Jones Day

In Short

The Situation: Banking regulators in the United States have issued the so-called "Resolution Stay Regulations," which require "global, systemically-important banks" ("GSIBs") to amend a broad variety of "qualified financial contracts" ("QFCs"), including spot and forward physical commodity contracts, securities underwritings, and other offerings.

The Result: GSIBs are required to bring all QFCs transacted on or after January 1, 2019 with "financial" counterparties into compliance by July 1, 2019 and with corporate clients by January 1, 2020.

Looking Ahead: Although often equated with derivatives, corporate counterparties and issuers of securities are starting to see "QFC resolution stay" provisions being proposed for insertion into QFCs in potentially unexpected circumstances, including in overseas offerings that have no connection with the U.S.

The Resolution Stay Regulations require GSIBs to amend or otherwise remediate a wide range of financial contracts and are reaching into potentially unexpected corners of the markets. QFCs are often equated with derivatives and "repo" agreements, but they also include spot and forward physical commodity contracts and "contract[s] for the purchase, sale, or loan of a security" and accordingly capture ordinary capital markets activities in which securities are purchased directly from the issuer for the purpose of re-sale to investors. Corporate clients in the U.S. and overseas are seeing "resolution stay" provisions being proposed for insertion into derivatives, physical commodity contracts and syndication agreements.

The resolution stay regulations are complex, and this short introduction must necessarily omit many important details and qualifications. Corporate counterparties and issuers are urged to seek detailed and individualized advice from competent counsel concerning the applicability of the Resolution Stay Regulations to their own circumstances.

What Are the QFC Provisions?

Regulatory Background: United States GSIBs are prohibited by the Resolution Stay Regulations from entering into QFCs that lack certain features ("QFC Provisions") designed to facilitate an "orderly resolution" in the event of the failure of the GSIB.

Failed banks (insured depository institutions) and GSIBs (non-insured holding companies and affiliates of insured banks and other financial companies) are subject to receivership under the Federal Deposit Insurance Act (the "FDIA") and the "orderly liquidation authority" provisions under Title II of Dodd-Frank ("Title II"), respectively. Both varieties of receivership (each, an "FDIC Receivership") mandate that the Federal Deposit Insurance Corporation (the "FDIC") act as receiver. One of the key goals in an FDIC Receivership is to transfer (by way of a so-called "Resolution Transfer") the assets (including operating subsidiaries and contractual rights under QFCs and other contracts) and associated liabilities of the failed institution to a financially capable third party or (preferably on a temporary basis) to an FDIC-created "bridge bank" (in either case, a "Resolution Transferee").

Counterparty Recognition of FDIC Receiverships: In order to facilitate such a Resolution Transfer, contractual restrictions on transfer ("Transfer Restrictions") of QFCs are rendered inoperative in an FDIC Receivership and counterparties are prohibited pursuant to the so-called "resolution stay" from exercising remedies under QFCs until 5:00 p.m. on the business day following commencement of the FDIC Receivership (and the resolution stay will become permanent upon a successful Resolution Transfer).

Title II (but not the FDIA) also imposes the resolution stay on the exercise of "cross-default" remedies by counterparties under QFCs that are triggered by the commencement of a Title II receivership for any consolidated affiliate (an "Insolvent Affiliate") of the "direct" GSIB counterparty, including Insolvent Affiliates that have provided "credit enhancements" (primarily guaranties and collateralization agreements) to such counterparties. Had such a provision been in effect during the 2008 financial crisis, the bankruptcy filing by Lehman Brothers Holdings Inc. ("LBHI") would not have resulted in cross-defaults under the QFCs of its trading subsidiaries, many of which turned out to be solvent. Title II also authorizes the transfer of "credit enhancements" from an Insolvent Affiliate to a Resolution Transferee. Had such a provision been in effect during the 2008 financial crisis and the assets of LBHI been transferred to a Resolution Transferee, the Lehman trading subsidiaries would have become subsidiaries of the Resolution Transferee and the Resolution Transferee would have assumed the associated liabilities under credit enhancements that had previously been provided by LBHI.

The FDIC Receivership portion of the Resolution Stay Regulations is relatively straightforward and uncontroversial, and "simply" requires GSIBs to secure the agreement of counterparties, with certain exceptions for entirely domestic situations, to abide by the existing stay-and-transfer provisions of U.S. law relative to the resolution stay and transfer of their QFCs and credit enhancements pursuant to a Resolution Transfer.

