On 10 July 2015, the Bulgarian parliament passed, at first reading, a bill intended to implement the EU Bank Recovery and Resolution Directive (BRRD). When that bill becomes law, it will provide, inter alia, increased protection for the close-out netting arrangements involving Bulgarian banks in distress. However, the bill must be amended in order to provide "appropriate protection" for close-out netting as required under the BRRD.

1 Introduction

As of 1 January 2015, all EU Member States must apply a single rulebook for the resolution of banks and large investment firms, as prescribed by Directive 2014/59/EU of the European Parliament and of the Council of 15 May 2014 establishing a framework for the recovery and resolution of credit institutions and investment firms (BRRD). The new rules aim to harmonise and improve the tools for dealing with bank crises across the EU. However, more than half a year after the deadline for BRRD implementation, Bulgaria has not yet adopted the requisite laws to implement it. On 28 May 2015, the European Commission therefore requested Bulgaria (alongside 10 other EU member states) to fully implement the BRRD. The Commission's request takes the form of a reasoned opinion, which is the second stage of EU infringement procedures. The request expressly states that if Bulgaria fails to comply within two months (i.e. by 28 July 2015) the Commission may refer the matter to the EU Court of Justice.

In response, on 10 July 2015, the Bulgarian parliament passed, at first reading, a bill, titled Law on Recovery and Restructuring of Credit Institutions and Investment Firms1 (Draft Law), which is intended to implement the BRRD. A bill becomes law in Bulgaria after enactment by the parliament at two different readings (sessions), so the Draft Law must still be debated and voted upon at one additional reading (session) of the parliament, a step which is expected to take place soon. The legislation, thus enacted by the parliament, will enter into force on the third day after being published in the State Gazette (the Official Journal of the Bulgarian State), unless the bill itself specifies another date.

The present article focuses on certain matters under the Draft Law that need to be improved so that there is "appropriate protection" for close-out netting arrangements under the BRRD. The BRRD, inter alia, requires that member states "ensure that there is appropriate protection for title transfer financial collateral arrangements and set-off and netting arrangements, so as to prevent the transfer of some, but not all, of the rights and liabilities that are protected under a title transfer financial collateral arrangement, a set-off arrangement or a netting arrangement between the institution under resolution and another person and the modification or termination of rights and liabilities that are protected under such a title transfer financial collateral arrangement, a set-off arrangement or a netting arrangement through the use of ancillary powers" (art 77, par 1 of the BRRD).

2 Why is Close-out Netting Important?

Close-out netting is a major risk-mitigation technique in many financial transactions and, most importantly, in agreements documenting derivatives (e.g. under ISDA Master Agreements). The protection and enforceability of close-out netting arrangements in cases of reorganization or insolvency proceedings against a Bulgarian counterparty is a key issue for financial institutions when deciding whether to enter into a derivative transaction.

However, in Bulgaria, as opposed to most other EU member states, there is no general protection for netting arrangements, and interested parties must rely on the existing piecemeal protections to make the close-out mechanism under their transaction enforceable. Thus, if a Bulgarian bank is counterparty to a transaction with an international element, and the netting arrangement is subjected to foreign laws which provide increased protection for netting in case of insolvency/reorganization measures, that foreign law protection will be applied by Bulgarian authorities irrespective of the fact that the particular insolvency/reorganization measures are governed by Bulgarian law (under the domestic Bulgarian law implementing art 25 of the EU Winding Up Directive for Credit Institutions). Furthermore, if there is an effective provision of financial collateral (in the sense of the domestic Bulgarian law implementing the EU Financial Collateral Directive) for the exposition calculated after potential netting under the specific transaction, the netting under such a transaction must be enforceable2.

It has been proposed that the implementation of the BRRD in Bulgaria is a good opportunity for the parliament to consider a statutory measure providing a general protection for netting, thus facilitating derivatives and other financial transactions with important hedging functions for businesses3. Although such a general protection for netting remains highly important, this article focuses only on the need to improve the Draft Law in order to appropriately protect the netting within the limited scope of the BRRD.

3 Problems with the definition for "netting arrangement" under the Draft Law

The definition of a "netting arrangement" (in art 2, par 1, item 98 of the BRRD) refers to "[an] enforcement event (however or wherever defined)" as the trigger of the netting arrangements4. This wording was obviously meant to be as broad as possible in order to embrace the long list of default events that are normally stated in netting arrangements.

However, the corresponding wording under the Draft Law differs, as it refers to the "occurrence of an event whereby performance is required" as the event that triggers the netting arrangements operation.

