Banks must not overlook the ramifications of proposed
amendments to close-out netting contracts, released last week
by Australian parliament, according to lawyers.
Allen & Overy’s Sydney-based partner, Angela
Flannery believes widespread concerns over the introduction of
a carbon tax has distracted the market from potentially
contentious changes to Australia’s existing
Payments Systems and Netting Act 1998.
The proposed revisions stipulate that, where the Australian
Prudential Regulation Authority (APRA) appoints a statutory
manager to a bank, there will be a brief 48-hour suspension of
the non-defaulting counterparties’ rights to
terminate close-out netting contracts (which include OTC
derivatives), to avoid potentially market-damaging close
The administrator will have the ability to continue that
suspension in the event that it determines that the liabilities
of the bank under the close out netting contracts will be able
to be met.
In doing so, the revisions would bring the
country’s netting legislation in line with
recommendations made in a 2010 Basel Committee Report and
Recommendations of the Cross-border Bank Resolution
They would also resolve the ambiguity between the Australian
Banking Act and the Payment Systems and Netting Act. Equivalent
revisions will apply to insurers under the proposed
In an approach that favours Banking Act considerations over
the rights of counterparties under pre-existing close-out
netting provisions, the amendments make clear the maintenance
of a stable financial system in Australia is more of a priority
than protecting the rights of counterparties.
"They stipulate that the question of whether the bank under
administration can pay amounts owing under the close out
netting contracts as and when they fall due must be considered
in the initial 48 hour period following the appointment of the
administrator," Flannery explained.
Counterparties cannot close out contracts until such inquiries
have been resolved.
"The counterparty would need to wait 48 hours to find out
whether or not it can terminate a contract," said
"And if it is then permitted to terminate, the position of the
counterparty could have grown substantially worse during that
time period," she added.
Counterparties were, therefore, likely to face additional
risks if the planned changes were accepted. And this would need
to be taken into account when entering into future contracts,
she said. "The ramifications of these revisions are not
positive for counterparties," she added.
Clayton Utz’s corporate advisory partner, Graeme
"The brief suspension of the non-defaulting counterparty's
right to terminate isn’t unduly restrictive of its
ultimate ability to protect its position," he said.
"It provides an opportunity for the external administrator to
step in and determine a resolution which will avoid a
pre-emptory and potentially market-damaging closeout." It could
also enable the contract position to be preserved if it can
The argument that the non-defaulting counterparty should have
a free hand to determine how best to protect its position, in
the event of an external administration, and that this might
include closing out its position against the entity that has
come under external administration was the
'laissez-faire’ approach, he said.
But provisions made for external administrator could also
cause difficulties and were not the appropriate test for a
statutory manager, said Flannery.
Under the revisions, a statutory manager will have 48 hours to
establish what close-out netting and hedging contracts the bank
has in place, make a determination as to whether a bank can
meet these contractual obligations and thereby a decision as to
whether Banking Act protection should continue.
"It’s a tall order for anyone to make that many
decisions in such a short space of time," said Flannery. "The
risk is external administrators will not be able to make those
judgments in that period."
A Sydney-based senior bankers’ counsel said the
48-hour suspension period was the most controversial aspect of
the proposed amendments.
"It is simply not long enough, to give effect to the intent of
the legislation" he said. "In fact I don’t agree
with the concept of a suspension period at all."
If there was going to be a suspension, it needed to coincide
with an adoption by the administrator that he had some firm
view the counterparties were going to be able to perform from
"Allowing a counterparty to flounder for 48 hours
doesn’t do the market a lot of good," he said. It
could cause general market panic, as seen in the US during the
financial crisis. Market moves could leave counterparties not
permitted to close out contracts in a significantly adverse
position once the suspension period culminates.
"It is a dangerous provision, and I don’t think
it is going to work," he said.
If a manager is to be appointed, there should be some
confidence that the entity still has life left in it, he said.
If that conclusion can be reached before the appointment of a
manager, managers should then become liable if they decide to
continue performance of contracts and the entity is unable to
perform, similar to the
existing provision on administration that exist under
Australian law today, he said.
"A fail-safe mechanism such as this would be needed if the
government was to establish confidence in the market," he
He believed the suspension period would be accepted because
the government had to react to what was happening around the
world. "Practically speaking, I don’t think it is
good law," he said. "All it is doing is delaying the
Allen & Overy’s Australian international
capital markets partner, Sonia Goumenis said it would be
preferable for statutory managers to focus only on whether the
contracts are important enough to the distressed bank in
determining whether or not to allow close out of the
In jurisdictions with similar provisions allowing a moratorium
on close out, such as the US, the provisions tend to only
operate where there is a transferee financial institution
willing to acquire the assets of the insolvent bank, she
External administrators therefore, though operating under
similarly tight timeframes, had only to focus on whether the
contracts were to be transferred not whether an institution was
able to make payments due.
Goumenis believes that the market has not yet given the
revisions enough attention. "They must start to focus on the
potential ramifications of this and whether changes will leave
them in a comparable position to counterparties in other
"The Australian Treasury has taken the view that in order to
restore confidence in the market, participants have to be happy
with outcome so the legislation that has been put forward that
is by no means a fait accompli," said the
The Australian government’s Financial Sector
Legislation Amendment (Close-out Netting Contracts) Bill 2011
was released for public consultation last week. The
consultation period ends July 25.
It is anticipated that changes will not be enacted until Q4