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Sidley Austin LLP, 787 Seventh Ave., New York, NY 10019, +1 212 839 5300; 1 S October 26, 2017 SIDLEY UPDATE Federal Reserve Adopts Rule Requiring GSIBs to Amend QFC Transactions to Limit Termination Rights of Counterparties On September 1, 2017, the Board of Governors of the Federal Reserve System (the Federal Reserve) adopted a rule (the Rule)1 that will require global systemically important U.S. bank holding companies (U.S. GSIBs)2 and most of their subsidiaries to amend a range of derivatives, short-term funding transactions, securities lending transactions and other qualifying financial contracts (QFCs). The required amendments will limit counterparty termination rights related to certain U.S. GSIB resolution and bankruptcy proceedings. Banks and other depository institutions regulated by the Office of the Comptroller of the Currency (OCC) or the Federal Deposit Insurance Corporation (FDIC) are “excluded banks” under the Rule, but they will be subject to “substantively identical” rules adopted by those agencies.3 Overview of the Rule Entities subject to the Rule’s requirements are defined as “covered entities.” That term includes all U.S. GSIB parents and subsidiaries other than excluded banks and certain limited categories of other subsidiaries.4 It also includes the U.S. operations of global systemically important foreign banking organizations (non-U.S. GSIBs).5 The Rule will require covered entities, when entering into certain QFC transactions with buy-side counterparties (as well as with other covered entities and excluded banks), to include specific contract terms in related agreements. Those terms are intended to achieve two distinct regulatory goals: (i) ensure 1 See Federal Reserve, Restrictions on Qualified Financial Contracts of Systemically Important U.S. Banking Organizations and the U.S. Operations of Systemically Important Foreign Banking Organizations; Revisions to the Definition of Qualifying Master Netting Agreement and Related Definitions, 82 Fed. Reg. 42882 (September 12, 2017) (the Adopting Release), available at https://www.gpo.gov/fdsys/pkg/FR-2017-09-12/pdf/2017-19053.pdf. 2 In this Sidley Update, “U.S. GSIB” means any U.S. bank holding company (BHC) that is identified as a global systemically important BHC pursuant to Federal Reserve rules. See Rule Section 252.82(b)(1). There are currently eight U.S. GSIBs: Bank of America Corporation, The Bank of New York Mellon Corporation, Citigroup Inc., Goldman Sachs Group, Inc., JPMorgan Chase & Co., Morgan Stanley Inc., State Street Corporation and Wells Fargo & Company. See Adopting Release at 42892. 3 See Adopting Release at 42882. On September 27, 2017, the FDIC adopted its rule, which (as expected) is substantively identical to the Rule. See FDIC, Restrictions on Qualified Financial Contracts of Certain FDIC-Supervised Institutions; Revisions to the Definition of Qualifying Master Netting Agreement and Related Definitions (Sept. 27, 2017), available at https://www.fdic.gov/news/news/press/2017/pr17072.html. The OCC is expected to adopt its rule shortly. 4 The Rule also excludes from its application (i) companies owned in satisfaction of a debt previously contacted, (ii) merchant banking and certain other portfolio companies and (iii) certain companies engaged in the business of making public welfare investments. See Rule Section 252.82(b)(2). 5 In this Sidley Update, “non-U.S. GSIB” means a global systemically important foreign banking organization meeting the criteria set forth in the Rule. See Rule Section 252.87. Attorney Advertising: For purposes of compliance with New York State Bar rules, our headquarters are Sidley Austin LLP, 787 Seventh Ave., New York, NY 10019, +1 212 839 5300; 1 S. Dearborn, Chicago, IL 60603, +1 312 853 7000; and 1501 K St., NW, Washington, DC 20005, +1 202 736 8000. Sidley Austin provides this information as a service to clients and other friends for educational purposes only. It should not be construed or relied on as legal advice or to create a lawyer-client relationship. SIDLEY UPDATE Page 2 cross-border enforcement of the two U.S. special resolution regimes — the orderly liquidation authority under Title II of the Dodd-Frank Act (OLA) and the Federal Deposit Insurance Act (FDIA) — as they may apply to covered entities; and (ii) prohibit counterparties of a covered entity from exercising a range of cross- default rights that are related, directly or indirectly, to an affiliate of the covered entity becoming subject to insolvency proceedings, including under Chapter 11 of the Bankruptcy Code. The Rule includes a safe harbor for QFCs that are amended by a covered entity and a given counterparty through their adherence to a qualifying protocol published (or to be published) by the International Swaps and Derivatives Association Inc. (ISDA). The safe harbor was provided even though the contract terms resulting from adherence to the qualifying ISDA protocols will differ in certain important respects from the contract terms that the Rule otherwise requires. Accordingly, the means by which a