This article is written by Raksha.
Bilateral Netting refers to combining all the individual swap agreements between the two parties into a master agreement. This consolidates the rights and liabilities of different contracts under one legal instrument. Swap contracts are a type of derivative instruments that determine the terms of cash flow between two parties at frequent intervals as determined by the parties of the contract. It allows hedging the risk by determining the future money to be paid at the current market conditions. In bilateral netting, if the two parties have different swap agreements through which one owes the other money or vice versa, they are combined into a single contract. Through this, the terms of multiple transactions are streamlined into a single contract. This is done by setting off the amount that is owed to each other.
For example, according to a contract, A needs to pay five thousand rupees to B for the purchase of goods from B. But, B owes A two thousand through a previous loan from A. These two separate contracts may be combined by the parties. After netting, A needs to pay B three thousand since B owed him the remaining sum. The implication of this is a reduction in the transaction cost incurred for multiple dealings between the same parties. The statute provides the meaning netting under Section 2(j) as the determination of the final amount that is payable between the parties of a bilateral qualified financial contract (QFC) by setting off the amount that is payable and owed mutually. A netting agreement is defined under Section 2(k), as an arrangement between the parties regarding netting of two or more bilateral contracts in a single contract. This contract finalizes the amount due between them as a result of netting different bilateral contracts.
Qualified Financial Contracts (QFC)
The meaning of QFC is provided under Sections 2(n) and 4(a) of the Act. It states that the relevant authority as appointed by the statute can designate a particular bilateral contract to be a QFC unless it is not in accordance with the directions of the central government or if it is a multilateral contract under Securities Contract Regulation Act, (1956) and Payment and Settlement Systems Act (2007). It is seen that this definition is exhaustive in nature and it does not specify the exact meaning of the nature of contracts included under QFC.
In order to understand this, the definition provided by the QFC stay rules of the United States can be referred to. Even though this is a broad definition, it specifies that it includes instruments such as “OTC, listed derivatives, swaps, FX transactions, commodity transactions and other securities contract.” The Dodd-Frank definition that was adopted post the 2008 financial crisis during the Obama government provides a similar definition and states that it includes securities, commodities, forward or futures contracts and swap agreements.
Reasons for the enactment of the statute
Among the contracts that fall under the category of QFC, Over Counter (OTC) Derivative contracts are popular. OTC refers to securities contracts that are not traded in a centralized stock exchange. It is bilaterally negotiated between the parties. Derivative contracts refer to the value of the security that depends on an underlying asset. It is seen as preferable to trade in OTC because the terms of the contract can be customized as per the negotiations between the parties and this might reduce the risk in future. Through this, it is also possible to trade in multiple OTC derivatives at one price without having a bearing on the transactions that are happening in the controlled exchange. The OTC trade in derivatives is conducted through dealers. At present this is converted to an electronic platform where all the transactions are recorded and the offers are displayed.
Derivative contracts are mainly used for the purpose of hedging risk. For example, a buyer wants to purchase large quantities of rubber as raw material for his manufacturing unit. He requires the supply of the material after 6 months. He approaches the seller for negotiating the current price and the terms of supply. In this scenario, the buyer is entering into a contract with the seller for the commodity at the current market price, but which is to be supplied six months later. The underlying asset in this derivative contract is rubber. The risk is hedged because there may be fluctuations in the price of rubber after six months based on factors such as demand, supply, weather, production, export and import. The change in price at the time of supply may prove to be a profit or loss to either of the parties based on the market conditions. If the market price has increased than what was previously agreed, the buyer earns a profit and if the price has decreased the seller gains.
If assumed that there were similar bilateral contracts between the buyer and seller in the past, the amount due in all these contractual arrangements can be set off in a single contract through netting. Through this, it enables the parties to show the net amount instead of the gross amount. Net amount is the outstanding which is calculated after deducting the amount due from one party to the other and gross is the total value of all the transactions without considering the liability. Therefore, the statute is enacted to provide a legal basis for such transactions.
The preamble of the statute states that it is enacted to provide: Enforceability to the netting of bilateral qualified financial contracts and to provide financial stability and competitiveness in the market. According to Section 3, the provisions of the Act are applicable to such bilateral QFC which are being netted under a netting agreement or otherwise. At least one of the parties to the contract must be regulated by the authorities that are mentioned in the first schedule. These authorities are the Reserve Bank of India, Securities Exchange Board of India, Insurance Regulatory Development Authority of India, Pension Fund Regulatory and Development Authority and International Financial Services Centers Authority.
