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Policy And Legal Perspectives On Initiatives To Restrict End-Users’ Default Rights Against Big Banks

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Too Big To Default: Policy And Legal Perspectives On Current Bank Regulator Initiatives To Restrict End-Users’ Default Rights Against Big Banks by Managed Funds Association

Executive Summary

Managed Funds Association has prepared this white paper to present the views of its members on stays of early termination rights for consideration by public policymakers and regulators. MFA represents the global alternative investment industry and its investors by advocating for public policies that foster efficient, transparent, and fair capital markets.

As a general matter, MFA supports public and private sector efforts to facilitate the orderly liquidation of troubled financial institutions and improve the stability of the financial markets. Given that many MFA members’ investors incurred significant losses resulting from the collapse of Lehman Brothers,1 MFA has been a strong supporter of legislative and regulatory efforts to strengthen the financial system.

However, MFA members have serious objections to the rapidly advancing initiatives of certain bank regulators to restrict or “stay” the Default Rights of end-users against a distressed financial institution (the Regulators’ Stay Initiatives). As explained further in this white paper, bank regulators in the United States, Europe, and Asia are seeking to require end-users to relinquish several of their contractual Default Rights against big banks in response to recommendations made by the Financial Stability Board (the FSB), an organization that is dominated by central bankers and finance ministers.

Although the FSB’s decisions are not legally binding on members’ jurisdictions, several of the world’s most important bank regulators (G-20 bank regulators), including the U.S. Federal Deposit Insurance Corporation (FDIC) and the U.S. Board of Governors of the Federal Reserve System (Federal Reserve,  and together with the FDIC, the U.S. Regulators), are seeking to implement the FSB’s recommendations (and the Regulators’ Stay Initiatives more specifically). MFA believes that the G-20 bank regulators are attempting to implement these initiatives without adequately consulting with relevant policymakers regarding their merits and potential consequences for the world’s leading financial markets. In addition, while the G-20 bank regulators will solicit public comment from industry stakeholders on proposed rules to implement the Regulators’ Stay Initiatives, it appears that the G-20 bank regulators have pre-determined to proceed with the Regulators’ Stay Initiatives. Therefore, MFA is concerned that issuance of such proposals will not constitute a meaningful opportunity for stakeholders to provide input on the initiatives.

Such an unexamined and global “taking” of end-user Default Rights ? under the auspices of the opaque FSB ? is troubling enough by itself. Moreover, it appears that U.S. Regulators are taking this FSB-led initiative a significant step further. Specifically, U.S. Regulators are proposing to require end-users to waive additional “cross-default” rights that are, and for decades have been, legally enforceable under U.S. law ? something even the FSB has not recommended.

In addition to our legal and process objections to such actions, MFA believes that forcing end-users to waive their Default Rights would be harmful for the markets and the global economy. Contractual Default Rights are critically important to end-users, particularly during stressed market conditions. Such rights not only allow them to protect their investors and other stakeholders from significant Lehman-like losses of their assets but also preserve the integrity and stability of the world’s leading financial markets. Therefore, placing any restrictions on these Default Rights as part of yet untested resolution strategies would be highly detrimental to the financial markets during stressed market conditions. Even if there were empirical evidence that waiver of such Default Rights would be beneficial to bank regulators’ efforts to resolve a distressed systemically important financial institution (SIFI), policymakers and regulators need to assess properly the impact of such waivers on non-defaulting market participants and financial market integrity more broadly before requiring such waivers, whether by regulation or legislation.

In this white paper, MFA: (i) highlights concerns about key aspects of these Regulators’ Stay Initiatives; and (ii) proposes recommendations that would facilitate an impartial and complete analysis of the relevant issues and a fair balancing of all relevant policy concerns by taking into account the implications for affected constituents. Specifically, in this white paper, MFA identifies the following concerns with the Regulators’ Stay Initiatives:

  • The FSB and G-20 bank regulators are advancing the Regulators’ Stay Initiatives without a mandate from public policymakers;
  • The G-20 bank regulators’ new resolution strategies have potential flaws and unintended consequences;
  • The contractual approach to imposing the Regulators’ Stay Initiatives is inherently flawed; and
  • The U.S. Regulators’ Cross-Default Stay Initiative is not a G-20 objective and is inconsistent with congressional intent.

In light of these concerns, MFA respectfully makes the following recommendations:

  • The International Organization of Securities Commissions (IOSCO) should prepare a report for G-20 legislators on the potential impact of the Regulators’ Stay Initiatives on endusers and financial markets more broadly and analyze the implications of pursuing a contract-based approach to imposing the Regulators’ Stay Initiatives;
  • The U.S. President’s Working Group for Financial Markets should reconvene to consider the findings of IOSCO’s report and, to the extent it concludes that certain of the report’s recommendations merit implementation in the United States, make recommendations to Congress for their implementation; and
  • The G-20 bank regulators and the U.S. Regulators should defer further action on their respective initiatives pending the outcome of the above effort.

Background: Why End-User Default Rights Have Generally Been Protected – Until Now

When facing a troubled SIFI counterparty, Default Rights are critically important to endusers. Default Rights protect an end-user, its investors, and other stakeholders by allowing the end-user to terminate and settle financial contracts with a failing bank entity, and thereby, minimize its exposure to such entity and better manage market risk. Because MFA members have affirmative fiduciary duties to act in their investors’ best interests, they are not able to waive Default Rights voluntarily without robust legal justification. For these reasons, MFA believes that restricting end-users’ Default Rights in a distressed SIFI scenario implicates fundamental public policy goals: the goals of protecting investors and ensuring the sound functioning of the financial markets.

Legislative efforts to protect Default Rights in the United States date back as far as the early 1980s. The U.S. President’s Working Group on Financial Markets (PWG) and members of U.S. Congress (Congress) have expressed the policy basis for protecting these important end-user rights as follows:

“The ability to terminate most financial market contracts upon an event of default is central to the effective management of market risk by financial market participants … Without these rights, parties are left with uncertainty as to whether the contracts will be performed, resulting in uncontrollable market risk. By providing for termination of a contract upon the default of a counterparty, a participant can remove uncertainty as to whether a contract will be performed, fix the value of the contract at that point, and attempt to re-hedge itself against its market risk.”

“The prompt closing out or liquidation of [open contracts] freezes the status quo and minimizes the potentially massive losses and chain reactions that could occur if the market were to move sharply in the wrong direction.”

“U.S. bankruptcy law has long accorded special treatment to transactions involving financial markets, to minimize volatility. Because financial markets can change significantly in a matter of days, or even hours, a non-bankrupt party to ongoing securities and other financial transactions could face heavy losses unless the transactions are resolved promptly and with finality.  The immediate termination for default and the netting provisions are critical aspects of swap transactions and are necessary for the protection of all parties in light of the potential for rapid changes in the financial markets.”

“[T]he effect of the swap provisions will be to provide certainty for swap transactions and thereby stabilize domestic markets by allowing the terms of the swap agreement to apply notwithstanding the bankruptcy filing.”

“The legislative history of the Swap Amendments plainly reveals that Congress recognized the growing importance of interest rate swaps and sought to immunize the swap market from the legal risks of bankruptcy.”

“[I]t is intended that the normal business practice in the event of a default of a party based on bankruptcy or insolvency is to terminate, liquidate or accelerate securities contracts, commodity contracts, forward contracts, repurchase agreements, swap agreements and master netting agreements with the bankrupt or insolvent party.”

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