PRA Hold Buy-Side in Headlock Over Early Termination

DRS’ Michael Beaton explores how proposals outlined in a recently published PRA consultation paper may impact financial contracts and in particular, contractual terminations. Many questions remain unanswered.

Introduction

On 26 May 2015, the Prudential Regulation Authority (PRA) published Consultation Paper CP 19/15, “Contractual stays in financial contracts governed by third-country law”.  The consultation period closes on 26 August 2015 and seeks comment on two aspects of current regulation which impact on portfolios of trading documentation – contractual stays and data mining.

Contractual Stays

Under the PRA proposals, relevant ‘firms’ would be prohibited from materially amending existing obligations[1] under “financial contracts” – or creating new obligations – unless the counterparty has agreed in writing to be subject to similar restrictions on termination, acceleration, close-out, set-off and netting as would apply as a result of the firm’s entry into resolution if the contract were governed by the laws of the United Kingdom (and, where the relevant firm is not a credit institution or investment firm, as if it were one).  This is intended to reduce the risk of contagion resulting from the mass early termination of financial contracts which are governed by third-country law following the entry of a firm into resolution, particularly in circumstances where those contracts governed by EU law would be stayed[2].

The proposal applies to PRA-authorised UK banks, building societies and PRA-designated UK investment firms, as well as their qualifying parent undertakings (‘firms’) in respect of financial contracts governed by third-country law (that is, the law of a jurisdiction outside the European Economic Area[3]).  However, obligations under financial contracts entered into with designated payment and securities settlement systems, recognised central counterparties, central banks or central governments would be excluded.  The PRA definition of “financial contracts” is the same as that under the Bank Resolution and Recovery Directive (BRRD), except that short-term interbank borrowing is excluded.  As such, it applies to obligations created under:

• securities contracts;
• commodities contracts;
• futures and forwards contracts;
• swap agreements;
• all other derivatives; and
• master agreements for any of the above or for contracts for the sale, purchase or delivery of a currency.

The PRA proposes a staged implementation of its new rule by counterparty, as set out below:

Recording information on financial contracts

On 6 March 2015, the European Banking Authority (EBA) published a consultation paper containing a “Draft Regulatory Standard on a minimum set of the information on financial contracts that should be contained in the detailed records” required by the BRRD^[4].  In light of this work, the PRA does not currently consider it necessary to impose a separate obligation to mine data from financial contracts or to require firms to undertake regular reporting on their financial contracts.  However, it does expect firms to be able to provide information on their financial contracts, including the governing law and whether the contract contains the necessary recognition provision.

Final Thoughts

Contractual measures, such as those outlined in the PRA consultation paper and already implemented by ISDA[5], are regarded as short-term tactical fixes, pending the enactment of a comprehensive statutory cross-border recognition framework such as that recommended by the Financial Stability Board[6].  Notwithstanding this fact, the scale of this exercise should not be underestimated, with the PRA itself suggesting that approximately 20% of all contracts may be impacted.

However, of more importance than questions of scale is the way in which the issue has been approached and the nature of what is at stake.  Non-PRA regulated counterparties of PRA-regulated firms stand to be locked out of the market unless they agree to these changes, with even the rollover or renewal of historical transactions constituting a ‘new obligation’, and therefore prohibited, unless the appropriate contractual amendment has been made.  Beyond this, buy-side firms have long expressed genuine concerns about the prospect of regulators stripping away the protections afforded by their contractual termination rights.  In addition, many legitimate questions remain unresolved.  Would a stay on early termination rights simply incentivise market participants to terminate before a stay could be imposed, fatally damaging attempts to reinforce market stability and defeating the whole object of the stay?  Can a fund manager voluntarily cede termination rights without being rendered in breach of fiduciary duties towards its client?  How will the existence of a statutory stay affect the pricing of a transaction?  Doesn’t this approach smack of ‘regulation by protocol’, by-passing the normal legislative process?  Unfortunately, it seems that these concerns have been waved away.  For now at least, the regulatory arm-twisting of the buy-side looks set to continue.  When the dust has settled it will be interesting to see whether the market has voted with its feet and chosen to trade with firms that are not subject to these rules.