The finance minister introduced the bill in Loksabha stating that it was drafted with the objective of ensuring financial stability and competitiveness in the Indian financial market. It was put forth that this bill seeks to bring bilateral netting under the law which had been hitherto only a commercial practice. It is seen to prove beneficial to the banking and financial institutions. It provides a legal basis to the close-out netting agreements between the parties and improves creditworthiness. The criticisms levelled against the bill were that it includes only the close-out type of netting and excludes other forms such as novation. It may also lead to a means of tax avoidance and money laundering resulting in regulatory issues. The statute does not include multilateral contracts because it is regulated by the Clearing Corporation of India.
Major Provisions of the Act
This statute provides for the option of a type of netting known as close-out netting. This is defined under Section 2(e) as a termination of a bilateral contract between two parties when there is a breach by one party and ascertaining the value that is to be paid through the netting and considering the positive and negative values. Other similar types of netting include settlement netting wherein the parties arrive at an aggregate amount that is to be paid before the final completion of the contract and netting by novation which is replacing the original contract with a new contract equivalent to the netted amount. The statute does not mention these other routes that could be adopted. However, the meaning of netting under Section 2(k) is an inclusive definition that lays down the meaning of netting as determining the net claim based on bilateral mutual understanding and ‘includes’ close-out netting.
The procedure for close-out netting is provided under Section 6 of the Act. In the event of termination of a bilateral QFC due to non-performance of any of the requirements as specified in the contract, a notice must be provided to proceed with the process of netting. The notice need not be sent if the party who failed to fulfil the obligations of the contract is already in an administrative proceeding such as insolvency or bankruptcy.
The valuation that results in a single net amount has the effect of dissolving the rights and liabilities of the parties with regards to all the QFCs. As per Section 7, the methodology that must be adopted for valuation must be according to the netting agreement between the parties. In the event of the contract not providing this, the dispute regarding the net amount is to be settled through arbitration. The determination of such value must be in a single currency. The party is obligated to pay the netted amount in furtherance of this contract. Further, this is applicable notwithstanding any other law in force and it is applicable to other qualified contract market participants such as a bank, insurance, pension fund, companies and partnership firms.
Section 8 of the statute provides that an administrative practitioner such as the insolvency professional, liquidator or trustee does not have the power to render the netting agreement null due to the ongoing corporate insolvency and restructuring proceedings. Therefore, the money or collateral that is owed by the insolvent person under the netting agreement stands valid and it must be enforced.
Further, Section 10 states that the provisions of the Act will have an overriding effect on any other law which is for the time being in force. This is based on the model netting law as enacted by the International Swaps and Derivative Association (ISDA). The implementation of the Act will reduce the counterparty risk considering that the netting agreement will be enforceable even though there are other legal proceedings. With other modifications, it is also expected to boost the bond market by reducing the nonpayment in swap agreements.
Advantages and Limitations
In order to assess the advantages and limitations of this statute, it is essential to check its impact on the subjects in the market that it governs. One of the motives behind enacting the legislation was reviving the bond market which includes debt instruments by the government or corporations. The government and corporate bond market in India have been expanding. But, the issue with this is the lack of liquidity in this market. In order to solve this, the Asian Development Bank has suggested that the control of these government bonds by authorities must be relaxed and FDI in this sector must be increased. Consolidation of multiple bonds and development of derivative and swap markets could also result in its improvement.
It is recognized that corporate bond markets have been impeded due to a lack of liquidity, transparency and competitiveness. Liquidity is a concern because it is not easy for investors to buy the bond and sell it in the secondary market. There is a lack of information about the market because of the disparity in the assessment of credit rating agencies. Competitiveness is lower when it is compared with other markets such as equity because it is dominated by public sector enterprises. As per the recent announcement of the finance minister in the 2021 budget, the government has proposed to establish an institution that will purchase stressed securities from corporate bonds to ensure liquidity. The current statute will aid this policy objective by improving transparency and liquidity since it provides legal enforceability for the netting agreements. This is because it will reduce the risk between parties and improve creditworthiness.
Further, this has importance in credit default swap agreements. These agreements are designed similar to the model of insurance for guaranteeing the seller of the bond that it would be paid even on the default of the buyer. According to this, there is a third party which insures the risk undertaken by the seller of the debt instrument on account of non-payment by the buyer. For instance, if ‘A’ has a pension fund and it has provided a loan to a company ‘B’ at a 10% rate of interest. Through a credit swap agreement, another entity ‘C’ can insure this debt for a rate of 2% of the 10% interest that is received by A for the bond. Hence, if B fails to repay A, it will be paid by C.
