Risk management is one of the most fundamental aspects of business growth. The use of derivatives in corporate risk management has grown exponentially in the last decade and has transformed global financial markets, fuelled in part by the success of the financial industry in creating a variety of over-the-counter (OTC) and exchange-traded products.
Derivatives are financial instruments, which derive their value over time from an underlying asset. Assets that can be subject matter of derivatives include equities, bonds, currencies, interest rates and commodities; while derivative variants include options, forwards, futures, swaps and swaptions.
Nigeria being one of the emerging economies in the global financial markets is an exploratory gold mine for derivatives transactions. While the Nigerian derivatives market is still relatively in its infancy and a completely standardised regulatory framework is yet to be fully developed, recent market activities have been geared towards creating awareness and encouraging derivatives trading, with positive results.
The National Association of Securities Dealers (NASD) recently launched an OTC market for the trading of, (among others), derivatives, options, futures, commodities and fixed income instruments.1 The Financial Markets Dealers Quotation (FMDQ) OTC market also recently launched an OTC market to trade in money market and fixed income instruments. The Nigerian Stock Exchange (NSE) recently announced plans to create an options market that will trade stock options, bond options and indices by Q4 2014, and projects that this will be followed by a futures market that will trade in currency and interest rate futures by 2016.2
With recent and pending development, Nigeria is bound to witness an escalation in the use of derivative instruments in the near future. This chapter examines the enforceability of the netting provisions under the International Swaps and Derivatives Association (ISDA) Master Agreements and highlights existing mitigants for perceived risks, while suggesting proposals for reform.
Derivatives transactions in Nigeria
The Nigerian derivatives market is in a nascent stage, however, Nigerian companies and financial institutions regularly enter into derivatives transactions especially with foreign counterparties. These transactions tend to be documented under the ISDA Master Agreements, which contain extensive provisions on termination, closeout and multibranch netting.
The ISDA Master Agreements typically govern all specific transactions entered into under it, with a single agreement clause3 designed to preclude cherry-picking by a liquidator. Enforceability of the netting provisions in the ISDA Master Agreements typically requires:
- that the netting agreement will be enforceable against an insolvent counterparty and will not be avoided by a liquidator;
- that the requirement for calculation of a net sum due from one party to the other will be enforceable;
- that the powers of the liquidator to cherry-pick by disclaiming onerous property, contract or transactions while insisting on performance of other contracts will be limited to the net amount due in accordance with the terms of the netting agreement, if at all; and
- that any transfer or substitution of collateral will not be considered a preference or fraudulent transfer.
The most fundamental principle of insolvency law in Nigeria is that of pari passu distribution of debt, which means that unsecured debts other than preferential debts rank equally between themselves in winding up. There is currently no legislation or formal rules dealing with termination or closeout netting in Nigeria, therefore termination and/or closeout netting may effectively mean payment of the counterparty's claims pro tanto ahead of other creditors. However, while the legal requirements to ensure enforceability of netting provisions under the ISDA Master Agreements may not be clear cut, the practicalities are not so far from the ideal.
Avoidance by liquidator
Under Nigerian law, the liquidator of an insolvent company has the right to cherry-pick and may, at any time within 12 months after the commencement of the winding up (or 12 months of the existence of the property coming to the liquidator's knowledge), disclaim onerous property, contract or transactions.4
Payment of a net sum
Nigerian law provides that any disposition of the property of a company, including things in action and any transfer of shares made after the commencement of winding up shall, unless the court otherwise orders, be void.5
Nigerian law also provides that where there has been mutual credits, mutual debts or other mutual dealings between a debtor and any other person claiming to prove a debt, an account of what is due from one party to the other in respect of such mutual dealing and the sum due shall be set off against any sum due from the other party and the balance of the account and no more shall be claimed or paid on either side respectively.6 Mutuality requires the claim and cross claims to be between the same parties in the same right.
A combined reading of the foregoing would suggest that, in the absence of mutuality of claims, the provisions in the ISDA Master Agreement, which provide for the netting of termination values in determining a single lump sum termination amount payable by one party to the other upon the occurrence of an Event of Default or Termination Event may be in contrast with Nigerian law. This matter is however yet to be put to the test in the Nigerian courts.
Preference or fraudulent transfers
Nigerian law also deems as a fraudulent preference (and hence void against the liquidator and other creditors,) any conveyance, payment or disposition of property in favour of a creditor, with a view to giving such creditor a preference over the other creditors, made within three months before the commencement of winding up.7
Commencement of winding up
There is no question that the netting arrangements work perfectly well where the netting is completed before winding up. However, issues may arise once a company has commenced liquidation proceedings.
Under Nigerian law, the time for commencement of winding up depends on the mode of winding up. In case of winding up by the court, it is deemed to commence when the winding up petition was presented, and as for voluntary winding up subject to the supervision of the court, it is deemed to commence when the resolution to wind up is passed.
While some legal systems have been able to preserve netting arrangements in insolvency under markets contracts and European Commission derivatives in relation to financial collateral by special statutory provisions in order to reduce systemic risks8, Nigeria currently lacks such statutory provisions.
The need for mitigation of these risks is however not lost on the financial market regulators and as such efforts are being made to address these and other perceived issues that may affect the enforceability of derivative transactions in Nigeria. In the meantime, there are existing risk mitigants available to all or particular counterparties.
