Article by Clinton Van Loggerenberg and Shawn Barnett

Globalisation and the rapid expansion of international trade has highlighted the need for uniform and consistent insolvency legislation across international markets. South Africa will take a further step towards such international best practice with the passing of the Judicial Matters Second Amendment Bill making provision for certain technical changes to Section 35B of the Insolvency Act.

There is an inherent tension between set-off and the provisions of many jurisdictions’ insolvency regimes which often provide for a "freezing" of estates upon insolvency. In this regard South Africa is no exception. In terms of South African insolvency law, the liquidator of an insolvent estate may elect to have any set-off which occurred up to 6 (six) months prior to insolvency set aside, in circumstances where such set-off did not occur within the ordinary course of business. In addition, upon insolvency, the insolvent estate vests in the liquidator, with no set-off being possible in respect of any debt owing between the insolvent and creditors. The only exception to this general prohibition against post-insolvency set-off, is contained in Section 35B of the Insolvency Act. Section 35B provides for post-insolvency set-off in respect of certain types of "agreements". The definition of "agreement" in Section 35B has been the subject of much debate, and can hardly be regarded as having a clear and accepted meaning. The memorandum which originally introduced Section 35B referred to the Section as being designed to protect the financial markets and financial market participants. This aim was to be achieved by defining "agreement" as including only those agreements for the delivery, exchange, settlement or payment of certain specific currencies, indices, instruments or commodities. Any agreement in respect of assets not listed in Section 35B does not qualify for post-insolvency set-off. Various views have developed over the years as to how Section 35B should be interpreted. Some market participants favoured a literal approach (including all agreements for the future delivery, exchange, settlement or payment of permissible assets, notwithstanding the nature of the transaction), while others favoured a more purposive approach focusing on whether the agreement in question is of the type originally intended to be covered by the Section (i.e. transactions on the information financial markets).

The uncertainty surrounding the interpretation of Section 35B has lead to many market participants not being able to reflect their counterparty positions on a net basis, and consequently having less scope to effect further transactions with certain counterparties. In addition, uncertainty surrounding the enforceability of certain collateral arrangements and the interaction between collateral arrangements and Section 35B, has left the South African financial markets in dire need of reform. The International Swaps and Derivatives Associations, Inc ("ISDA") has, for many years, been involved in the promotion of law reform in many jurisdictions, with the aim of ensuring that the netting provisions of the documentation which is most commonly used in the privately negotiated derivative markets are enforceable. ISDA has also become a driving force behind the clarification and, to the extent possible, standardisation of the laws applicable to collateral arrangements commonly used in international financial transactions. ISDA documentation has become widely used in South Africa and, together with the South African collateral and netting opinions, confirmed the need for legislative intervention to clarify the South African position in respect of post-insolvency set-off.

This intervention will come shortly with the passing of the Judicial Matters Second Amendment Bill. The Bill substitutes the current Section 35B of the Insolvency Act with a new Section 35B. The new Section 35B will contain an amended definition of "agreement", which if passed into law in its current form, will widen the type of transactions capable of post-insolvency set-off. For purposes of the new Section 35B, "agreement" will include any agreement which provides, upon the insolvency of a party to that agreement, for all unperformed obligations to be terminated, valued and set-off. Accordingly, "agreement" is defined based on whether the parties to such agreement have specifically provided for set-off and not with reference to the specific obligations in respect of specific underlying assets. The new Section 35B also specifically provides that security arrangements effected by way of a title transfer as an obligation capable of post-insolvency set-off (pledges and cessions in security are however excluded). Upon the amended Section 35B being passed into law, it will be important for parties to any agreement to include close-out set-off provisions in their agreements, especially in circumstances where various agreements are entered into between the same counterparties, or collateral arrangements are put in place.

The new Section 35B is indeed a significant amendment to South African insolvency law, but must be considered in the light of international developments. A number of jurisdictions have adopted laws that protect the enforceability of netting and set-off agreements upon the insolvency of one of the parties. Netting legislation, which began in the United States, has spread to other jurisdictions throughout the world and continues to do so. Since 1989, laws expressly protecting the enforceability of set-off for privately negotiated derivative transactions in local insolvency proceedings have been enacted in many jurisdictions, including Belgium, Canada, the Cayman Islands, Denmark, France, Germany, Ireland, Luxembourg, Sweden and Switzerland. However, what is notable about international netting legislation is that the validity of post-insolvency set-off often only applies to certain specified types of transactions. Those specified transactions are described in a list of enumerated transactions. The new Section 35B is however wider, and is not, as its predecessor, limited to specified types of transactions, but to all transactions specifically providing for the termination and post insolvency set-off of unperformed obligations. With South Africa increasingly becoming part of a larger global community and attempting to attract international trade, it is vital for local insolvency laws to adhere to international best practices. Further, clear netting and set-off legislation provides additional benefits to banks, insofar as banks, can, in terms of the second Basle Accord, rely on set-off in calculating their credit exposures for capital adequacy purposes. However, in order to rely on set-off for capital adequacy purposes, banks must obtain legal opinions confirming that the set-off arrangement will be upheld in all relevant jurisdictions. Obtaining such opinions will be greatly simplified in circumstances where clear unambiguous legislation is in place.

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.