covered entity and a given counterparty choose to comply with the Rule will involve choosing not only between contracting mechanisms (protocol adherence versus bilateral documentation execution) but also between contractual terms that differ substantively. Compliance with the Rule will be phased in over one year beginning January 1, 2019. However, as discussed toward the end of this Sidley Update, it is likely that covered entities will seek to ensure Rule compliance with all counterparties by January 1, 2019, including those counterparties for which the phase-in date is later. In the balance of this Sidley Update, we will address the following topics: • QFC Transactions Covered by the Rule • Basic Operation of the Rule • U.S. Special Resolution Regimes and Required Opt-In Provisions • U.S. Bankruptcy Code and Restrictions on Cross-Defaults • ISDA Protocols • Differences Between the Rule’s Stated Requirements and the ISDA Protocols • Other Issues • Observations QFC Transactions Covered by the Rule The Rule incorporates the Dodd-Frank Act’s definition of QFC. That definition includes “swaps, repo and reverse repo transactions, securities lending and borrowing transactions, commodity contracts, and forward agreements.”6 To narrow the breadth of the Rule’s application, the Rule applies only to “covered QFCs.” The definition of covered QFC narrows the Rule’s reach in two respects. The first considers the terms of a QFC to determine if it is “in scope” under the Rule. The second considers the date that the respective covered entity 6 See Adopting Release at 42894 (citing 12 U.S.C. 5390(c)(8)(D)). SIDLEY UPDATE Page 3 entered into the in-scope QFC (or certain related QFCs) to determine if it is a covered QFC (or, alternatively, whether the QFC, though in scope, is effectively grandfathered).7 A QFC is in scope if it either • explicitly restricts transfer of the QFC (or any interest or obligation in or under, or any property securing, the QFC) from a covered entity (whether or not in connection with any default) or • explicitly provides one or more “default rights” with respect to a QFC that may be exercised against a covered entity. The Rule defines “default rights” very broadly. The definition encompasses not only typical termination and liquidation rights but also rights to demand additional collateral or margin (other than where the demand is based solely on mark-to-market requirements).8 Thus, for example, a typical credit rating downgrade provision would be covered.9 Because of the broad definition, most swap, repurchase and securities lending transactions that are subject to industry standard master agreements will be in scope. In contrast, spot foreign exchange transactions, though they are QFCs, will not be in scope if they are not subject to explicit terms restricting transfers or providing default rights. That may be true for many such transactions,10 but caution is warranted because trading relationships with covered entities may be subject to broadly worded master agreements or other umbrella trading documentation. An in-scope QFC will be a covered QFC if it is entered into11 by a covered entity after January 1, 2019 (irrespective of the type of QFC counterparty or related compliance phase-in date, as discussed below). In addition, if a covered entity and a given counterparty enter into a QFC (whether or not in scope) after January 1, 2019, then all in-scope QFCs between the two parties entered into prior to January 1, 2019 will become covered QFCs automatically. Moreover, the Rule includes a triggering mechanism for covered QFCs that is tied to affiliation: If a QFC (whether or not in scope) is executed on or after January 1, 2019 between (i) a covered entity or any affiliate that is either a covered entity or an excluded bank; and (ii) a counterparty or any of its consolidated affiliates, then all in-scope QFCs between the first covered entity and the counterparty or any of the counterparty’s consolidated affiliates will become covered QFCs automatically (regardless of when the in-scope QFCs were executed).12 7 In addition, the Rule excludes (i) covered QFCs to which a central counterparty clearinghouse (CCP) is a party or to which each party (other than the covered entity) is a financial market utility (FMU) and (ii) certain “types of contracts or agreements.” See Rule Sections 252.88(a) (referring to CCPs and FMUs) and 252.88(c) (referring to certain investment advisory contracts and warrants). 8 See Rule Section 252.81 (paragraph (1)(ii) of the definition of “default right,” which excludes “a right or operation of a contractual provision arising solely from a change in the value of collateral or margin or a change in the amount of an economic exposure”). 9 See Adopting Release at 42900 (describing permissible changes in margin due to changes in market price, not for “changes due to counterparty credit risk (e.g., credit rating downgrades)”). 10 See Adopting Release at 42894 (“[C]ommenters urged the Board to exclude QFCs that do not contain any transfer restrictions or default rights...
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