07 Jul 2019

Netting – A detailed analysis

Authored by: James Farn

Given the absence of any mandatory set-off rights on insolvency in the current UAE Bankruptcy Law, the application and effectiveness of netting provisions in financial market contracts made with a UAE counterparty has historically been uncertain.

Many jurisdictions allow creditors to protect themselves against a potential default by a counterparty under such contracts – 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 (in common with many other states in the GCC and wider Arab region) does not recognize mandatory set-off on insolvency and historically has had no specific netting law to deal with the specific subject of netting.

However, the UAE now has a specific Federal netting law which attempts to address these uncertainties so that market participants know when they are protected (and when they are not) in the case of a bankrupt counterparty. This means that the enforceability of netting agreements, close-out netting and related collateral arrangements will now generally be recognized ‘onshore’ in the UAE.

This new law (UAE Federal Law No 10 of 2018) (Netting Law) came into force in the UAE on 30 October, 2018.

Why does netting matter?

  • Without the ability to net positions, financial institutions would attract almost impossibly high capital adequacy requirements. Basel Accords permit the use of net exposure for regulatory purposes.
  • The requirement to take collateral (security) required to secure the resulting net positions is reduced.
  • For a derivatives market to flourish, the effectiveness of close-out netting should be safeguarded.

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 properly understand the objectives of the Netting Law, it’s important to first understand what netting is (and what is not).

What is netting?

At the most general level, netting is concerned with the ability to set-off reciprocal claims on the insolvency of a counterparty. Netting in this context essentially falls into two categories:

Payment Netting:  If Party A owes Dirhams 100 to Party B, and Party B owes Dirhams 60 to Party A, then Party A merely pays over the difference (i.e. Dirhams 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 Dirhams 100 and Dirhams 60, are replaced by a new obligation of Party A to pay over Dirhams 40 to Party A.

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.

In recent years, the issue of close-out netting has become focused principally in the area of major financial transactions, particularly in derivatives and other forms of financial trading.

Most market contracts fall into one of two main categories:

  • a contract for the payment of a liquidated sum or an unliquidated claim – for example, payments or claims under an interest ‘cap’ or ‘floor’ (a ‘payment’ contract); and
  • a contract in which the parties must deliver either (i) property – for example, a contract for the delivery of commodities; or (ii) money such as an interest rate swap or foreign exchange contract (an ‘executory’ contract).

Many (but not all) market contracts will be ‘executory’ contracts, often involving ‘two-way’ payment obligations between the contracting parties. The trading rules of many recognized commodity and stock markets operate in this way. The non-defaulting party under outstanding contracts agrees to pay any profits to the defaulting (insolvent) party on termination, rather than the non-defaulting party simply walking away, rescinding the contracts and keeping all profits. Where the insolvent is obliged to pay losses and retain profits under a ‘two-way’ payment arrangement, both insolvency set-off and termination of the outstanding contracts is required.

The UAE Bankruptcy Law gives limited scope for a trustee-in-bankruptcy to disclaim unprofitable contracts. Although untested, it’s likely that the trustee would not be able to ‘cherry-pick’ the profitable contracts and repudiate the unprofitable ones from the insolvent’s standpoint.

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 International Swaps and Derivatives Association (ISDA) forms are the most common and can be adapted for a variety of different transactions such as interest rate swaps, currency swaps, options and futures. However, the validity of the netting arrangements is primarily (but not exclusively) connected with insolvency law and not the governing law of the contract concerned.

Set-off rights and rescission on insolvency in the UAE

Insolvency set-off in civil code countries (which follow Roman Law) is very different from the application of insolvency set-off in most common law countries.

In the UAE, there is no statutory acceleration of monetary claims for set-off purposes in bankruptcy. Automatic set-off of reciprocal claims on insolvency in the UAE is prohibited. The parties cannot ‘contract-in’ to make set-off automatic on bankruptcy. The principle is that automatic set-off on bankruptcy acts like an unpublicized (or unregistered) security interest which effectively causes the insolvent’s assets to disappear on bankruptcy to the detriment of all of the bankrupt’s other unsecured creditors and therefore is not allowed.

The general principle under the UAE Bankruptcy Law is that for insolvency set-off to apply, reciprocal claims must satisfy the conditions of the solvent set-off rules prior to the date on which bankruptcy procedures commence (and not when the bankruptcy order is made). This means that the claims must be liquidated, due and legally payable or that the claims must have been set-off by contract prior to bankruptcy. Post-commencement debts will not be eligible for insolvency set-off. In those circumstances, a creditor must pay the cross-claim into the insolvent’s estate and prove for that claim.

In practical terms, the issue of close-out netting is often dealt with in one of two different ways:

  • To provide that all contracts between the parties are automatically deemed to be cancelled and losses and gains set off immediately prior to the commencement of insolvency proceedings – the classic ‘Automatic Early Termination’ (AET) clause often seen in ISDA documentation.
  • To allow set–off and rescission of a contract if there is a ‘close-connection’ between the transactions occurring under that contract (sometimes called ‘Transaction Set-Off’).

These techniques have historically raised legal issues in the UAE, partly because UAE law does not specifically recognize Transaction Set–Off.

General objectives of the Netting Law

The new Netting Law aims to:

  • enhance the prospect of netting-out exposures under market contracts in the event of UAE counterparty insolvency; and
  • protect margin and security (collateral) given to support the obligations of the insolvent counterparty.

In general terms, netting is now available if 3 conditions are satisfied:

  1. the transaction is a ‘permitted’ one – broadly any market contract which qualifies as a netting agreement and/or includes provision of collateral to support the obligations of a counterparty;
  1. one of the parties is a ‘protected’ person – the non-defaulting or non-insolvent counterparty to the contract (whether a natural or juridical person); and
  1. the transaction arises under a prescribed type of market contract – a ‘Qualifying Financial Contract’ as defined in the Netting Law.

