Vol 9 (2012) - Issue 2

Article preview

Conditional Conflict of Laws Rules: A Proposal in the Area of Bank Resolution and Netting in Cross-border Scenarios

1. Introduction
In very simple terms, netting implies the replacement of two or more existing obligations to make payments by a single obligation to pay the difference. Netting lessens the counterparty credit risk by reducing the amount of cash flow between the parties. Netting is, therefore, an important risk control mechanism. Under a close-out netting arrangement, if a defined event occurs in relation to one party – insolvency for instance – the other party may terminate all outstanding contracts between them, calculate the positive or negative market values of each contract on the basis of an agreed valuation mechanism and offset them, so that only the balance is due. Netting and close-out netting arrangements reduce exposures and risks between counterparties and for this reason are common in financial markets.
However, the recent crisis has revealed that allowing the immediate termination of all outstanding financial contracts can generate another form of systemic risk, namely that a rush by the counterparties of a financial institution to terminate their contracts may itself destabilise financial markets, given the large volume of operations that this entails. For this reason, some jurisdictions empower the relevant authorities to delay the immediate operation of early termination rights in order to allow for the transfer of financial contracts from a troubled institution to another entity in order to maintain continuity.
In this context, the Basel Committee on Banking Supervision has set out two main goals in the context of bank resolution and netting: (i) a moratorium on the enforcement of early termination clauses in contracts must not jeopardise the reliability of netting agreements, and (ii) the cross-jurisdictional differences in respect of netting must not render bank resolution ineffective. As one commentator pointed out, the Basel Committee proposes a number of measures with regard to the first issue, but it is silent on the second.
The purpose of this paper is precisely to propose a solution to that second concern based on the notion of conditional conflict of laws rules; that is to say, conflict rules that operate if and only if the designated law satisfies certain predetermined minimum standards.
The key element of this solution is to allocate in the lex concursus the powers to avoid the immediate operation of the close-out provision in netting agreements so as to enable the transfer of the financial contract to another institution, even if the netting agreement is governed by a different law, but under specific conditions. If these conditions are not satisfied, the law governing the netting agreement applies without limitation.
This paper is structured as follows. Section 2 will explain the concept of conditional conflict of laws rules. Section 3 will outline the main characteristic of closeout netting arrangements. Section 4 will describe the problems raised by these arrangements in a cross-border scenario, in particular with regard to the rules that lay down a moratorium on the enforcement of early termination clauses. Finally, Section 5 will propose a modification to the conflict of laws rule on netting contained in the European Directive on reorganisation and winding-up of credit institutions. We will not address the question of whether it is possible to achieve a similar result by means of statutory interpretation.