The huge role of U.S. banks in the derivatives industry means counterparties must understand the treatment of close-out netting and set-off for an insolvent bank by the Federal Deposit Insurance Corporation (FDIC). Close-out netting and set-off, both of which are typically provided under the ISDA Master Agreement, provide the most effective and efficient way to minimize credit risk with respect to the insolvency of a counterparty.
Close-out Netting. The solvent party is concerned that upon the insolvency of its counterparty, it will have to make payments to the receiver or conservator, while remaining as a general creditor with respect to payments the insolvent bank owes to it. In such a scenario, the possibility of collecting these amounts is minimal. Close-out netting, as provided under the ISDA Master, eliminates much of that concern. First, it provides that the solvent counterparty can terminate the ISDA Agreement upon the bank's insolvency. As part of the termination and close-out of an ISDA Agreement, each included individual or included transaction is closed-out at its mark-to-market value. The mark-to-market value is usually equal to the cost of replacing the individual terminated transaction.
Second, close-out netting provides that the solvent party can then net the termination value of any transaction for which it is out-of-the-money with the termination value of any Transaction for which it is in-the-money.
Set-off. Set-off rights are similar and generally are provided for under the ISDA Agreement. The terms set-off or offset refer to the right of the solvent party to contractually set-off or offset the net amount it owes to the insolvent party under the ISDA Agreement, which occurs after close-out netting has been applied, against any other amounts that the insolvent party owes to the solvent party, or vice versa. For example, assume that the solvent party owes the insolvent bank a net amount of USD20 under the ISDA Agreement, and the insolvent bank owes the solvent party USD30 on a different transaction apart from the ISDA Agreement. The right of set-off under the ISDA Agreement would contractually permit the solvent party to set-off the USD20 that it owes the insolvent bank against the USD30 that the insolvent bank owes to the solvent party, with the result being that the insolvent bank owes the solvent party USD10.
FDIA. Although the ISDA Agreement contractually provides for both close-out netting and set-off, the concern is that banking insolvency rules would prevent the solvent counterparty from exercising such rights. The insolvency of an insured financial institution (i.e. a U.S. bank that accepts FDIC insured deposits) is governed by Federal Deposit Insurance Act as amended by FIRREA. In addition, the Federal Deposit Insurance Corporation Improvement Act of 1991 ("FDICIA") also must be considered. Parties are often tempted to assume that the special insolvency rules with respect to the treatment of derivatives for an insolvent U.S. bank under FDIA are completely parallel with the rules found in the U.S. Federal bankruptcy code (the "Code"), the rules that govern the bankruptcy of most U.S. corporations. However, the mechanics and policy rationales behind FDIA are quite different from those under the Code.
Close-out Netting Under FDIA. Under FDIA, the general rule is the FDIC may enforce a contract with a solvent counterparty if the sole reason for the termination of the contract is the appointment of the FDIC as the receiver or conservator for the insolvent bank. There exists, however, important exceptions for contracts involving swap agreements. Swap agreements are defined under FDIA in a manner similar to that of the Code and includes a wide variety of the most common over-the-counter derivative transactions.
Upon the appointment of the FDIC as a receiver or as a conservator, the FDIC initially has the power to transfer an ISDA Agreement to another FDIC-insured bank. There is no such parallel power for the bankruptcy trustee of a debtor under the Code. This means that a solvent party not only cannot initially terminate the ISDA Agreement with an insolvent bank, but also may end up with a different counterparty altogether. Although such transfers, historically as a practical matter are rare the power to do so is invested in the FDIC.
If the FDIC is a receiver, however, such transfer power must be exercised immediately. If the FDIC does not transfer an ISDA Agreement by close of business on the day following its appointment as a receiver, the solvent counterparty may then go ahead and terminate the ISDA Agreement. This closely resembles a solvent creditor's rights under the Code, although there is still a one day delay for terminating the ISDA Agreement that does not occur under the Code.
