Close-out Rights in a Resolution Scenario: New CDIC Guidance

March 5, 2018

On March 1, 2018, Canada Deposit Insurance Corporation (CDIC) released its updated Guidance on the Exercise of Eligible Financial Contracts Close-out Rights in a Resolution Scenario. This new Guidance reflects 2017 amendments to provisions of the Canada Deposit Insurance Corporation Act (CDIC Act) dealing with stays on close-out of eligible financial contracts (EFCs). It’s very nice when complicated legislation comes with Guidance from the very folks that would have to put it into action, although hopefully they never will.

Last October, we posted about the amendments themselves. Those of you who grabbed your copy of the Canadian ISDA opinions as soon as they were hot off the press will no doubt have avidly read all about them in the update. But for the stragglers who are still catching up with recent developments, a few highlights of the resolution stay, as described in the Guidance note, are set out below.

(If you’re really new to this area, an EFC is a Canadian concept encompassing derivatives, repos, securities loans, margin loans, futures and some other financial contracts, while the CDIC Act deals with the resolution of financial institutions (largely banks) whose deposits are insured by CDIC (“FIs”).)

CDIC Act Resolution Stays

The following description of the CDIC Act resolution stays largely mirrors that in the Guidance, but with some paraphrasing on my part. Or you could just read the Guidance note itself!

No stay

As the Guidance states, close-out rights of EFC counterparties are not affected by the general stays that apply where a resolution order is made. Moreover, even the stays that do apply to EFCs do not affect a counterparty’s right to terminate, net or deal with financial collateral (“close-out rights”) where the default is a performance default, such as a failure to make a payment or a delivery, or any other trigger other than the specific ones listed below that relate to the resolution order. Also, parties can deal with financial collateral to satisfy any payment, delivery or settlement obligation.

To put it in the simplest terms, EFC counterparties can exercise any close-out rights unless and to the extent they are triggered by any resolution related events described below.

Resolution Event Triggers

If a resolution order is made, EFC counterparties will be stayed from exercising close-out rights in the following five scenarios only:

  1. the insolvency or deteriorated financial condition of the FI, any of its affiliates or credit support providers or guarantors (the “Insolvency/DFC”)
  2. the making of a resolution order or any change of control or ownership of the FI or any of its affiliates that is related to the making of the order
  3. the assignment or assumption of the EFC to or by a bridge institution or a third party
  4. a “bail-in” conversion (CDIC describes this as “open bank resolution”)
  5. a conversion of any of the FI’s shares or liabilities in accordance with their contractual terms (for example, non-viability contingent capital (known as “NVCC”) instruments).

Temporary stay

The stay for reason only of the Insolvency/DFC (the first one in the list above) ceases to apply automatically at 5:00 p.m. on the second business day after the day on which the resolution order was made. After this “temporary stay period” ends, EFC counterparties are free to rely on Insolvency/DFC to exercise close-out rights as long as that Insolvency/DFC still exists at the time the temporary stay period ends. In exercising their close-out rights, EFC counterparties are not precluded from pointing to the facts that led to the making of the resolution order as evidence of the Insolvency/DFC.

Permanent stay

However (and subject to some exceptions), even after the temporary stay period is over, EFC counterparties will still not be able to exercise their close-out rights on the basis of triggers 2, 3, 4 or 5 in the above list. CDIC refers to this as the “permanent stay”.

The Big Picture

As CDIC notes, what all of this amounts to is that, when the temporary stay period is over, counterparties to EFCs should be in a position to have confidence that either:

  • they will be able to exercise close-out rights on account of Insolvency/DFC; or
  • their EFCs will continue with:
    • the FI (their original counterparty), which is restored to financial viability through implementation of the resolution tools and accompanying stabilization measures;
    • a credit-worthy third party acquirer; or
    • a solvent and CDIC supported bridge institution.

Sticking to the theme of “confidence” for a moment, note that where CDIC assigns an EFC to a third-party or a bridge bank, the CDIC Act provides for certain creditor safeguards. Specifically:

  • CDIC must assign all of the EFCs outstanding between the FI and the EFC counterparty and its affiliates (i.e. no cherry-picking); and
  • CDIC may only assign an EFC to a third party if that party meets certain conditions, including that, among other things, it is:
    • balance sheet solvent;
    • able to discharge its obligations under the assigned EFC as they become due; and
    • at least as creditworthy as the FI was immediately before the resolution order was made (taking into account any credit support or guarantee in respect of the obligations under the EFC before and after the assignment, respectively).

Different Resolution Scenarios

Finally, we can take a closer look at the basic resolution scenarios and how they would be expected to play out under CDIC’s guidance.

Open bank resolution

In an open bank resolution scenario, the expectation is that immediate actions would be taken to restore confidence in the FI and to maintain the stability of the financial system in Canada. Following stabilization and any restructuring of the FI that may be necessary, CDIC would return the FI to private control.

Forced sale

In some cases it may be necessary to sell the assets of the FI to one or more third parties. CDIC would be in control of the FI (as shareholder or receiver) and in that sense would “force” the sale on the FI. (Since the EFCs of the FI can be novated to the third party without a counterparty’s consent, the EFC counterparties may feel like the forced ones!) If you are a counterparty whose EFCs have been transferred you would no longer have any close-out rights related to the defaults of the FI and you could not rely on the transfer as a default. No cherry-picking is permitted.

However, if your EFCs stay with the non-viable FI, CDIC can give you notice that the stay will be lifted so that close-out rights can be immediately exercised. (And you still have your right to rely on Insolvency/DFC in that context as well.)

Bridge institution resolution

CDIC has the ability to transfer the non-viable FI’s critical functions and viable operations to a bridge institution. CDIC would subsequently transfer the bridge institution or its assets to private ownership or arrange for another exit transaction.

CDIC, as receiver and sole shareholder, would cause a purchase and assumption transaction to be entered into between the FI and the bridge institution. Creditors can take comfort from the fact that CDIC has a statutory obligation to ensure the bridge institution can meet its financial obligations.

CDIC may transfer EFCs to the bridge institution, provided it adheres to the “no cherry-picking” rules. Within the temporary stay period, CDIC would either complete the transfer of an EFC to the bridge institution or undertake to do so.

If CDIC provides an undertaking to transfer an EFC to the bridge bank within the temporary stay period, such an undertaking would extend the temporary stay period only until the transfer is completed (the expected date of which would likely be specified in the undertaking). In practice, the transfer would be completed as close to the two business days as possible, in keeping with the expectation in the FSB Key Attributes that the temporary stay be strictly limited in time. The permanent stay would continue to apply in respect of EFCs that are transferred to the bridge institution.

However, if CDIC does not transfer, or undertake to transfer, EFC with a particular counterparty to the bridge institution within the temporary stay period, the EFC counterparties could exercise close-out rights immediately after the temporary stay period ends.

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