Termination and close-out netting together constitute the single most important technique for reducing credit risk in the derivatives markets. A typical derivatives contract provides for the termination of all transactions on the default of a counterparty, either automatically or at the option of the non-defaulting party.
In order for these termination provisions and the associated contractual remedies to be effective, they must be enforceable both under the governing law of the document and under any other laws applicable to the counterparty. Most importantly, since there is a strong likelihood that the default will occur as a result of insolvency, they must be enforceable under the insolvency laws of the jurisdiction of the organisation of the counterparty.
The combination of the EU’s Financial Collateral Arrangements Directive and the adoption of netting legislation based on the International Swaps and Derivatives Association (ISDA) Model Netting Act means that established practice in the derivatives market has been validated under corporate insolvency law in an increasing number of jurisdictions.
If there has been one development that has changed the questions that are being asked of offshore jurisdictions over the past 12 months, it is the use of entities other than straightforward companies. Partnerships and trusts are increasingly used by funds and as part of structured finance transactions.
Any jurisdiction that considers itself a serious choice of domicile for funds now offers a segregated portfolio company in one guise or another. Increasingly, therefore, the question the financial institutions are asking in respect of their prime brokerage arrangements and derivatives transactions is: ‘does close-out netting still work in respect of entities other than straightforward corporates?’.
But what is the developing position in the British Virgin Islands (BVI)? And what are the ways in which the market is overcoming questions of legal certainty with respect to segregated portfolio companies, partnerships and trusts?
With more than 700,000 companies and a thriving funds industry, the BVI has inevitably been a focus for questions regarding close-out netting. The completion of the transition to a new corporate regime on 1 January 2007 brought with it the segregated portfolio company, and already this is in wide use by the funds industry.
The BVI’s established partnership legislation includes a limited partnership based on the English LLP.
Trusts have historically been one of the BVI’s undisputed strengths. BVI trust law took a further step forward in 2003 with the enactment of the Virgin Island Special Trusts Act, which enables special trusts to be settled that allow property to be held on trust for retention rather than for sale and to permit the trustees to leave the management of an underlying company to the directors. Although originally conceived of as a succession-planning tool, these trusts are finding broader application in the structured finance arena and are increasingly encountered in connection with derivatives transactions.
The BVI has responded to the needs of the derivatives market with a regime that effectively validates netting agreements in their entirety through insolvency. The primary constituents of the netting regime in the BVI are the insolvency set-off rules and the netting and financial contract provisions.
Insolvency set-off is essentially an enhanced version of English automatic insolvency set-off and includes explicit recognition of debt subordination agreements and the ability for a creditor to waive the benefit of the set-off provisions if done before liquidation. Most importantly from the derivatives perspective, the insolvency set-off provisions are expressly made subject to provisions relating to netting arrangements in financial contracts.
Based on the ISDA Model Netting Act, the netting provisions of BVI law in effect validate netting agreements in their entirety through insolvency.
A netting agreement is defined as an agreement between two parties, in relation to present or future financial contracts between them, the provisions of which include the termination of those contracts for the time being in existence, the determination of termination values of those contracts and the set-off of the termination values so as to arrive at a net amount due. Examples of financial contracts have been set out in rules and include swaps and other derivatives contracts, securities lending and repurchase agreements, title-transfer collateral arrangements and any other agreement that the BVI Financial Services Commission designates as such.
The effect of these provisions is that the contractual provisions of a netting agreement will prevail even if the automatic insolvency set-off rules were to produce a different result, notwithstanding any preference or undervalue that might otherwise cause a BVI court to set aside the transaction.
Netting against other entities
** Segregated portfolio companies. For the purposes of set-off and netting, the portfolios of a segregated portfolio company are effectively treated as if they are distinct legal entities. Netting provisions of a netting agreement will therefore be enforceable in the BVI providing they do not purport to net amounts due from one portfolio against amounts due to another.
Achieving close-out netting across portfolios presents much the same problem as achieving close-out netting across multiple counterparties: while in principle netting requires mutuality, structures that contractually transfer the liabilities of one entity to another and then achieve bipartite netting against each of those entities separately can achieve the required effect.
** Partnerships. Critically, the close-out netting provisions of BVI law are not limited to companies. There is therefore no difficulty in principle with the enforcement of close-out netting provisions against a partnership. However, partners are only liable for the partnership debts that accrue during their time as partners. A change in the partnership therefore effectively defeats the mutuality required for insolvency set-off to apply. Although the netting provisions of BVI law are not limited to companies, this question of mutuality is not dealt with.
It is anticipated that, when further rules are promulgated, they will expressly extend the scope of netting to partnerships and will provide that parties dealing with a partnership will be entitled to net obligations owed to the partnership with obligations owed by the partnership notwithstanding any change in the composition of the partnership. Until such rules are brought into force, parties wishing to enter into netting agreements with partnerships should always seek to prohibit changes in the partnership or include market-approved provisions for automatic novation.
**Trusts. Similar issues of mutuality affect trusts. If a new trustee is appointed during the lifetime of a netting agreement, transactions entered into by the old trustee on behalf of the trust will need to undergo novation.
As the funds and structured finance industries embrace new structures and different organisational entities, the BVI has responded with both state-of-the-art regulation and a permissive netting regime.
With the use of automatic novation provisions, the BVI can now provide close-out netting solutions for pretty much any entity, and as the derivatives market tests itself against different entities, the regulatory regime of the BVI moves with it. It is no coincidence, therefore, that the BVI, already established as the world’s leading offshore corporate domicile, is increasingly recognised as one of the derivatives industry’s preferred offshore jurisdictions.
Peter Tarn is global head of banking and Russell Willings is an associate at Harneys