United States: Federal Reserve Board Restricts QFC Cancellation Rights

The Board of Governors of the Federal Reserve System ("FRB") adopted a new rule (the "final rule") that requires U.S. global systemically important banking institutions ("GSIBs"), all GSIB subsidiaries (other than certain subsidiaries regulated by the OCC) and the U.S. operations of foreign GSIBs to amend qualified financial contracts ("QFCs") so that they cannot be cancelled immediately in the event of bankruptcy or a resolution process involving the GSIB or its affiliate. Such "QFCs" include derivatives, securities lending agreements and repurchase agreements.

On September 1, 2017, the FRB voted to approve the final rule in order to "protect financial stability" and help "address [the] too-big-to-fail problem." An entity that is subject to the final rule is (i) "required to ensure that its QFCs provide that any default rights and restrictions on the transfer of the QFCs are limited" to be consistent with the orderly liquidation authority under Dodd-Frank and the Federal Deposit Insurance Act" and (ii) "prohibited from being party to QFCs that would allow a QFC counterparty to exercise default rights against the covered entity, directly or indirectly, based on the entry into a resolution proceeding under the Dodd-Frank Act or Federal Deposit Insurance Act, or any other resolution proceeding, of an affiliate of the covered entity." These requirements are intended to ensure that QFC obligations can be transferred from a party in resolution under U.S. law to a solvent party even if the QFC is subject to non-U.S. law. The requirements are also intended to facilitate "single point of entry" resolutions where the parent company would be resolved through an insolvency process so as to preserve and recapitalize critical subsidiaries. The final rule changes certain definitions in FRB regulatory capital and liquidity rules to ensure that the treatment of QFCs is not impacted by restrictions implemented by the final rule.

The FRB asserted that the final rule will "limit[] disruptions" to a GSIB that enters into resolution proceedings. By restricting the ability of QFC counterparties to cancel contracts immediately when resolution proceedings are instituted, the FRB hopes to mitigate the potential for "failure" and "disorderly resolution" that could lead to significant systemic distress. FRB Governor Jerome H. Powell said that the final rule "should help avoid the threat of a disorderly and mass unraveling of QFC."

Covered entities must ensure that new QFCs within the scope of the final rule are in compliance with the requirements if the QFCs are executed after the applicable compliance date, which is (i) January 1, 2019, in the case of QFCs with other GSIBs, (ii) July 1, 2019, in the case of QFCs that are non-GSIB financial counterparties other than small banks, and (iii) January 1, 2020, in the case of all other counterparties. In addition, covered entities must amend existing covered QFCs with a counterparty by the applicable compliance date whenever any member of the GSIB family that is a covered entity under the rule enters into a new covered QFC after January 1, 2019 with any consolidated affiliate of the counterparty.

Commentary / Jeff Robins

To the extent that the final rule requires recognition of existing bankruptcy protections, it is not a significant substantive impingement on creditor rights. However, the restrictions on cross-default rights are more material, as they prohibit cross-defaults tied to the resolution of a GSIB affiliate under essentially any (U.S. or non-U.S.) insolvency regime for at least a 24-to-48 hour period, and this prohibition stays in place if the affiliate becomes subject to a Chapter 11 bankruptcy. While this is designed to allow the use of the U.S. bankruptcy code to effect an orderly "single point of entry" resolution, it may require adjustments in the use of parent (or affiliate) guarantees.

Market participants, as well as the FRB, will clearly be looking to rely on industry protocols to reduce the administrative burden of re-documenting hundreds of thousands of QFCs. However, practitioners should be mindful that the scope of the final rule is quite broad and complicated. For example, "covered QFCs" include essentially any "safe-harbored" contracts that limit transfers by the covered entity or include contractual or non-contractual default rights for the counterparty. This would include for example, many prime brokerage agreements, as they frequently include provisions limiting certain transfers of the contract by the prime broker. Additionally, the requirement to amend existing QFCs any time a covered affiliate enters into a new QFC with the counterparty or any consolidated affiliate of the counterparty will likely be something of a logistical nightmare.

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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