Article by Tamer Amara, Arthur Iliev and Alexander Anichkin
This article discusses the recent amendments to a number of Russian laws (including the Securities Market Law, the Central Bank Law, the Private Pension Funds Law, etc.) that were signed into law on 25 November 2009 and will become effective on 1 January 2010.
These amendments are extensive and develop the legislative framework for the regulation of derivatives in Russia. In particular, the amendments introduce the definitions of a 'derivative' and a 'repo transaction' and clarify certain aspects of trading in derivatives with Russian counterparties.
For a discussion of the recent changes to Russian tax legislation, please refer to our publication entitled "Taxation of Derivatives and Transactions with Securities New Rules".
In order to better assess the impact of the amendments, it is helpful to understand the regulation of derivatives and repos in Russia that existed before the forthcoming changes.
Apart from the occasional reference to derivatives and repos in the Russian Central Bank (the "CBR") regulations and a couple of sections in the Tax Code dealing with the taxation of derivatives and repos, historically one would struggle to find a reference to a derivative or a repo in Russian laws and regulations.
In February 2007, Article 1062 of the Russian Civil Code was amended to expressly provide for the enforceability of derivative transactions linked to commodities, securities, FX and interest rates, indexes and rates of inflation provided that at least one of the parties to such a transaction is an entity with a banking or professional market participant ("PMP") licence. It remains unclear whether the enforceability protection granted by this article would be limited to Russian entities only or whether it would also extend to foreign banks and PMPs.
In December 2007, the Securities Market Law was amended to include the concept of 'qualified investors' ("QIs"). An investor may be a QI either by operation of law1 ("QIs by operation of law") or be recognised as such if it satisfies certain qualitative and quantitative criteria (relating to own capital, assets, revenues, volume of trading in financial instruments, etc.) ("QIs by recognition") set out in the Securities Market Law and regulations of the Federal Financial Markets Service ("FFMS"). The determination of whether an investor is a QI is required to be made by a Russian broker or asset manager with respect either to a particular security or instrument or a portfolio of securities or instruments.
Further changes to the Securities Market Law were introduced in May 2009 and dealt with the offering of foreign securities and 'other financial instruments' (defined as cash- and, arguably, physically-settled derivatives linked to the underlying assets listed in the Civil Code) to QIs and non-QIs. In particular, paragraph 13 of Article 51.1 of the Securities Market Law established that 'foreign financial instruments' that have not been recognised as foreign securities (in accordance with the procedure set out in the Securities Market Law) may only be offered to, and may only be bought and sold by, QIs.
As the concept of 'foreign financial instruments' captured the majority of derivative instruments, the amendments introduced a degree of uncertainty as to how non-Russian entities should structure their derivative trades with Russian counterparties that are not QIs by operation of law. The resulting market practice varied, with certain institutions continuing to execute direct derivatives trades with Russian corporates that were recognised as QIs on the basis of standalone arrangements; others utilised more conservative structures interposing Russian brokers who performed the QI recognition and executed derivative trades on behalf and at the expense of Russian corporates (acting as their agent).
Regulation of Derivatives
The amendments introduce the concept of a 'derivative' (proizvodniy finansoviy instrument) which covers (a) transactions linked to commodities, securities, FX and interest rates, rates of inflation, derivatives and statistical information as well as weather and credit derivatives and other transactions where payments depend on the occurrence or non-occurrence of another event provided for in the legislation or FFMS regulations "the possibility of the occurrence of which is unknown"; (b) call and put options; and (c) transactions providing for the transfer of securities, cash or commodities to the other party not earlier than the third day after the trade date provided that the transaction documentation indicates that such a transaction is a derivative.
The new definition provides for an extended list of derivative transactions as compared to that in the Civil Code (thus expanding the range of transactions enjoying enforceability protection) and the previous version of the Securities Market Law and includes credit, weather and emission reduction-linked derivatives as well as trades that are linked to statistical information (which is presumably intended to cover transactions like mortality and longevity derivatives) and authorises the FFMS to expand that list of eligible underlying assets for the purposes of the definition.
The other important point to note is the definition might potentially extend to any forward transaction (providing for the delivery of securities, cash or commodities) that is settled on a T+3 or more basis thus affecting deliverable FX and securities forward transactions that are customarily entered into in the Russian domestic market. It is therefore important to ensure that the documentation (including master agreements) under which such deliverable transactions are executed expressly state that these transactions are not derivatives.
Although the concept of a master (framework) agreement is contained in Russian law and master agreements were widely used in the Russian market, the Securities Market Law is amended to include express references to the possibility of documenting derivative transactions under master agreements which can now incorporate by reference the terms of standard form documentation adopted by self-regulating organisations ("SROs") in the securities markets that is published in the press or on the Internet (such as the standard documentation that was published by the Association of Russian Banks, NAUFOR and the National Foreign Exchange Association earlier this year).
