New considerations for contractual stays

New considerations for contractual stays

Between 2016 and 2017, significant changes to the law governing stays in derivatives contracts will come into effect, bringing many new considerations for lawyers to familiarise themselves with. Michael Beaton, managing partner at Derivatives Risk Solutions, explains how the law change will affect third-country organisations, having a considerable effect on business arrangements outside the EEA.

Original news

A policy statement from the Prudential Regulation Authority (PRA) sets out final rules aimed at reducing the risk of contagion from the failure of a relevant firm and supporting its orderly resolution. The rules ensure resolution action taken in relation to a firm would not immediately lead to the early termination of its financial arrangements (or those of its subsidiaries) governed by third-country law while similar financial arrangements governed by the UK laws, or those of another EEA jurisdiction, are stayed.

What are the requirements?

The EU Bank Recovery and Resolution Directive 2014/59/EU (BRRD) gives the Bank of England (in certain circumstances, and in its capacity as UK resolution authority) the power to temporarily suspend the rights of a counterparty to a contract with a firm in resolution to:

  • terminate, or
  • enforce any security interest

In support of this power, the PRA has introduced a requirement (as detailed in Policy Statement PS25/15) which, broadly, prohibits any in-scope firm (see below) which has entered into a ‘Third-Country Law Financial Arrangement’ from:

  • creating a new obligation, or
  • materially amending an existing obligation

in relation to that arrangement unless its counterparty agrees ‘in an enforceable manner’ (and not necessarily ‘in writing’) to be subject to similar restrictions on early termination and enforcement of security interests to those that would apply as a result of a UK firm’s entry into resolution, if the financial arrangement were governed by UK law.

A Third-Country Law Financial Arrangement means any obligation created under any of the contracts detailed below, to the extent that they are governed by the law of a non-EEA country and which contain termination rights or rights to enforce security interests that are (or could be) subject to a stay under the Banking Act 2009 if the financial arrangement were governed by UK law:

  • securities contracts
  • commodities contracts
  • futures and forwards contracts
  • swap agreements
  • all other derivatives, and
  • master agreements for any of the above or for contracts for the sale, purchase or delivery of a currency

Third-Country Law Financial Arrangements which do not contain termination rights or rights to enforce security interests or are entered into by subsidiaries whose obligations are neither guaranteed nor otherwise supported by a UK firm are exempt.

To which firms do the rules apply?

The rules apply to:

  • PRA-authorised banks, building societies, PRA-designated investment firms and their qualifying parent undertakings (ie financial holding companies and mixed financial holding companies to the extent that they have a registered office or head office in the UK) (relevant firms), and
  • credit institutions, investment firms and financial institutions that are subsidiaries of relevant firms (irrespective of the jurisdiction of incorporation or establishment) to the extent that the subsidiary enters into a Third-Country Law Financial Arrangement

To which firms do the rules not apply?

UK firms are not required to include contractual recognition language in their agreements with:

  • third-country financial market infrastructure, including:
    • central counterparties
    • payment systems
    • exchanges
    • trading facilities, or
  • any agency or branch of a central government

What is a 'material amendment'?

A material amendment is any change made to a determinant of the payout or risk profile of a transaction. It is for UK firms to determine on a case-by-case basis whether an amendment is ‘material’. In practice, this will vary depending upon the nature of the financial arrangement, but will include modification of:

  • interest rates
  • exchange rates
  • reference assets
  • maturity
  • payment dates, and
  • pre-payment events

Non-material amendments include:

  • changes that occur automatically by the terms of the contract without the need for any subsequent agreement by the parties, such as roll over or renewal of the contract, and

administrative changes such as changes to notification, confirmation or payment details, clarification of definitions, business day conventions, or other similar technical amendments

Why have the rules been promulgated?

The rules are part of a coordinated effort among Financial Stability Board (FSB) members to improve cross-border recognition of resolution stays in the absence of statutory recognition by enforcing bilateral contractual solutions. The PRA requirements are intended to:

  • reduce the risk of contagion from the failure of a firm, and

support its orderly resolution by ensuring that the taking of a resolution action would not immediately lead to the early termination of Third-Country Law Financial Arrangements while similar financial arrangements governed by EEA law are stayed


The rules are effective from:

  • 1 June 2016 in respect of Third-Country Law Financial Arrangements with counterparties that are credit institutions or investment firms, and

1 January 2017 in respect of Third-Country Law Financial Arrangements with all other counterparties

What will the effect of these rules be on derivatives and financial instruments, such as repos, which are subject to contractual set off and netting?