This wording restricts the eligible default events to only those events as a consequence of which "performance is required", i.e. acceleration takes place. In contrast, it is currently common for some typical netting arrangement default clause events to provide that, as a result of those events occurring, mutual obligations are terminated and replaced by one net obligation, with no mention of any acceleration in such clauses. Therefore, it is doubtful whether the Draft Law would embrace such contractual provisions unless they expressly provide that, as a consequence of those events taking place, "performance is required". The BRRD does not permit such doubts, as it refers to the relevant events as being "however" defined (i.e. permitting broad contractual freedom to the parties on that matter).

This wording may be problematic even in netting arrangements containing a contractual stipulation whereby, following a default event, obligations are accelerated (i.e. "performance is required"). It is unlikely that the Draft Law permits purely contractual acceleration (when referring to the fact that "performance is required"); rather it seems that acceleration must further be permitted by law (the BRRD casts away such doubts by providing that the event may be "wherever" defined – i.e. the parties' definition in a contract is sufficient, and any superimposing of statutory requirements to make the event of default eligible is not permitted under the BRRD).

As it is crucial that the wording describing the "enforcement event" (as an element of the "netting arrangement" definition) be as broad as possible, the definition for "netting arrangement" in the Draft Law has to be expanded following the wording under the BRRD to satisfactorily cover all relevant circumstances.

4 What is "appropriate protection" in the sense the Draft Law implementing art 77, par 1 of the BRRD with respect to partial property transfers?

With respect to art 109, par 1 of the Draft Law, which (when enacted) is expected to implement art 77, par 1 of the BRRD, it seems that the Bulgarian parliament considers that "appropriate protection" against partial property transfers is to treat them as void. However, partial property transfers may be part of a larger transfer of rights and liabilities by the resolution authority. In such a case, it is possible that the approach under the Draft Law might invalidate the whole transfer, even though most of the rights and liabilities being transferred are not protected by title transfer collateral, set-off or netting arrangement5.

A better approach has been proposed by ISDA under its Briefing Note for Member States of the European Union on Implementation of Article 77(1) (Protection for financial collateral, set-off and netting agreements) of 13 August 20146 (ISDA Briefing Note). ISDA proposed not voiding such a transfer, but instead that any right or liability so transferred is transferred subject to the operation of the set-off or netting under the relevant title transfer collateral, set-off or netting arrangement7. In other words, the operation of the relevant set-off or netting would take priority over the rights of the transferee, so that the transferee would receive only what remains of the relevant right or liability transferred after operation of the set-off or netting8.

5 Insolvency avoidance risks with respect to payments made under a derivative before close-out netting event

The BRRD, similar to the EU Financial Collateral Directive, protects netting arrangements defined as covering only those obligations that are accelerated or terminated following a default event. In other words, it does not expressly protect any voluntary payments made under a respective financial transaction (e.g. a derivative containing a netting arrangement), where those payments have already been made before the default event9, i.e. within the period after the date when the payor was actually insolvent (that date being fixed by the court permitted to look backwards in order to take into account all circumstances of the case, i.e. relying on hindsight) and the date when the insolvency proceedings were formally commenced (if it is not the same) that period being known as "Suspect Period". This approach was most likely motivated by an assumption that payments made within a Suspect Period should normally be vulnerable (under EU member states' national insolvency laws) only if there is some preferential effect associated with the payment – e.g. if the recipient had knowledge of the payor's actual state of insolvency.

However, this is not the case in Bulgaria, where performance of a monetary obligation that was due (изискуемо), regardless of the manner of performance, made after the date when the payor was actually insolvent and cumulatively within a six month period before submission of the application for commencing insolvency proceedings, is void. This general rule is not restricted (as in other jurisdictions) by a requirement that the payment have a preferential effect (e.g. that the recipient should have known about the insolvency of the payor). The payee may indeed rely on some exceptions - if consideration (in the form of goods or services) has actually been provided by the payee to the insolvent counterparty before or within 30 days of the payment, and (cumulatively) the transaction was in the ordinary course of business of the insolvent counterparty. However, the consideration provided to an insolvent entity under a derivative would normally also be a payment (e.g. a payment in a different currency under an FX forward). It is difficult to square such payments with the concept of "goods or services" (a prerequisite for the exception to be applicable), so they may be vulnerable under the avoidance rule. That avoidance rule is applicable to all corporate entities in Bulgaria including investment firms within the scope of the BRRD.

