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 solvent party.
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.
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