Any agreement which qualifies as a netting agreement will in principle be enforceable on the insolvency of the UAE counterparty. This includes:

  1. any netting agreement made or concluded in connection with a Qualified Financial Contract; and
  1. and security agreement or arrangement to support the obligations of a counterparty under such agreement.

Any element of uncertainty (gharar) associated with a netting agreement (including those principles concerning speculative transactions as described the UAE Civil Code) will not affect its validity or enforceability.

The definition of a netting agreement is sufficiently wide to cover both the ‘payment’ and the ‘executory’ types of contract referred to above. Cross–product netting (the netting of different types of contract) would also appear to be possible.

A netting agreement may cover a bilateral close-out netting agreement between two parties and also a multi-branch netting agreement (which 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). Multi-branch netting avoids the potential problem of ‘ring-fencing’ certain transactions which were booked in different jurisdictions which may apply their own insolvency provisions.

Such provisions allow for the calculation of both a single net termination sum on a global basis and on a local basis. The trustee or liquidator pays (or receives) only the lesser of these amounts. Any amounts paid or received are reduced by amounts collected or paid in other countries under the same Qualified Financial Contract so that there is no double payment or recovery.

Market contracts

  • The scope of Qualified Financial Contracts under the Netting Law is broad and includes various types of financial transactions covered by the definition in Section 1 of the 2006 MNA as well as Sharia-compliant contracts.
  • It is intended that a special Committee will be formed comprising representatives of the UAE Ministry of Finance, the UAE Central Bank, the Emirates Securities & Commodities Authority and the UAE Insurance Authority. This Committee will have the authority to designate as additional, and generally to add to, replace or remove from the list, any financial agreement, contract or transaction as a Qualified Financial Contract.
  • Netting agreements include master agreements, master-master netting agreements, related collateral arrangements (such as credit support annexes, credit support deeds, title transfer collateral arrangements and mortgages registerable under the UAE Moveable Property Law (MPL), comparable Sharia-compliant agreements or arrangements and multi-branch netting agreements. The Netting Law does not restrict the netting regime to specific types of international industry standard documents (such as the 2002 ISDA Master Agreement). Specific examples of netting transactions are given in the Netting Law.

How does the Netting Law achieve its objectives?

The Netting Law contains provisions which have the effect of generally restricting or dis-applying the following ‘standard’ insolvency provisions:

  • The trustee’s power to disclaim contracts and the ability of the Court to disclaim contracts on the bankruptcy 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 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.’ However, the Law gives no further guidance as to what may constitute a ‘disadvantage‘ in such circumstances.

Market collateral

The Netting Law strengthens the validity (and priority) of security taken to support the obligations of a counterparty under a market contract. Such security may be enforced without notice or any consent from any other party.

Although the provisions under the Netting Law are general in nature, their effect may include the removal of any ‘stay’ or freeze on security enforcement where formal bankruptcy proceedings have been initiated unless (i) the contracting parties agree otherwise under the terms of that collateral arrangement; and (ii) the provisions of any relevant Federal law which concerns the realization, appropriation or enforcement of such collateral are ‘taken into consideration.’

As an example, the MPL allows for the enforcement of mortgage security over designated assets such as cash without the requirement for any Court order where the parties agree. These provisions allow such security to take the form of an ‘executable deed’ for the purposes of the UAE Civil Procedures Law (and therefore negate the need for an order from the Execution Court prior to enforcement).

It is thought that the general effect of these provisions under the Netting Law would also enhance the validity of margin deposits (whether taken in the form of securities or cash).

Territorial scope

The Netting Law applies to any Qualifying Financial Contract or collateral arrangement which is entered into within the State (UAE) and where the insolvent (as a contracting party) will be subject to UAE Bankruptcy Law, if declared bankrupt.

The application of the Netting Law is not limited to any particular type of market participant. Counterparties to a netting agreement which are incorporated, regulated or registered in either of the two UAE financial free zones (DIFC and ADGM) are generally considered to be a foreign party (although the Netting Law may be applicable to financial institutions licensed in those zones in certain circumstances).

Some conclusions

  • The Netting Law substantially removes many of the 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 the basic rules of set–off must apply in order for effective close-out netting to occur, even under the new Netting Law.

  • There must always be mutuality. Under UAE law, it’s possible to set-off a contractual claim by the return or delivery of property or money (a money claim set-off against a property claim). In practical terms however, the contracting parties will more often than not be debtor-creditors (a money claim set-off against a competing money claim). Each must be personally liable on the claim that he owes to the other. UAE law will not allow a counterparty faced with a liability to use someone’s else’s debt to set-off against that liability.
  • It is not possible to net if one or both counterparties act as agents on behalf of their clients as principal or, more generally, between parties in an inter-group arrangement unless there is an appropriate guarantee structure put in place to preserve mutuality.
  • Because netting is primarily (but not exclusively) governed by insolvency law, the application of the netting provisions may differ according to the character of the insolvent counterparty. In the UAE, certain counterparties (such as Federal or Emirati entities established by special laws) may not be subject to insolvency proceedings at all.
  • If the competing claims or debts are in different currencies, set-off will require conversion into the same currency. Under UAE law, any debt owing by the insolvent counterparty would need to be converted into Dirhams automatically on bankruptcy. Currency differences could defeat insolvency set-off unless the contract provides for conversion into the currency of the debt owing by the insolvent party.
  • Contracts entered into after commencement of bankruptcy proceedings against the UAE counterparty may be vulnerable because the ability of the debtor to transact is effectively removed and vested in the bankruptcy trustee.
Originally commissioned by the International Bar Association, 
 
 

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.