Reduction of default risk: Delivery vs payment
Under the Rules and Regulations of the NSE,9 NASD or FMDQ OTC, delivery and settlement is effected on a delivery-versus-payment (DVP) basis. All trades have a three-day settlement schedule (T+3) except for trades in federal and states bonds, which have a T+2, trade cycle10.
For exchange traded and OTC derivatives, DVP not only reduces or eliminates default risk by ensuring that a counterparty will give up its securities if, and only if, it receives full payment for them, it also ensures in the case of settlement post insolvency, a liquidator cannot fail to perform its payment obligations while insisting on performance on the part of a counterparty.
Transactions in respect of all counterparties
Given that a liquidator is allowed to disclaim onerous property, contracts or transactions under Nigerian law, while at the same time able to cherry-pick and insist on the performance of favourable contracts, it is worthy to note that a liquidator takes the assets of the company in the same way it finds it. Hence where Automatic Early Termination has been specified to apply, such terms will be enforceable, and a termination value and a net payable sum, possible.
Regarding preference and fraudulent transactions, Nigerian law requires the establishment of a clear intention to prefer one creditor to another.11 Therefore it is not sufficient to trigger the fraudulent preference provisions by showing a preference, it must be shown that the preference was fraudulent. First, the suspect period is relatively short (three months). Secondly, it may be a bit of a challenge to establish fraud under an ISDA Master Agreement potentially governing several transactions over time.
Transactions in respect of particular counterparties
Derivatives transactions in which the counterparty is a Nigerian registered bank or financial institution may not necessarily suffer from the same challenges faced with ordinary corporates in regard to termination or closeout netting. This is because banks and financial institutions are typically subject to additional administrative procedures prior to the onset of insolvency.
For instance, where a bank informs the Central Bank of Nigeria (CBN) that it is likely to be unable to meet its obligations, or it is insolvent, or where the CBN is satisfied that the bank is in a grave situation as regards to its ability to meet its payment obligations, the Governor of the CBN may give orders as to the management of the bank, and if the CBN considers those steps to be insufficient, the CBN may cede control of the bank to the Nigeria Deposit Insurance Corporation (NDIC).
The NDIC has the authority to remain in control of and carry on the business of the bank until such a time as in the opinion of the CBN that it is no longer necessary for the NDIC to remain in control of the business of the ailing bank.12
In the event that the ailing bank cannot be rehabilitated, the NDIC may recommend to the CBN other resolution measures, which may include the revocation of the bank's licence. Where the licence of a bank has been revoked, NDIC shall apply to the Federal High Court for a winding up order of the affairs of the bank.
Also, an insurance company may only be wound up subject to the approval of the Insurance Commission by not less than 50 policy holders, each of whom holds a policy that has been in force for not less than three years, on the grounds specified in CAMA13.
There are additional administrative rehabilitation procedures in place before the commencement of winding up for a bank, other financial institution or insurance company.14 Therefore, the provisions of the ISDA Master Agreement which defined 'bankruptcy event' to include the passing of a resolution for a counterparty's official management, the appointment of an administrator, conservator, receiver, trustee, custodian or other similar official for it or for all or substantially all of its assets or any event which has an analogous effect to any of the events specified earlier would be sufficient to trigger Automatic Early Termination (where it has been specified to apply) and hence the termination and close-out netting provisions before the commencement of such counterparty's insolvency.
From all indications, derivatives will continue to be used as a tool for risk reduction and efficient portfolio management. As Nigeria positions itself to take advantage of the benefits of these dynamic financial instruments, it may be useful to develop a legal structure that enhances the enforceability of derivative transactions in Nigeria through the enactment of an enabling law. Such a law should, at the very least ensure:
- that derivative transactions shall not be deemed to be unenforceable by reason of gaming, gambling, wagering or insurance laws; and
- that netting agreements will be enforceable against an insolvent counterparty and will not be avoided by a liquidator, be considered a preference or otherwise rendered unenforceable by mandatory insolvency laws.
The Nigerian financial market regulators are aware of this and with the Securities and Exchange Commission actively driving the establishment of an enabling legal framework for derivatives transactions in Nigeria, we expect that any current perceived legal issues will be addressed soon.
1 Rule 7(2)(c), Rules and Regulations of the NASD OTC Market.
2 Ilori, B., 2012. Likely Impact of Options, Futures on NSE. The Punch Newspaper. Also available at (http://www.punchng.com/business/investment-platform/likely-impact-of-options-futures-on-nse/) [Accessed on April 17, 2014].
3 Each transaction being recorded in a confirmation but being described as forming part only of a single agreement contained in and subject to the terms of the Master Agreement Section 1(c) ISDA Master Agreement (2002).
4 Section 499 Companies and Allied Matters Act, Cap C20, LFN 2004 (CAMA).
5 Section 413 of CAMA.
6 Section 493 of CAMA.
7 Section 495(1) of CAMA
8 R.M. Goode, 2011. Principles of Corporate Insolvency Law. 4th ed. London: Sweet and Maxwell. p.289.
9 Rule 120(b) Rules and Regulations of the Nigerian Stock Exchange Governing Dealing Members.
10 Rule 8 (3)(c) and 8 (6) of the National Association of Securities Dealers OTC Market Rules.
12 Sections 35(1)(2), 36 and 38 Banks And Other Financial Institutions Act Chapter B3, Laws of the Federation of Nigeria, 2004 (BOFIA).
13 Sections 408 and 409.
14 Section 32, Insurance Act, Cap 117, LFN 2004.
Originally published by The Euromoney Derivatives & Risk Management Handbooks 2014.
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.