Derivative traders last month breathed a collective sigh of relief as the draft Companies Amendment Bill (the "Amendment Bill") confirmed that derivative trades will be safe during business rescue proceedings. If passed in its present form, the Amendment Bill will end months of debate regarding the powers of a business rescue practioner to interfere with netting, set-off and close-out of derivative transactions.
It has now been made clear that exchange-traded derivatives and over-the-counter derivative transactions concluded under Master Agreements are thankfully still safe from interference by business rescue practioners.
Trades under a Master Agreement like the 2002 ISDA (the International Swaps and Derivatives Association Inc. Agreement) ("Master Agreements") are safe from the clutches of a business rescue practioner.
Most of us are aware of the far-reaching powers which the first draft of the new Companies Act conferred on a business rescue practioner. He or she could cancel or suspend any provision of an agreement to which a company in financial distress was a party. One exception to this rule was an agreement of employment. The second exception was ambiguously drafted and seemed to cover Master Agreements as contemplated in Section 35B and exchange-traded derivatives that fall within Section 35A of the Insolvency Act, 1936. The intention of the legislature was not entirely clear, although it was believed that these transactions were meant to be safe from suspension or cancellation during business rescue proceedings. This controversial issue has now been resolved by the new, re-drafted wording found in the Amendment Bill.
The Insolvency Issues – Why the Debate?
When Section 35B of the Insolvency Act was amended in March 2005, the effect was to preserve pre- and post-insolvency netting and set-off provisions contained in the Master Agreements which govern over-the-counter derivative transactions in South Africa. Section 35B carves out the derivative transactions executed under these Master Agreements so that any netting which had taken place pre-insolvency would not be subject to the Insolvency Act's provisions relating to voidable dispositions, voidable preferences and undue preferences. The liquidator would have to abide by the netting and set-off provisions of the Master Agreements. Furthermore, upon insolvency, all unperformed obligations under the Master Agreements terminate automatically, the values of the unperformed obligations are determined at market value and set-off, and a net amount is payable. Similarly, Section 35A preserves all pre-insolvency set-off, netting and close-outs of positions concluded on a stock exchange in terms of the rules of that exchange, and all such set-offs, netting and close-outs are binding on a liquidator upon insolvency.
The debate arose when the first draft of the new Companies Act was published. It seemed to blur the distinction between liquidation and pre-insolvency proceedings like business rescue.
Under the first draft of the new Companies Act, the fear was that "cherry-picking" by the practioner would be allowed and would lead to increased systemic market risk.
Firstly, the powers of the business rescue practioner have been curtailed so that the business rescue practioner may only suspend, for the duration of the business rescue proceedings, obligations arising under an agreement to which the financially distressed company is a party at the beginning of the business rescue proceedings.
The business rescue practioner may only cancel agreements as approved by the court upon urgent application, and on terms that are just and reasonable.
The most significant improvement relevant to the derivatives market in South Africa is that Section 136(2A) has been inserted and unambiguously states as follows:
"When acting in terms of subsection (2) –
(a) a business rescue practioner must not suspend any provision of –
(i) an employment contract; or
(ii) an agreement to which section 35A or 35B of the Insolvency Act, 1936 (Act No. 24 of 1936) applies."
By referring to an agreement to which Section 35A and Section 35B applies, the legislature has made it clear that business rescue and insolvency proceedings are two separate and distinct processes. The new wording also renders obsolete the contention that the new Companies Act would trump the Insolvency Act. Clearly then, netting, set-off and close-out under Master Agreements as defined in Section 35B and transactions concluded on exchange as contemplated by Section 35A will be excluded from the business rescue practioner's far-reaching powers.
The same conclusions apply to repurchase and reverse repurchase transactions concluded under the GMRA (Global Master Repurchase Agreement) and securities lending transactions concluded and under the GMSLA (Global Master Securities Lending Agreement).
What to Expect?
Our view is that the intention of the legislature was always to exclude Master Agreements and their corresponding collateral arrangements from the business rescue practioners' powers and to preserve the provisions of the Master Agreements and the trades concluded on exchange despite one party becoming financially distressed and subject to business rescue proceedings. Clarifying amendments have now been published in the much anticipated Draft Companies Amendment Bill released on 19 July 2010 which confirm this view. In our opinion, the Amendment Bill, insofar as it relates to Section 136, should be enacted in its current form. This way the integrity of the pre- and post-insolvency netting provisions of the Master Agreements such as the ISDA, GMRA and GMSLA will be preserved, and trades concluded on exchange will still be closed-out and netted according to the rules of that exchange.
This article first appeared on www.financierworldwide.com.© 2010 Financier Worldwide Limited
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