There should not be any adverse impact on the ability to set off or net per se. However, the PRA requirements raise the prospect that the ability to terminate (and therefore for the close-out netting process to be triggered) may be postponed. The risk is that not all jurisdictions will implement contractual stays at either the same time or in the same way—creating an uneven playing field in which some firms can close out in circumstances where others cannot.

What impact will there be on derivatives documents?

The PRA requirements will have a significant impact on derivative documentation governed by non-EEA law (eg New York or Australian law). The PRA itself suggests that approximately 20% of all contracts may be impacted. In practice, complexity may also be layered on top of scale in the case of third-country subsidiaries of a UK firm. Such entities could be subject to multiple obligations to amend financial contracts to recognise stays that could apply in different jurisdictions.

How can lawyers best prepare their clients for the new rules before they come into force in June 2016?

Whether advising the ‘sell side’ or the ‘buy side’, the nature of the PRA requirement means that forward planning is essential if compliance is to be achieved. From a practical point of view, the deadlines set by the PRA will bite at a time when the resource necessary in order to achieve compliance is likely to be at a premium due to the pressure of complying with other regulatory requirements which will impact documentation, such as central clearing, contractual bail-in and the non-cleared margin rules.

All firms will require assistance in understanding which documents are in scope—ie the nature of a ‘financial arrangement’. The PRA has deliberately not exhaustively defined the concept, expecting firms to identify which of their contracts are within scope. Beyond this, the full extent of ‘material-’ versus ‘non-material-’ amendments must be understood. Legal counsel should also familiarise themselves with the various industry efforts to comply, in particular the ISDA 2015 Universal Resolution Stay Protocol. The 2015 protocol is an example of a contractual mechanism designed to achieve the policy goals of the PRA rules in respect of over-the-counter bilateral derivatives traded under the ISDA Master Agreement (1992 and 2002 versions) and certain securities financing transactions. However, firms should note that the PRA rules relate to a broader range of financial arrangements than are currently covered by the 2015 protocol and the PRA requires firms to satisfy themselves that it meets the requirements. The 2015 protocol is primarily designed for ‘sell-side’ firms, but will be supplemented during the course of 2016 by the ‘ISDA Resolution Stay Jurisdictional Modular Protocol’ (designed for the ‘buy-side’).

Consideration must also be given to the various questions that remain unanswered but which potentially create risk for both ‘sell side’ and ‘buy side’ firms. For example:

  • Would a stay on early termination rights simply incentivise market participants to terminate before a stay could be imposed, fatally damaging attempts to reinforce market stability and defeating the whole object of the stay?
  • Can a fund manager voluntarily cede termination rights without being rendered in breach of fiduciary duties towards its client?
  • How will the existence of a statutory stay affect the pricing of a transaction?

Non-PRA regulated counterparties of PRA-regulated firms (ie ‘buy side’ firms) also need to understand the impact that the requirement will have on two of their primary contractual protections—termination rights and security interests. More generally, they need to be apprised of the fact that they stand to be locked out of the market unless they agree to these changes, with even the rollover or renewal of historical transactions constituting a ‘new obligation’, and therefore prohibited, unless the appropriate contractual amendment has been made.

Interviewed by Julian Sayarer.

The views expressed by our Legal Analysis interviewees are not necessarily those of the proprietor.

 First published on LexisPSL Banking & Finance. Click here for a free trial.

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About the author:

Emma is head of the Banking and Finance team and the Finance Group at LexisNexis®UK.

Emma has wide-ranging experience in derivatives and capital markets with a particular emphasis on credit derivatives and structured products. Emma qualified as a solicitor with Allen & Overy LLP, working in the derivatives and structured finance teams in both their London and Paris offices before gaining experience with Deutsche Bank AG (advising the foreign exchange prime brokerage desk) and Crédit Agricole CIB (advising the fixed income and derivatives desk) before joining LexisNexis®.