Statutory recognition of netting, contractual subordination and non-petition provisions

26 Jan 2012

With the continuing development of sophisticated cross-border financial transactions, certain contractual practices have evolved and, with the passage of time, become recognised as standard in the relevant marketplace. Financial centres such as Jersey monitor such developments with a view to implementing policy and/or legislation as may be required or desirable to maintain and enhance the reputation of Jersey as a jurisdiction of choice for such cross-border transactions.

The legislation described in this briefing deals with certain contractual provisions which have become common in the marketplace. The development in other jurisdictions of specific laws dealing with these matters has encouraged a desire to establish statutory recognition of the types of contractual provisions concerned (albeit that strong legal opinion has been available in Jersey on these issues). This also tracks certain developments within the European Union where a task force looking at stability in the financial marketplace has encouraged the implementation of domestic legislation in EU member states dealing with the efficacy of netting provisions, in particular.

The Bankruptcy (Netting, Contractual Subordination and Non-Petition Provisions) (Jersey) Law 2005 (the "Law") came into force in Jersey on 12 August 2005.

The Law provides legal certainty as regards certain key contractual provisions used in banking, derivative, capital markets and structured finance transactions (including securitisations).

The Law confirms the effectiveness of contractual close-out netting, set-off, subordination and non-petition provisions.

The Law improves the structural legal characteristics of many banking, derivative, capital markets and structured finance transactions and therefore benefits all participants in these transactions (as well as regulators, rating agencies and other interested third parties).

By creating greater legal certainty, the Law further enhances the reputation of Jersey as a developed and stable jurisdiction within which to undertake sophisticated cross-border financial transactions.

Close out netting and set-off
Close-out netting
The concept of close-out netting underpins the derivatives markets.

Close-out netting provisions may be found in a range of derivative products. For example, close out netting provisions are employed in the International Swap and Derivatives Association (ISDA) Master Agreements.

In brief, under the terms of the relevant derivative, when a specified event occurs (such as insolvency), the underlying transactions effected by the parties pursuant to the derivative are terminated. There is usually a formula (or method) by which the liabilities in respect of each terminated transaction are then quantified. However, rather than each party paying its respective termination liabilities to the other, close-out netting provides for the consolidation of the respective liabilities (so that only the difference in value between the liabilities (i.e. the net amount) is taken into account). In other words, the respective termination liabilities are replaced by a new single net payment obligation.

Close-out netting is particularly useful for derivatives that have delivery (rather than payment) obligations.  For example, the obligations under a derivative may be to deliver assets (such as commodities or securities).  Close-out netting would operate so as to terminate the underlying transactions, to replace the delivery obligations with payment obligations (by reference to a valuation procedure) and for the netting of the resultant money claims into a single net payment obligation.

Close-out netting is often important to institutional counterparties by reference to the regulatory capital position they may report to their regulators assuming the efficacy of the contractual close out arrangement (i.e. they may be permitted to report "net" exposure).

Set-off
The concept of set-off is similar to the concept of netting but of much wider application to banking and financing transactions generally.

A contractual set-off clause allows one contractual party to set-off amounts owed by that contractual party against amounts owed to that contractual party.

Contractual set-off is different from close-out netting.  The main differences are that set-off need not involve the termination of an underlying transaction; set-off need not involve a contractual formula to determine the respective money claims; and set-off does not give rise to a replacement net payment obligation. All that happens with set-off is that one existing claim is reduced. Set-off provisions may therefore be seen as being wider in scope than close-out netting provisions.

Position before the Law
Prior to the introduction of the Law, there were certain technical concerns as to the effectiveness of contractual close-out netting and set-off provisions on the insolvency of a company.

In the event of a declaration of désastre (bankruptcy) under the Bankruptcy (Désastre) (Jersey) Law 1990 (the "Désastre Law"), mandatory set-off rules apply.

Article 34 of the Désastre Law provides as follows:
"Where there have been mutual credits, mutual debts or other mutual dealings between the debtor and a creditor, an account shall be taken of what is due from the one party to the other as at the date of the declaration [of désastre] in respect of such mutual dealings and the sum due from one party shall be set-off against any sum due from the other party, and the balance of the account, and no more, shall be claimed or paid on either side respectively."

Article 166 of the Companies (Jersey) Law 1991 imports the same rule to a creditors' winding-up procedure in respect of Jersey companies.

As these insolvency provisions are of mandatory application, any agreement between the parties to "vary" or "contract out" of this regime could be open to doubt on the basis of public policy concerns.

Position under the Law
Article 2 (1) of the Law provides that (despite any enactment or rule of law to the contrary) a close-out netting or set-off provision of an agreement is enforceable in accordance with its terms.

Article 2 (2) of the Law further provides that any such close-out netting or set-off provision remains enforceable despite (a) the bankruptcy of a party to the agreement (or any other person) and (b) the lack of any mutuality of obligation between a party to the agreement and any other person.

