In a decision of 9 June 2016, the German Federal Court of
Justice (Bundesgerichtshof, "BGH") has ruled
that the determination of the close-out amount in a netting
provision based on the German Master Agreement for Financial
Derivatives Transactions (Rahmenvertrag für
Finanztermingeschäfte or DRV) is not legally effective in
the event of insolvency to the extent that it deviates from section
104 of the German Insolvency Code.
The reasoning of the decision has now been published and
provides a number of answers to questions which are important for
future contractual netting arrangements.
Choice of law is decisive
Generally, the effects of insolvency proceedings on agreements
are governed by the law of the country where the proceedings are
opened. In the case adjudicated by the BGH, the insolvent party was
a Lehman entity which was subject to administration proceedings
under English law before the High Court of Justice in London. With
respect to netting agreements, however, an exception applies under
the German laws implementing the relevant EU Directive.1
The effects of insolvency proceedings are governed by the law which
governs the netting agreement, as was now confirmed by the BGH. In
the case at hand, the netting agreement was governed by German law
so that German insolvency law applied. In other words, the
parties' choice of law when entering into the derivatives
transaction, also determines the insolvency law applicable to the
agreement if one of the parties fails.
Contractual close-out netting is ineffective to the extent it
deviates from statutory law
The netting provision in the stock option agreement which was
based on the German Master Agreement for Financial Derivatives
Transactions in the case at hand, provided for the stock option
agreement to terminate as soon as one of the parties filed for
insolvency. In addition, it provided for a method of determining
the close-out amount, which looked at market prices on the date of
the insolvency application and capped the amount payable to the
insolvent party's estate in the event that the early
termination of the stock option agreement was beneficial to the
The effects of insolvency proceedings on financial derivatives
transactions such as the stock option agreement, are governed by
section 104 of the German Insolvency Code. It provides for a
termination of such transactions upon the opening of insolvency
proceedings, and that the parties may agree on a point in time for
the determination of the close-out amount, as long as that time is
no later than five business days after the opening of the
insolvency proceeding. If the parties did not agree on a date for
the determination of the close-out amount that is after the opening
of insolvency proceedings, then the second business day after the
opening applies. The amount payable to the insolvent party's
estate in the event that the early termination of the financial
transaction turned out to be beneficial to the solvent party, is
determined by looking at the difference between the agreed price
and the market or stock exchange price prevailing at a point in
time agreed by the parties. It is, however not capped.
The BGH did not decide the question as to whether the
contractual netting provision was ineffective to the extent that it
provided for a termination at the time the insolvency petition was
filed, while section 104 terminates the financial transaction at
the (later) time of the opening of the insolvency proceeding. The
court did, however, rule that the netting provision was ineffective
to the extent that it deviated from the method and time of
determining the close-out amount provided for in section 104.
Amendment of the Law?
On 9 June 2016, the German Ministry of Finance and the German
Ministry of Justice issued a joint statement in relation to the
judgement. It says that, in case the judgement will have a broader
impact on the acceptance of the commonly used master agreements in
the marketplace and by the supervisory authorities, the German
government will immediately initiate a change of the relevant
insolvency law provisions in order to ensure that master agreements
remain accepted in the market. Our initial view is that we would
expect such an amendment to be made soon.
1. Art. 25 of the Directive 2001/24/EC of the European
Parliament and of the Council of 4 April 2001 on the reorganisation
and the winding-up of credit institutions.
The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.
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