Another instrument that comes under the ambit of QFC is Derivatives. The trading of these instruments began in India in 2001 when the SEBI granted permission for trading in commodity derivatives on BSE and NSE. The investors who are trading in derivatives are wary of risks such as counterparty risk, market risk and liquidity risk. Counterparty risk refers to the possibility of not performing the obligations as per the contract by one of the parties. This risk is higher in OTC trading. Therefore, the enforceability of bilateral netting is beneficial to reduce these risks in OTC trading and improving the creditworthiness of the parties.
The legislation provides that the netting agreement shall be enforced notwithstanding the contradiction with any other law in force. In most cases, the inability to perform a contract and the consequent close-out netting is due to the insolvency of one of the parties. The Insolvency and Bankruptcy code of 2016 was enacted to codify the laws relating to insolvency and reduce the period of time that was consumed in the legal process. Through this statute, the process is time-bound and well-defined.
If one of the parties becomes insolvent, the netting agreement and the money that is owed by the insolvent party are enforceable even though the corporate insolvency proceedings have been initiated. Therefore, the party who is owed money through the netting agreements stand in the position of a financial creditor. Due to the pandemic, the code was amended and the minimum threshold for initiating the resolution proceedings was increased from 1 lakh to 1 crore, which is the maximum permissible limit for the government. This increases the scope of application of both statutes.
It is important to understand the laws in other countries since netting agreements are cross-border transactions in many cases. The master agreement and provisions of close-out netting will be applicable if there is the termination of the agreement and both parties are solvent. However, if one of the parties becomes insolvent, the insolvency laws of a particular country are applied and this affects the operation of the netting agreement. For instance, a recent judgement from the German Federal Court of Justice has held that the master netting agreement is not applicable if it is not in accordance with Section 104 of the insolvency code.
This states that the netting agreement will not be applicable once the insolvency proceedings commence. The parties can decide the date on which the amount will be determined as per the agreement. If the date is not decided, the amount is settled on the second day of the insolvency proceedings. Even if the parties have chosen that a particular law is applicable for a derivative transaction, it becomes inapplicable if it differs from the law that governs the netting agreement. Therefore, if the law applicable for the derivative transaction is German, the insolvency proceeding must also be in accordance with German law.
In the United States, netting is governed by federal law and the states have formulated specific provisions in this regard. The bilateral and multilateral clearing houses govern the enforcement of these agreements. The amendment to the Bankruptcy Code in 2005 provides for safe harbor provisions with respect to master netting agreements and this excludes the automatic stay on such agreements. This means that the agreements that fall under the purview of the safe harbor provisions are not affected by the moratorium and the stay that is imposed due to the insolvency of the party and the contract must be enforced.
Netting agreements were brought under this purview because they have an impact on the financial system if it is rendered unenforceable. This is similar to the law in India. According to Section 14(3) of the 2016 code, the government has the option to notify the contracts that are exempted from the application of moratorium. With the enactment of the Bilateral Netting statute, the Central Government has clearly excluded netting agreements from the purview Section 14 and it can be enforced even if there is an insolvency proceeding initiated against the party to the contract.
This legislation has been enacted by the government to improve the market conditions especially after the impact of the pandemic on the enforceability of contracts. It has provided a legal basis for the commercial practice of bilateral netting. This eases the burden of the creditors and reduces the transaction cost since the settlement can be carried out by calculating the net amount. However, the statute is rudimentary and it provides only a basic framework for these transactions. Unlike multilateral netting, it is not overseen by a single authority since QFC comes under the purview of various regulatory authorities and the netting agreements must comply with the rules that are made by them. Further, it might result in a multiplicity of legal proceedings if there is no netting agreement or if there are ambiguous terms in the netting agreement that does not specify the exact method of valuing the net amount.
This would result in arbitration, delay in the settlement and increase in transaction cost. The Act does not include the rights of third parties whose rights will be affected as a result of the bilateral netting agreement. This would result in an externality on the third party. Even though it is advantageous in terms of improving creditworthiness and counter-party risks, parties may choose close-out netting even if there is a breach in a completely unrelated transaction. In addition to considering these aspects, the statute must also incorporate the validity of cross-border netting agreements in India.
- H. Kent Baker, Greg Filbeck,, Investment Risk Management, Oxford University Press, 508-522 (2015).
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