Contractual subordination
Subordination
Most structured financing transactions (and many banking transactions where participating creditors wish to agree their ranking amongst themselves) depend on the creditors of an obligor agreeing an order of priority in respect of the application of available monies in discharge of the obligor's indebtedness, either within or outside the context of security being provided.

Under a contractual subordination provision, a party would agree to subordinate (or otherwise defer) that party's claim against an obligor to the claims of other creditors.

One simple example may be seen in property financings where a borrower incurs both senior debt and subordinated debt. The senior lender, the junior lender and the borrower enter into a subordination agreement pursuant to which the junior lender agrees to subordinate its claims against the borrower in favour of the senior lender. The exact terms of the subordination will be a matter of commercial negotiation but, in the context of a property financing, the commercial arrangements may be such that the junior creditor agrees to receive no payments at all in respect of the junior debt unless and until the senior debt has been paid and discharged in full. This is sometimes referred to as a "deep subordination".

Another example can be seen in a typical securitisation structure where contractual subordination is important in the context of the order of priority set out in payment "waterfalls" dealing with the application of a special purpose vehicle's available monies to meet its liabilities.

Position before the Law
Before the introduction of the Law, technical concerns existed as to the efficacy of contractual subordination provisions.

The technical concerns are similar to those outlined above concerning close-out netting and set-off.

In summary, in the event of a désastre (bankruptcy) or creditors' winding-up of a Jersey company, there is a statutory regime dealing with how the assets of a company should be distributed. One of the key principles is that unsecured creditors (who are not preferred) should rank equally on a distribution of the company's assets on a pari passu basis.  To the extent that the parties agree to "vary" or "contract out" of these procedures through subordination arrangements, such arrangements could be seen as being vulnerable to attack on the basis that they avoid a mandatory statutory regime and therefore do not accord with public policy.

Some comfort could be obtained from the English case of Re Maxwell Communications Corporation plc (No. 2) [1994] 1 B.C.L.C.1. which upheld the effectiveness of contractual subordination arrangements. Although not binding in Jersey, this case would have been of persuasive value in the absence of local case law on the point. However, the Law now provides statutory certainty.

Position under the Law
Article 2 (1) of the Law provides that (despite any enactment or rule of law to the contrary) a contractual subordination provision is enforceable in accordance with its terms.  

Article 2 (2) of the Law reinforces this position by providing that the subordination remains effective on the bankruptcy of any person.

Non-petition
Non-petition covenants
In structured financings, it is often the case that a special purpose vehicle (an "SPV") will be used. The SPV will be a company whose only business is a particular structured finance transaction. The SPV will not conduct any trading activities or business apart from the particular structured finance transaction.

Rating agency requirements will often dictate that the SPV will be structured as a bankruptcy remote entity, so that the risk of an insolvency of the SPV will be mitigated to the extent possible.

There are various structural features that can be adopted to assist in making an SPV bankruptcy remote.

One such feature is where key transaction creditors of the SPV in a structured finance transaction (for example, lenders, service providers, administration agents etc.) contractually agree that they will not petition for the insolvency (or other winding-up) of the SPV until such time as the relevant indebtedness of the SPV has been paid and discharged in full. Indeed, depending on the drafting of the non-petition covenants, the covenants might be stated to apply for a given period after such repayment, in order to give additional protection against any statutory setting aside provisions which might apply on an insolvency of the SPV and which might be used to challenge the validity of the repayment.

Position before the Law
Prior to the enactment of the Law, there were technical concerns as to the efficacy of non-petition provisions.

A creditor has statutory rights to instigate the insolvency of a debtor and it could be argued that any contractual restriction of these rights would be ineffective on public policy grounds as an attempt to modify applicable insolvency laws.

Position under the Law
As a result of the introduction of the Law, any residual doubt concerning the efficacy of such non-petition covenants has been removed.

Article 3 (1) of the Law provides that a non-petition covenant is enforceable in accordance with its terms.

Article 3 (2) of the Law strengthens the position further, providing that a non-petition covenant remains enforceable despite the bankruptcy of any person.

Fraud and misrepresentation
Article 5 (2) of the Law stipulates that nothing in the Law affects the application of any law that renders an agreement unenforceable on the grounds of fraud or misrepresentation.

Therefore, the Law preserves the application of general contract law principles relating to fraud or misrepresentation.

Any agreement may still be challenged on the basis of fraud or misrepresentation and, if an agreement is found to be unenforceable as a consequence of fraud or misrepresentation, the Law will not operate to preserve the effectiveness of any close-out netting provisions, set-off provisions, subordination provisions or non-petition covenants contained within any such agreement.

Jersey branch of foreign body corporate
The Law also contains provisions at Article 6 specifying that close-out netting provisions, contractual subordination provisions, non-petition provisions and set-off provisions in any agreement shall also be valid and enforceable in Jersey where one of the parties to the agreement is a branch established or operating in Jersey of a foreign body corporate, notwithstanding any enactment or rule of law that may be applicable to such body corporate, including the domestic law of the jurisdiction under which it is established. The purpose behind this provision is to give certainty when dealing with counterparties operating in or from Jersey, whether or not established under Jersey law.