New netting legislation in Lithuania
Augustas Klezys and Tomas Kontautas
Sorainen
Vilnius
Augustas Klezys (Bio)
Tomas Kontautas (Bio)
Recent and ongoing developments in the financial markets and banking system have proved that mitigation of systemic risk of the whole financial system is crucial. Taking into account that daily exposure in financial markets exceeds world GDP, reduction of open positions is a preferential cure for volatile markets. Close-out netting and set-off allow the parties to discharge their reciprocal obligations (or to cancel a series of open contracts between the parties and set off the resulting gains and losses in case of close-out netting) and avoid situations where the defaulter is paid but does not pay. Therefore close-out netting and set-off may substantially reduce exposure and are the key criteria indicating pro-creditor or pro-debtor attitudes in different jurisdictions.
On June 30 2011 the Law Amending the Law on Financial Collateral Arrangements (the Financial Collateral Law, or the Law) came into effect. The Financial Collateral Law not only implements Directive 2009/44/EC but also, following the International Swaps and Derivatives Association (Isda) Model Netting Act, decreases systemic risk and creates more certainty in derivatives contracts by including provisions enabling close-out netting on insolvency under qualified financial agreements. The draft Financial Collateral Law was prepared by the Ministry of Finance in cooperation with the Association of Lithuanian Banks advised by Sorainen and using Isda technical assistance.
Scope of netting legislation
Since both the Law on Bankruptcy of Enterprises and the Restructuring Law give priority to the regulation established in the Financial Collateral Law, the scope of the latter is an issue of high importance. The application of the Financial Collateral Law is narrowed to qualified financial agreements on financial instruments and foreign exchange which may be concluded between specific counterparties only.
Qualified financial agreements providing for close-out netting provisions in respect of financial claims and obligations thereunder may be concluded between specific counterparties only: state authorities; central and international (regional) banks and funds (e.g. the European Bank for Reconstruction and Development, the European Investment Fund); supervised financial institutions, including credit institutions, financial brokerage firms, insurance companies, management companies; central counterparties, settlement agents or clearing houses; trustees or representatives of any one or more persons itemised above that includes bondholders or holders of other forms of securitised debt; persons other than a natural person provided that the other party is an institution listed above. Note, however, that the scope of the Financial Collateral Law does not include entities organised in, licensed and supervised by supervisory institutions of countries other than EU or EEA (European Economic Area) Member States.
As mentioned, qualified financial agreements are executed in financial instruments or foreign exchange. However, the Financial Collateral Law does not provide criteria or lists of derivative transactions covered by the definition of financial instruments under the Law. Therefore, if financial agreements are executed in derivative contracts, which do not fall within the scope of Directive 2004/39/EC (MiFID) and the Law on Markets in Financial Instruments, the risk arises that such agreements might be re-categorised and considered as not falling within the scope of the Financial Collateral Law. The legal consequence would be that close-out netting provisions with respect to financial claims and obligations under such financial agreements may be regarded as invalid and unenforceable.
Automatic early termination
Automatic early termination (or automatic cancellation) is a provision that a series of open contracts between the parties are deemed to be cancelled and losses and gains set off immediately prior to institution of insolvency proceedings. However, Lithuanian law does not provide for automatic early termination. Under the Financial Collateral Law, the non-defaulting party must inform the defaulting party about execution of close-out netting provisions within one working day. Thus, for instance, if an event of default occurred two weeks before, the non-defaulting party cannot deem that contracts as cancelled immediately prior to the event of default, because the defaulting party was not informed about the execution of close-out netting provisions within the set deadline.
"Cherry-picking"
Under Lithuanian law the insolvency administrator can generally abandon or terminate loss-making contracts, with the effect that the bankruptcy estate will terminate loss-making contracts but require the debtor to perform contracts profitable to the estate (cherry-picking). However, according to the Financial Collateral Law, close-out netting provisions should take effect in respect of claims and obligations under qualified financial agreements, notwithstanding commencement or continuation of insolvency proceedings of the defaulting party and (or) any purported assignment, judicial or other attachment or seizure. On that basis we believe that parties to qualified financial agreements may agree on netting provisions, but only if those provisions are valid and enforceable under the Financial Collateral Law.
Moreover, the Financial Collateral Law explicitly prohibits the insolvency administrator from "cherry-picking" under a qualified financial agreement. According to the Law, the insolvency administrator does not have a right to reject enforcement of agreements, restrain payments, liabilities or other rights, which arise from one or more qualified financial agreements. We should note that this provision is valid until execution of close-out netting, and therefore we believe that "cherry picking" is permitted only as to the single net amount owing one way or another which has been produced as a result of execution of a close-out netting provision, i.e. cancellation, calculation and set-off of gains and losses on each contract.
In summary, by enabling close-out netting in respect of financial claims and obligations under qualified financial agreements in its domestic legal system, Lithuania has significantly decreased risk in the financial system and joined the club of progressive jurisdictions in the field of derivative transactions regulation.