With respect to banks (the other type of entity within the scope of the BRRD), there is a special Bank Insolvency Act, whereby a similar avoidance rule provides that any payment made by the insolvent bank after the initial date of its insolvency10 is void (without exception). The initial date of the banks' insolvency is to be determined by the court, and there is no express statutory restriction on that power, i.e. the court may arguably rely on hindsight. A recent case concerning the insolvency of Bulgaria's Corporate Commercial Bank AD (CCB) provides an example where the court decided that it is not restricted to look backwards to fix the initial date of insolvency. In that case, the bank was declared insolvent due to an own capital insufficiency, and the court relying on hindsight decided to fix the initial date of its insolvency on 20 June 2014, although it was not until 6 November 2014 that the regulatory authority - the Bulgarian National Bank, made for the first time the finding (on CCB's own capital insufficiency), revoked CCB's licence, and brought anapplication for opening insolvency proceedings11. Thus, the avoidance rule might potentially invalidate a derivative payment made prior to a default event, should a court rule the date of insolvency to be prior to the payment being made. This would be irrespective of the knowledge of the payee.

In practice, we believe that there are possibilities to reduce the risks described above with appropriate contractual arrangements, but further discussion of such arrangements exceeds the limited scope of this article. What is most important is that the parliament take the opportunity now, when implementing the BRRD, to restrict the scope of the avoidance rules described above, and guarantee appropriate protection for all payments received, in good faith, under financial transactions with respect to which netting arrangements are in place.


1. Available at: http://www.parliament.bg/bg/bills/ID/15435

2. Krumov, T., "Scope of the Close-out Netting under the Bulgarian Financial Collateral Act", Law of Commerce and Obligations Magazine, No 1, 2015, pp.33-45 (in Bulgarian) (http://www.epi.bg/index.php?src=%2Fdisplay.php%3Ftid%3D781530)

3. For more details, see Radoslav Sabotinov (UniCredit Bulbank AD) and Tsvetan Krumov (Schoenherr), "Significance of Close-out Netting for Derivatives", 15 June2015, Capital Daily, page 22 of the print edition / also available online (in Bulgarian) at: http://www.capital.bg/biznes/vunshni_analizi/2015/06/14/2553040_znachenie_na_prikljuchvashtoto_netirane_pri/; as well as Radoslav Sabotinov (UniCredit Bulbank AD), Tsvetan Krumov (Schoenherr), and Stefan Paulmayer (Schoenherr), "Bedeutung des Close-out Netting bei Derivativen", Wirtschaftsblat, Nr.7, Juli 2015, p.23 of the print edition / also available online (in German) at: http://www.wirtschaftsblatt-bg.com/index.php?m=18054⟨=3

4. In this respect, the approach under the BRRD is similar to the one under the EU Financial Collateral Directive, defining "enforcement event" as "an event of default or any similar event as agreed between the parties".

5. We previously highlighted this aspect of the Draft Law in the ISDA BRRD Implementation Monitor of 17June2015, available at: http://www2.isda.org/isda-brrd-implementation-monitor/

6. Available at: http://www2.isda.org/attachment/NjkzMQ==/EU_BRRD_%20ISDA_Briefing_Note_Art_77_Aug14.pdf

7. See the ISDA Briefing Note, p.3.

8. Ibid.

9. The lack of such express protection does not mean that there are no arguments that protection may nevertheless be induced from the logic behind the EU Financial Collateral Directive and the BRRD. However, the lack of express protection is a matter of concern.

10. That avoidance rule is construed by Bulgarian courts as embracing the period commencing on the date after the initial date of the bank's insolvency. In other words if the court has fixed 20 June 2014 as the initial date of the bank's insolvency, the said avoidance rule would void payments made within the Suspect Period commencing on 21June2014.

11. That was decided under the judgement of the Sofia Appellate Court No1443 of 3 July 2015. The Appellate Court reversed the first court instance judgement which had held that the court may not rely on hindsight and subsequently had fixed the initial date of the bank's insolvency on 6 November 2015. With all due respect, in our opinion, the Appellate Court's judgment violates the tacit principle that a bank is insolvent only when the regulatory authority has decided so, which arguably underlies a number of rules under the Bulgarian Credit Institutions Act and the Bulgarian Bank Insolvency Act (see the comment of Tsvetan Krumov in this respect at: http://www.capital.bg/politika_i_ikonomika/bulgaria/2015/04/22/2517747_sudut_obiavi_falita_na_ktb/). Nevertheless that Appellate Court's judgement, although not yet final, would most probably enter into force as it was challenged (in accordance with public information of 25 July 2015) by persons whom the courts have so far subsequently characterized as not being "interested parties" (former directors of CCB and shareholders in CCB) and thus not having a standing to appeal.

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.