Australia banks ignoring controversial netting rules

Author: | Published: 13 Jul 2011
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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 outs.

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 Group.

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 revisions.

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 Flannery.

"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 Dennis disagreed.

"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 be.

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 the outset.

"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 said.

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 inevitable."

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 contracts.

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 said.

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 jurisdictions."

"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 bankers’ counsel.

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 2011.