For large counterparties based in G20 countries, margin rules for over-the-counter (OTC) derivatives have been a challenge for some time. By contrast, New Zealand counterparties have, until recently, been largely immune from the effects of these rules. However, given the global nature of the OTC derivatives markets, and the dependency of local banks on offshore funding, that shelter was never going to last. We might have been permitted to play in the global OTC sandpit up until now, but the big boys get to set the rules. And, when they change them, your choices are to accept the new rules or find another sandpit to play in.
The Reserve Bank and the Ministry of Business, Innovation & Employment (the Agencies), along with the Treasury, recognised this inevitability and, in late 2016, engaged with the industry and overseas regulators to assess the likely impact in New Zealand of foreign margin rules. That engagement culminated in the release of a consultation paper on 13 July 2017.
What you need to know
What is the problem?
The paper notes that, under local law, there are a number of potential legal impediments to compliance with foreign margin rules. However, three impediments are key:
- the moratoria on exercising secured creditor rights in a statutory management or administration,
- the preferred status given to certain creditors in a liquidation under the Companies Act 1993, which may trump the interest of a holder of cash margin, and
- uncertainty whether holders of (cash or securities) margin have the protection of certain provisions in the Personal Property Securities Act 1999 (PPSA) on which they typically rely to confer priority.
The Agencies focus solely on these three impediments - their view being that the other impediments are unlikely to be insurmountable.
What is the proposed fix?
The Agencies propose two options: status quo or targeted legislative change. They favour the latter.
The proposed legislative change is best explained in two parts: first, the circumstances in which a new statutory exclusion from the impediments outlined above would be available; and, secondly, the nature of that exclusion.
(1) Circumstances in which exclusion would be available
The Agencies propose that the exclusion would be available for security interests over initial margin (IM) where:
- the OTC derivative is subject to a netting agreement that is enforceable under New Zealand law,
- the security interest is evidenced in writing,
- the security interest is over financial property, and
- if the New Zealand counterparty were insolvent at the time when the security interest was created, the secured party was not aware of that fact.
Of those pre-conditions, only the first one warrants comment. Given the acknowledgement in the paper that domestic margin requirements are unlikely at this stage, this pre-condition offers a rare example of foreign law dictating the applicability of New Zealand law. That is, the starting point for considering the availability of an exclusion from mandatory New Zealand law would be the requirements of foreign law.
(2) Nature of the exclusion
The exclusion would, for the three impediments, operate as follows:
- it would carve out the exercise of secured creditor rights from the moratoria – but the carve-out for registered banks would be subject to a short delay or stay (perhaps two business days), in recognition of the unique systemic importance of banks and the likelihood that the Reserve Bank's Open Bank Resolution (OBR) policy would apply to them,
- it would be an exception to the rule in the Companies Act that prefers certain creditors ahead of the interest of a holder of cash margin, and
- it would confer a 'super-priority' on holders of (cash or securities) margin, operating in a similar manner to section 103A of the PPSA (which confers a similar super-priority on the operator of a designated settlement system).
A bonus clarification
In addition to this proposed fix, the Agencies intend to amend the PPSA to clarify an issue that has been the source of a significant difference of opinion within the New Zealand legal profession. This is the issue of whether an outright transfer of collateral under an agreement such as an ISDA Credit Support Annex gives rise to a "security interest" for the purposes of the PPSA. We think it does. Others disagree.
This proposed clarification is welcomed because the current uncertainty is frustrating for both market participants and the lawyers who advise them. More substantively, mischaracterising a transaction that is a "security interest" can have substantial legal implications.
This is a very positive initiative, which is the end-product of many months of discussions with market participants, industry associations and overseas regulators. We agree with the Agencies' focus on the three key impediments. Aiming for a more comprehensive, gold-plated, reform would invariably delay it or even threaten its chances of success altogether. We also agree with the nature of the exclusion that is proposed.
However, we question whether, if the reform proceeds as proposed, an opportunity might go begging. Specifically, the first pre-condition to the availability of the exclusion is that there be a regulatory requirement for posting margin. Accordingly, the exclusion would not apply to:
- cleared transactions,
- uncleared transactions not covered by a regulatory mandate for margin, or
- variation margin (VM). The Agencies conclude in the paper that there are no legal impediments to New Zealand banks' ability to provide VM under the new margin rules. This seems to be based on their understanding that all VM is provided by way of an outright transfer of collateral.
Our view is that all margin arrangements are equally worthy of protection, given the size and systemic importance of those who rely on them.
The next step
Submissions on the consultation paper close on 24 August 2017. Once submissions have been considered, the Agencies will decide whether to proceed with legislative amendments and, if so, whether to merely amend the existing legislation or to create a new standalone Netting Act. The former seems more likely. Creating a new Netting Act would invariably invite greater legislative scrutiny, and raise fears of a more widespread change in creditors' rights, than would amending existing legislation.
If you would like assistance with preparing a submission, or guidance on how this development would affect your business, please contact David Craig or your usual Bell Gully adviser.
This publication is necessarily brief and general in nature. You should seek professional advice before taking any action in relation to the matters dealt with in this publication.