Financial institutions, central banks and other participants in the financial market in their daily operations apply a variety of mechanisms designed to reduce their exposure to the insolvency of a counterparty. First, they use various types of security interest, or collateral, e.g. in the form of guarantee, pledge, hypothec, charge or transfer of title. Second, since the early 1990s, they have been using close-out netting.
Regulatory authorities (most recently, the Financial Stability Board (FSB) and the Cross-border Bank Resolution Group of the Basel Committee on Banking Supervision) strongly encourage the use of close-out netting arrangements (alongside collateral) because of their beneficial effects on the stability of the financial system. As these techniques are capable of reducing counterparty risk, both collateral and close-out netting are also taken into account to determine a financial institution’s capital ratio under the Basel II and III Accords.
The notion of close-out netting is a relatively new addition to the legal terminology. Broadly speaking, close-out netting is often understood as resembling the classical concept of set-off applied upon default or insolvency of one of the parties. However, close-out netting encompasses many additional elements and is functionally and conceptually different from traditional set-off. A close-out netting mechanism comes into operation either by a declaration (‘close-out’) of one party when a pre-defined event happens, in particular default or insolvency of its counterparty (‘termination event’), or it is triggered automatically when such an event occurs (‘automatic termination’). The mechanism extends to a number, often hundreds, of financial contracts between the parties that are contractually included in a netting agreement.
Upon close-out or automatic termination, all covered contracts are terminated and the market value of each is determined under a pre-defined valuation mechanism. The sum value of all contracts is then aggregated, resulting in one single payment obligation (‘net amount’). The net amount remains the only obligation to be settled and is generally due immediately after being determined.
Close-out netting, as a new concept, initially faced obstacles in a number of jurisdictions. In particular, it used to conflict with ‘cherry picking’ powers of insolvency administrators, i.e. the right to chose amongst the executory contacts those that are favourable for the insolvency estate and therefore have to be performed. Since the 1990s, some 40 jurisdictions, amongst them nearly all important financial markets, have recognised the positive effect of netting on the stability of the market and changed their legal framework so as to accommodate this new legal concept.
However, in recent years, financial markets have become much more international. Consequently, the two parties to a netting agreement are often located in different jurisdictions. In the event of insolvency of one of the parties it might be unclear whether the close-out netting agreement remains enforceable, in particular if it is governed by the law of the other party or the law of a third country. This doubt as to the enforceability of close-out netting agreements in a cross-jurisdictional context has negative repercussions on the risk assessment of financial institutions. If a close-out netting agreement were to be held to be unenforceable by a court, the other party might face severe financial losses and fall insolvent itself. If the same type of close-out netting agreement is used in a wider market, such effects can even become systemic.
At its 67th session (Rome, 1 December 2010) the General Assembly of UNIDROIT approved the work programme for the triennium 2011-2013 and endorsed the recommendation of the Governing Council concerning the development of an international instrument on netting and assigned the highest level of priority to this subject.
UNIDROIT commissioned a study assessing the extent of legal risk arising out of situations involving cross-jurisdictional netting and identifying the causes of legal obstacles to the proper operation of netting agreements. Additionally, the study explores possible solutions and appropriate steps to take, if any. [Preliminary draft Report on the need for an international instrument on the enforceability of close-out netting in general and in the context of bank resolution]
The Secretary General of UNIDROIT set up a Study Group of renowned experts in the law of international financial markets which met in April 2011, in September 2011 and in February 2012. The Study Group established a set of draft Principles regarding the enforceability of close-out netting provisions.
At its 91st session (Rome, 7-9 May 2012), the UNIDROIT Governing Council has endorsed the proposal of the Secretariat to convene a Committee of governmental experts for further consideration and finalisation of these draft Principles for adoption by the Governing Council. The Committee of governmental experts met for two sessions, in October 2012 and March 2013 respectively. At its second meeting (4-8 March 2013), the Committee of governmental experts approved a revised set of the Draft Principles as Draft Principles on the Operation of Close-out Netting Provisions. The text as approved by the Committee can be found in the Report on the second meeting (C.G.E./Netting/2/Report). It was decided that these Draft Principles, including the explanations and commentaries, should be submitted to the Governing Council for adoption at its 92nd session, due to be held in Rome, from 8 to10 May 2013.
The UNIDROIT Governing Council, at its 92nd session held from 8 to 10 May 2013, adopted the Principles on the Operation of Close-out Netting Provisions retaining the text of the provisions as prepared by the Committee. Final text with comments.