12 Nov 2018

Netting in the UAE

Authored by: Valeria Lysenko, Alan Rodgers & James Farn

In brief:

  • Netting legislation is introduced in the UAE at federal level.
  • Enforceability of netting agreements, close-out netting and related collateral arrangements will now be recognised onshore in the UAE.
  • In this article, we summarise the concept of netting and review the UAE’s new netting legislation.

On 20 September 2018, the long-awaited netting law (UAE Federal Law No 10 of 2018) (Netting Law) was issued. The Netting Law came into effect a month following the date of its publication in the UAE Federal Official Gazette, so 31 October 2018.

The Netting Law draws heavily from, and is by-and-large based on, the provisions of the 2006 Model Netting Act (2006 MNA) published by the International Swaps and Derivatives Association (ISDA). Both DIFC and ADGM as separate financial free zones in the UAE have their own netting laws which are also modelled on the MNA.

However, to understand the objectives of this Law, it’s essential to first understand the concept of netting.

What is netting?

Netting is concerned with the ability to set-off reciprocal claims on the insolvency of a counterparty. This means that netting is primarily (but not exclusively) connected with insolvency law affecting the insolvent party and not the governing law of the contract concerned.

Netting in this context essentially falls into two categories:

  1. Payment Netting: If Party A owes AED 100 to Party B, and Party B owes AED 60 to Party A, then Party A merely pays over the difference (ie AED 40) rather than each Party making separate payments to each other that would economically have the same outcome. The old obligations to pay over, respectively AED 100 and AED 60, are replaced by a new obligation of Party A to pay over the net amount owing of the transactions namely AED 40 to Party B.
  1. Close-out Netting: This is a process that takes place when there has been a problem under a contract that has resulted in a default, and the contractual relationship between the parties is to be terminated. Exposures in open’ contracts are reduced if one party becomes insolvent before the value date. As an example, Party A and Party B have open foreign exchange contracts with each other. One shows a profit of 5 and the other loss of 5. If Party B becomes insolvent before the contracts mature and if Party A could cancel and set off the losses and gains, Party A’s exposure to Party B would be zero. Conversely, if termination and set-off were not possible, Party A would have a gross exposure of 5.

In close-out netting the idea is that all obligations are accelerated and the original contracts are terminated. A calculation is made by which a single amount is then owed by one party to the other party. All old agreements disappear and are replaced by a new one. This exercise must also include (i) the valuation of the unperformed or ‘open’ obligations under the contracts; and (ii) a mechanism which determines the single sum (or close-out amount) owed by one party to the other.

Typically close-out netting takes place according to one of the industry standard documents that cover a multitude of transactions between the same parties – for example under a master agreement. The ISDA forms are most common and can be adapted for a variety of different transactions such as interest rate swaps, currency swaps, options and futures.

Why does netting matter?

  • It is fundamental to most hedging transactions (notably under ISDA forms).
  • Without the ability to net positions, financial institutions would attract almost impossibly high capital adequacy requirements.
  • The requirement to take collateral (security) required to secure the resulting net positions is reduced.
  • For a derivatives market to flourish then the effectiveness of close-out netting should be safeguarded.
  • A netting law typically allows the parties to avoid being drawn into the bankruptcy of the insolvent party. The idea is that set-off and termination takes place immediately before (and therefore outside) the counterparty’s bankruptcy.

Set-off rights and rescission on insolvency in the UAE

Many jurisdictions (including England and Wales) allow creditors to protect themselves against a potential default by a counterparty, typically by rescinding contracts and by applying set-off which may be mandatory in the event of insolvency. These jurisdictions typically have specific netting rules to deal with this issue.

The UAE (as a ‘refusing’ jurisdiction) does not recognise mandatory set-off of all claims between the contracting parties on the insolvency of a UAE counterparty.  UAE law allows termination of a contract based on non-performance (but not specifically on bankruptcy, unless the parties agree otherwise). Given the absence of any automatic set-off rights on insolvency in the current UAE Bankruptcy legislation, the effectiveness of netting provisions in market contracts made with a UAE counterparty has therefore historically been uncertain. The Netting Law is designed to provide the needed clarity.

7 highlights of the Netting Law

The new legislation enhances the prospect of netting-out exposures under market contracts in the event of a UAE counterparty insolvency. Specifically:

  1. it applies to certain qualified financial contracts that are defined and includes netting agreements and master netting agreements;
  1. any agreement which qualifies as a netting agreement will in principle be enforceable in accordance with its terms on the insolvency of the counterparty;
  1. it applies to qualifying financial contracts which are entered into by a person in the UAE (but excluding the financial free zones);
  1. it generally protects margin and security (collateral) given to support the obligations of a counterparty;
  1. it limits the rights of the  trustee in a bankruptcy of a counterparty to void payments in certain circumstances and the effect of the existing bankruptcy law to void post-petition disposals;
  1. it provides that any element of uncertainty or speculation (gharar) referred to under the UAE Civil Code will not affect the validity or enforceability of a netting agreement; and
  1. allows for the netting or set-off of all termination amounts due to or from all pre-designated branches of a multi-branch party (regardless of where the transactions were booked).

Some conclusions

The Netting Law contains provisions which have the effect of generally restricting or dis-applying the following ‘ordinary’ insolvency provisions under UAE Law. These include:

  • The trustee’s power to disclaim contracts and the ability of the Court to disclaim contracts on the insolvency of the UAE counterparty.
  • Rules which avoid ‘preferences’ and the actions of defaulting creditors – particularly those which can be set aside within the statutory the 2 year ‘claw-back’ period from the date of commencement of the bankruptcy order.
  • The statutory ‘stay’ or freeze on proceedings (including the ability to net) post-commencement of bankruptcy proceedings.
    There is, however, a limited exception which allows the trustee to deny or refuse performance in circumstances where the non-defaulting party’s actions put the insolvent’s unsecured or secured creditors at a ‘disadvantage’.
  • The Netting Law removes many of the UAE legal issues associated with insolvency set-off and rescission of contracts in insolvency under current UAE Federal laws.
  • This should significantly assist with progressing international recognition of the UAE as a positive netting jurisdiction.

However, a word of caution. Parties must not forget that for netting to apply in any particular case, the basic rules concerning the application of set-off must always exist. Specifically, there must be mutuality of claims and each party must be personally liable on the claim that he owes to the other. Other factors may also exist which could have an effect on the ability to set-off (and therefore net) on insolvency in any given circumstance, notwithstanding the objectives of the new Netting Law.

 
 

This article, including any advice, commentary or recommendation herein, is provided on a complimentary basis without consideration of any specific objectives, circumstances or facts. It reflects the views of the writer which may, in some cases, differ from those of the firm, especially in the developing jurisdiction of the UAE.