Not so long ago, the Ukrainian Parliament has finally made a successful attempt to implement the derivatives reform in Ukraine. The work on the draft law dates back more than ten years and includes several iterations in the Parliament. No wonder there has been much celebration among the stakeholders and market participants. Alerts and press-releases have been sent around saying that Ukrainian law is now familiar with close-out netting and inviting those interested to take a closer look. This article aims to do just that – take a closer look at how the new statutory provisions on close-out netting will operate in the specific context of the 2002 ISDA Master Agreement.
Sayenko Kharenko has been a part of the working group on the draft law introducing the reform almost since the beginning of the work. Because we have been deeply involved for a while, I thought that it would be useful to give a practical perspective on the information that is currently out there and run a more detailed analysis of the new regime in the context of the specific provisions of the 2002 ISDA Master Agreement.
A couple of reservations before we get to the point. First, the law is still pending President’s signature and promulgation (this is a big law), although we think, and hope, that this is just a matter of time. Second, even once the law in general becomes operative, the close-out netting regime will become effective in all aspects in July 2021. Third, the provisions of the law are quite complicated, and a lot will depend on how Ukrainian courts will apply them (judges will probably need some training). And last, this is just and article, not legal advice or anything else that can get me in trouble.
The overview in this article covers the following aspects:
In summary, close-out netting provisions of the 2002 ISDA Master Agreement should generally work as intended in the context of the new Ukrainian law. This is especially so outside of insolvency of a Ukrainian counterparty. If you get into the insolvency territory, there are some bumps you should be aware of, including mandatory automatic early termination, some additional administrative requirements in case of insolvency of a Ukrainian bank, impossibility to offset the Early Termination Amount and accrue interest on it following insolvency.
If your counterparty is the National Bank of Ukraine, you are generally safe, as these guys can’t go broke (legally speaking at least).
Now, to the details.
Since ISDA Master Agreement would likely be governed by English, New York or, more recently, French Law, a question arises if a foreign law contract establishing close-out netting terms is recognised from the Ukrainian law perspective. The answer is yes – there is nothing in the Ukrainian close-out netting rules that would prevent foreign-law governed netting agreements.
This is subject to two reservations. First, choice of foreign governing law by the parties needs to comply with the conditions under the Ukrainian conflict of laws rules (if a transaction is between a foreign and Ukrainian counterparties – it should suffice). Second, there will still be certain limitations that are covered below, most of them arising in case of an insolvency of a Ukrainian counterparty.
Early termination date and automatic early termination
ISDA Master Agreement allows a Non-Defaulting Party to designate an Early Termination Date by notice. Besides, the parties may opt for Automatic Early Termination in respect of certain insolvency events of default.
In an insolvency-related scenario, Ukrainian close-out netting rules do not allow for this optionality. The law contains a term “close-out netting date”, which is defined as the earlier of the date provided for in the agreement and the “date of insolvency” (being, for example, the date of opening of insolvency proceedings by a court in respect of a regular corporate entity or declaration of insolvency of a bank by the National Bank of Ukraine).
While the question of interpreting the usage of “close-out netting date” in various contexts may be debated, we tend to stick to the conservative side for now and treat it as an equivalent of the Early Termination Date under ISDA Master Agreement. What follows from that is that if a Ukrainian counterparty faces an insolvency event of default, Ukrainian law would impose an automatic early termination. Such interpretation is supported by another provision of the law saying that a netting agreement may provide that close-out netting would be effected by notice, except that this option is not available in case of an insolvency event.
That being said, we should note that the “insolvency events” requiring automatic early termination under Ukrainian law are not exactly the same as the relevant events described in 5(a)(vii) of the ISDA Master Agreement. The “insolvency events” under the Ukrainian law are to a large extent based on the “opening of insolvency proceedings” events under the Settlement Finality Directive. Therefore, voluntary dissolution, general arrangements and compositions with creditors, may technically fall outside of the statutory automatic early termination requirement.
The bottom line is that, one should remember that there is a mandatory automatic early termination in case of at least some insolvency events. Unless the approach is corrected in the law, the optimal practical way to deal with this from the contractual perspective remains to be determined and we are currently considering different possibilities (for example, limiting the automatic early termination to the minimum possible triggers).
Calculation of the close-out amount and early termination amount
First, the Determining Party. The Ukrainian law does mention that a netting agreement should refer to a “person responsible for conducting close-out netting”. While the wording in the law could have been clearer, in our view there is nothing that would prevent operation of the provisions of the ISDA Master Agreement as to who runs the calculations of the Close-out Amount (including where this would be two Affected Parties or even an agent of a Determining Party).