Cross-Default Remedies in Other Insolvent Affiliate Proceedings: The Resolution Stay Regulations go on, however, to require more than "mere" observance of otherwise applicable law and require GSIBs to secure the explicit agreement of their counterparties to waive any credit enhancement Transfer Restrictions and not to exercise cross-default remedies under their QFCs merely as the result of the commencement of an insolvency proceeding anywhere in the world by or in respect of an Insolvent Affiliate.

The stay on cross-default rights (an "Agreed Cross-Default Stay") is similar to the "resolution stay" in duration, except that it continues indefinitely if the Insolvent Affiliate commences a case under Chapter 11 of the United States Bankruptcy Code, and similarly becomes permanent upon the execution of a successful Resolution Transfer. The Agreed Cross-Default Stay is conditioned on insolvency proceedings not being commenced for the direct counterparty and on full and timely performance of all payment and delivery (including collateral delivery) obligations under the QFC and any credit enhancements.

Which GSIBs Are Subject To the Resolution Stay Regulations?

The Resolution Stay Regulations apply to all United States GSIBs and their affiliates globally, and to United States branches and subsidiaries of non-United States GSIBs. A list of GSIBs as of November 2018 may be found at http://www.fsb.org/2018/11/2018-list-of-global-systemically-important-banks-g-sibs/.

It is important to recognize that the Resolution Stay Regulations do not directly require non-GSIBs to do anything (and references herein to what is "required" by the Resolution Stay Regulations are to be read as subject to this caveat). Rather, they prohibit GSIBs from transacting QFCs that do not incorporate the QFC Provisions, and agreement to the QFC Provisions is accordingly a condition to doing business with all "in-scope" GSIBs. Any compliance "gaps" or other failures, however, are solely the responsibility of the applicable GSIB.

When Do the Resolution Stay Regulations Become Effective?

"In-scope" GSIBs already have the obligation to bring all QFCs transacted on or after January 1, 2019 into eventual compliance with the Resolution Stay Regulations, with the relevant "compliance date" being July 1, 2019 for "financial counterparties" and January 1, 2020 for non-financial counterparties. QFCs transacted prior to January 1, 2019 ("Legacy QFCs") also need to be brought into compliance on or before the applicable compliance date if (and only if) the original GSIB counterparty or any of its affiliates transacts with the original counterparty or any of its affiliates on or after January 1, 2019.

What Means Are Available for Complying With the Resolution Stay Regulations?

GSIBs have essentially two options for remediating QFCs: (i) bilateral amendments on a contract-by-contract basis and (ii) counterparty adherence to an industry "protocol" that has been published by the International Swaps and Derivatives Association, Inc. ("ISDA") and specifically approved under the Resolution Stay Regulations. Bilateral amendments must adhere to the letter of the Resolution Stay Regulations, and ISDA and other industry groups have published or are working on standardized "bilateral amendment" language.

Protocol adherence is performed on a corporate group basis and will automatically amend all QFCs (including Legacy QFCs) with all adherent GSIBs to include the QFC Provisions. The protocol accordingly represents a "one-stop shop" for amending the entirety of a corporate group's QFCs with all GSIBs. The Protocol also contains certain "counterparty friendly" provisions that are not strictly permitted under the Resolution Stay Regulations to encourage protocol adherence on a broad basis. There are situations, nevertheless, in which a specific counterparty might wish to limit and control the QFCs that are being amended to include the QFC Provisions. Advice of counsel is heavily encouraged in determining which approach to adopt.

Three Key Takeaways
  1. The broad definition of QFC under the Resolution Stay Regulations reaches well beyond derivatives and includes transactions such as spot and forward physical commodity contracts and off-shore sales of securities to a U.S. GSIB affiliate underwriter. If they haven't already, corporate counterparties and issuers should expect to receive proposals to amend QFCs to meet the January 1, 2020 compliance date for GSIBs to remediate their QFCs with non-financial counterparties. The risk of failing to do so rests entirely on the relevant GSIB, but a remediated QFC will in effect be a condition to doing business with all in-scope GSIBs.
  2. Although they are complex, the Resolution Stay Regulations seek to facilitate a Resolution Transfer for a GSIB by means of two conceptually straightforward agreements on the part of counterparties: to observe the stay-and-transfer provisions under FDIC Receiverships and to disable cross-defaults and Transfer Restrictions on credit enhancements when insolvency proceedings are commenced for an Insolvent Affiliate.
  3. Two methods exist for GSIBs to bring their QFCs into compliance with the Resolution Stay regulations: bilateral amendment, in which case the amendment must adhere strictly to the Resolution Stay Regulations, and ISDA protocol adherence, which contains certain dispensations from the Resolution Stay Regulations and is a "one-stop shop" for affiliated groups of counterparties to amend all QFCs between them but is also an instrument that may be excessively broad for specific circumstances.
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