Also, although the amendments go on to say that a master agreement may establish the grounds and the procedure of termination of all derivatives transactions concluded under that master agreement and establish the procedure of calculation of a single termination (close-out) amount to be paid by one party to the other, they do not refer or allow close-out netting (presumably to be covered by the netting legislation currently undergoing the approval of the Russian Parliament).
Exchange Traded Derivatives
The amendments allow exchange traded derivatives to be traded on (i) stock exchanges; and (b) commodity exchanges (but only with respect to derivatives specified in the Russian legislation on commodity exchanges). Exchange traded derivatives should be traded on the basis of FFMS regulations-compliant specifications and any amendments or additions to those specifications should also be registered with the FFMS. It is also worth noting that the Securities Market Law requires that the clearing organisation (house) must act as the central counterparty for exchange trading of derivatives (current market practice varies, with RTS Clearing Chamber being the central counterparty while the legal analysis with respect to MICEX is less clear).
The amendments also establish certain limitations with respect to trading credit derivatives with Russian counterparties. In particular:
- with respect to exchange traded credit derivatives, the Securities Market Law states that the seller of the credit protection must be a QI (either by operation of law or by recognition) and the buyer must be a legal entity; and
- with respect to over-the-counter derivatives, credit protection can only be sold by a bank, a broker or a dealer and bought by legal entities.
Although the wording of the relevant provisions is not entirely clear, in practical terms, the restriction is likely to result in the prohibition of (a) credit default swaps with Russian corporates acting as sellers of credit protection and (b) arguably, sales of credit linked notes to Russian entities other than banks, brokers and dealers. There is also a risk that this restriction might affect the market for extinguishable (vanishing, cancellable) derivative products.
Trading with Russian Counterparties
The Securities Market Law is also amended to clarify the manner in which derivative transactions should be executed with Russian entities that are not QIs by operation of law. Article 51.4(7) states that derivatives intended for QIs can only be executed through brokers, with the exception of QIs by operation of law and cases established by the FFMS. The list of derivatives intended for QIs is established by the FFMS; however, the Securities Market Law also provides that foreign financial instruments that have not been registered with the FFMS (which would be the case with derivatives) can only be sold to, or bought by, QIs.
In light of the above, it is unclear how one should structure derivative trades between non-Russian entities and their Russian counterparties that are not QIs by operation of law. While it is now sufficiently clear that such a trade should involve at least one Russian broker (acting at the expense of the Russian counterparty), it is also possible to argue that both parties need to act through brokers.
Regulation of Repos
The amendments introduce new Article 51.3 of the Securities Market Law that includes the concept of a 'repo transaction'. The definition itself is quite extensive and deals with a number of important concepts incidental to cross-border repo transactions, including margining, substitution of purchased securities, payments of manufactured dividends, etc..
As is the case with derivatives, the Securities Market Law allows parties to conclude master repo agreements and incorporate the terms of published standard form repo agreements developed by SROs in the securities market. Master repo agreements may also establish the procedure of termination of all repo transactions following the occurrence of an event of default and establish the procedure of calculation of a single termination (close-out) amount.
Individuals may enter into repo agreements only through brokers and only if the counterparty is a broker, dealer, custodian, asset manager, clearing organisation or bank.
We also note that although any restrictions on the ability of the purchaser to dispose of the purchased securities would affect the true transfer of title analysis as a matter of English law, Russian law, on the contrary, expressly allows for such a possibility and goes on to say that any such restriction should be registered in the purchaser's custody account.
The introduction of the concept of a repo will result in the further reduction of the risk of recharacterisation of repo transactions into secured loans and establish a legislative backdrop against which the Russian repo market will continue to develop.
To recap, the key principal changes introduced by the new legislation are as follows:
- expansion of the list of eligible transactions enjoying enforceability protection under Russian law (subject to the continuing uncertainty with respect to eligible counterparties);
- introduction of restrictions on the ability of Russian corporates to enter into credit derivative transactions;
- further clarification of structuring of cross-border derivative transactions between non-Russian entities and Russian counterparties that are not QIs by operation of law; and
- incorporation of the concept of a 'repo transaction' into the Securities Market Law thereby reducing the recharacterisation risks.
However, as is usually the case in Russia, the wording of the amendments is not ideal and sometimes conflicting allowing for multiple interpretations. Also, the implementation of the new rules remains subject to FFMS regulations that are yet to be adopted and the practical application of these rules will, to a significant extent, depend on those regulations.
1 The relevant definition includes Russian banks, brokers and dealers, fund managers, investment funds, private pension funds, asset managers, insurance companies, the CBR, Bank for Development Vnesheconombank (VEB), Russian Deposit Insurance Agency, supranational financial organisations, etc..
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.