Then, there is a question of determination itself. For the purposes of close-out amount calculations, the law uses a term “value of obligations” of a party under a derivative transaction, and then follows with a statement that the procedure for determination of such value should be established by the netting agreement. “Value of obligations” is, in turn, defined as “monetary equivalent” of the relevant obligations. Again, for complete clarity, a bit of further explanation in the law itself might have been helpful. Still, we believe that the approach of losses (costs) and gains in replacing or obtaining an economic equivalent, as used in the definition of Close-out Amount under ISDA Master Agreement, should be covered. The provision of the law giving the freedom to the parties to establish in the netting agreement how they wish the “value of obligations” to be determined gives comfort in this context. For the same reason, we believe that the Unpaid Amounts should also be captured by the statutory “value of obligations” concept.
In light of automatic early termination, it is probably worth touching upon adjustments for bankruptcy of the Early Termination Amount under 6(e)(iii) of the ISDA Master Agreement. Our view is that this should fall under the umbrella of the “procedure for determination” that may be established by the parties. At the same time, we should admit that there is room for different interpretations here.
Finally, the date as of which the Close-out Amount (or “value of obligations”) is to be determined. ISDA Master Agreement provides for determination as of or as soon as commercially reasonable following the Early Termination Date. If this aspect is treated as part of the “procedure for determination” under the Ukrainian law (which, we believe, it probably should), then the conclusion would be that it works fine. However, one should note the requirement in the banks’ insolvency context to complete close-out netting within seven business days following the insolvency date, which indirectly limits the reference date of the calculation.
Providing a statement of calculations and more
Under ISDA Master Agreement, once calculations of the Early Termination Amount is made, a party (or both parties) sends to the other party a statement showing the calculations, specifying the Early Termination Amount and the account to which the payment needs to be made. If the Defaulting Party is a Ukrainian bank and the default is such bank’s insolvency, that will not be all.
The Ukrainian law currently requires that a Non-Defaulting Party provides the insolvent bank and the Deposit Guarantee Fund (the Ukrainian bank resolution authority) with a list of transactions that are subject to close-out netting and the estimated date of completion of the close-out netting. And this information has to be provided within three business days from the date of declaration of the bank’s insolvency.
Usefulness of this requirement seems questionable at best. Why the need for a separate list? Why the need for heads-up on completion of the calculations? While we opposed this in the drafting work, the provision found its way into in the law. Our first hope is that it will be removed in the future. If not, a potential solution may be to incorporate this in the statement under 6(d)(i) of the ISDA Master Agreement, if timing permits. We also hope that the Deposit Guarantee Fund will not require this to be mailed to them.
For banks, the law also requires that close-out netting is completed within seven business days following the insolvency date. We appreciate that insolvency of a bank may hardly go unnoticed in practice, but still this limitation may present an inconvenience given mandatory automatic early termination.
The law does not contain similar requirements in case of a non-bank counterparty insolvency. Probably, because there is no particular insolvency authority for regular corporates to come up with this type of things.
Set-off under section 6(f)
Set-off provisions under section 6(f) of the ISDA Master Agreement should work just fine outside of insolvency of a Ukrainian counterparty.
In an insolvency scenario, once an Early Termination Amount is determined, it becomes subject to the general Ukrainian insolvency regime for creditors’ claims and obligations. Both insolvency rules for regular corporates and banks make set-off in insolvency impossible (practically impossible in case of regular corporates). Therefore, set-off under section 6(f) would be unenforceable in Ukraine in that case.
There is a practical subtlety relating to the question of whether the Ukrainian insolvency law would be recognised outside of Ukraine (i.e., have an extraterritorial effect). For instance, if a foreign Non-Defaulting Party holds Ukrainian insolvent party on deposit outside of Ukraine, it might still be able to offset that against an Early Termination Amount payable to it.
Interest under 9(h)(ii)
Operation of provisions on interest for the purposes of determining Unpaid Amounts should not be affected by the Ukrainian law, since it should be captured by the “value of obligations” concept (see the section on the Close-out Amount and Early Termination Amount above). Remember that in case of an early termination due to insolvency, the Ukrainian law requires early termination on the date of insolvency.
The situation is different for interest on Early Termination Amount, again in the insolvency scenario.
If an insolvent counterparty is a bank, the rule is clear and simple – accrual of interest on creditors claims is not allowed upon declaration of insolvency and introduction of temporary administration in respect of the bank.
The rules are less clear where an insolvent counterparty is a regular corporate. Between opening of insolvency proceedings and until the beginning of the liquidation procedure (if it comes to that), the law restricts accrual of so-called “penalties” and similar payments for the breach of monetary obligations. If the court takes a formal view that interest on the Early Termination Amount is a type of sanction for failure to pay when due, then any such interest will be unenforceable. Once the liquidation is ordered by the court, there is again an express provision of the Ukrainian insolvency law stating that no further interest can be accrued.
We believe this covers most of the important contractual issues relevant to early termination and close-out netting provisions, with some focus on insolvency of a Ukrainian counterparty. There is definitely more on the topic to get our heads around (like clawback rules or enforcement of collateral), but we will try to cover these separately later.
And we would be happy to chat!