A solvent counterparty's termination rights under the ISDA Agreement are suspended if the FDIC is appointed as a conservator. Here, the FDIC as a conservator essentially steps into the shoes of the insolvent bank and assumes the rights and obligations of the insolvent bank. To terminate an ISDA Agreement after the appointment of the FDIC as a conservator, an event of default (other than an insolvency or insolvency related event) or a termination event would have to occur or the conservatorship would have to be replaced by a receivership. This is opposite from under the Code in which there is no stay on the solvent party from terminating the ISDA Agreement.
As a practical matter, the vast majority of U.S. banks are now put into receivership as opposed to conservatorship. It is unclear, however, how the FDIC would deal with the insolvency of a large U.S. bank that was also acting as a derivatives dealer. By placing the dealer into a conservatorship, a solvent counterparty's rights to terminate the ISDA Agreement may be indefinitely suspended.
Many believe a party's close-out netting rights could still be enforced under certain circumstances under FDICIA, which provides that "notwithstanding any other provision of law", a party may enforce the close-out netting terms of a netting contract entered into between financial institutions. ISDA has obtained legal memorandums that support such a reading of the statute. The FDIC, on the contrary, has taken the official position that FDICIA only enforces a party's netting rights and not the right to terminate an ISDA Agreement.
Cherrypicking. A concern for solvent parties with respect to close-out netting, especially when the FDIC is appointed as a conservator, is cherrypicking. FDIA, however, has eliminated this risk. This is important because the solvent party's credit analysis is dependent upon close-out netting between all of the transactions entered into with the bank.
FDIA defines a swap agreement as including both an ISDA Agreement as well as each of the underlying transactions. Even though there may be hundreds of transactions entered under a single ISDA Agreement, FDIA treats it is as one agreement. Consistent with this definition, if the FDIC elects to transfer an ISDA Agreement, it must also transfer all of the underlying transactions in the same ISDA Agreement to the same transferee.
Set-off of a Qualified Financial Contract. Beyond close-out netting, FDIA expressly provides for set-off of the early termination amount under the ISDA Agreement with amounts due under other qualified financial contracts. FDIA defines qualified financial contracts as including a swap agreement, a qualified financial contract includes a securities contract, commodity contract, a forward contract or a repurchase agreement. A party entering into a swap agreement with a U.S. bank may also have entered other qualified financial contracts with that same bank that were not documented under the same ISDA Agreement. The contractual set-off provision found in an ISDA Agreement should be sufficient to permit a party, under FDIA, to set-off the amount owing under a swap agreement with amounts owing under any other qualified financial contracts entered into with the same party.
Set-off Against Other Amounts. After exercising its close-out netting rights and setting-off any net amounts that the solvent party owes to the insolvent bank under qualified financial contracts, there may still be amounts owed by the solvent party to the insolvent U.S. bank under the ISDA. The solvent party would want to set-off such amount against any other amounts (apart from amounts under qualified financial contracts) owed by the insolvent bank to it such as deposits that the solvent party has with the U.S. bank.
Although the FDIC will generally recognize and will enforce a creditor's right of set-off against an insolvent bank, such rights may be severely limited because of application of the depositor preference liquidation provisions of FDIA. The FDIC would probably view these provisions as preempting such a set-off right. Under the depositor preference liquidation provisions, the FDIC as a receiver or conservator is required to distribute amounts collected from the liquidation or resolution of the insolvent bank and then pay off any claims against the bank. Before the claims of general creditors are paid, the administrative expenses of the FDIC and any domestic deposit liabilities of the insolvent bank are paid off first.
If the solvent party were out of the money, the FDIC would require the party first to pay in any amounts that such a party owed and would consider the solvent party to be a general creditor for any amounts owing to it by the insolvent bank.
Permitting the party to set-off any amounts owing to it by the insolvent bank that were not of the same preference would appear to violate the depositor preference provision. This is because an insolvent bank's obligation to a party with a low preference would be paid through application of the set-off prior to the other deposit liabilities with a higher preference being paid off. Effectively, the only opportunity to exercise a set-off right would appear to be a situation in which the solvent party that is out of the money under the ISDA Agreement had insured deposits with the insolvent bank that would be paid by the FDIC.
This week's Learning Curve was written by Christian Johnson, associate professor at Loyola Law Schoolin Chicago. He can be contacted at cjohns6@luc.edu
