap Margin – When and what to
post
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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
US Swap Margin – Documentation
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ESAs Consultation Paper on Margin for
Uncleared Derivatives (April 2014)
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Scope: IM Principles: Other Principles: Origin and Timing
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)
VM applies to
physically settled FX
swaps and forwards
(and principal on
currency swaps).
Parties can agree no
IM for these
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
Appears to prohibit
cross-product
margining (IM models
may count risk offsets
within a netting set /
same underlying class)
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
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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
Developments in German law governed
derivatives documentation
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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 close-
out netting
The BGH dismissed the payment claim in its judgment of 15 November 2012
Insolvency-related termination clauses restricting the insolvency representative's cherry-
picking 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
BGH judgment of 15 November 2012 on
insolvency-related termination rights (1)
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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)
BGH judgment of 15 November 2012 on
insolvency-related termination rights (2)
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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
BGH judgment of 22 March 2011 on
CMS Spread Ladder Swaps
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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)
BGH judgment of 3 June 2014 on
disclosure requirements for kick-backs
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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
Regulatory Background
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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
General duties under civil law
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Securities Financing Transactions
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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
Securities Financing Transactions (1)
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Rehypothecation – written agreement
– prior consent
– risk disclosure
– collateral to be transferred to an account in the name of the receiving
counterparty
Securities Financing Transactions (2)
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Contacts
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Marc Benzler Partner, Frankfurt
T: +49 697 199 3304
E: marc.benzler
@cliffordchance.com
Gareth Old Partner, New York
T: +1 212 878 8539
E: gareth.old
@cliffordchance.com
Habib Motani Partner, London
T: +44 20 7006 1718
E: habib.motani
@cliffordchance.com
Clifford Chance, 10 Upper Bank Street, London, E14 5JJ
© Clifford Chance 2014
Clifford Chance LLP is a limited liability partnership registered in England and Wales under number OC323571
Registered office: 10 Upper Bank Street, London, E14 5JJ
We use the word 'partner' to refer to a member of Clifford Chance LLP, or an employee or consultant with equivalent standing and qualifications
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