Common use of Close-Out Netting Clause in Contracts

Close-Out Netting. The purpose of close-out netting is to reduce the exposures on open contracts should a party become insolvent during the lifecycle of the contract. Close-out netting thus operates by way of forming an agreement that typically allows the solvent party to terminate all contracts between parties, calculate the losses and gains on each contract, and then set them off so that a single balance is owing.98 This is the ‘net’ amount.99 Collateral transactions are therefore usually dealt with en-masse from a capital requirement and risk management perspective. For instance, it is not uncommon for party A and party B to have many outstanding mutual obliga- tions through various collateral transactions. It would arguably be cheaper and more efficient to assess the relevant risk, post adequate financial collateral/ margin and calculate the necessary underlying capital if these transactions are dealt with on an aggregate basis.100 As noted above in section 3.4.2, collateral transactions covered by close-out netting are often protected by ‘safe harbours’, meaning that these transactions are shielded from traditional insolvency law rules that would otherwise be 98 ▇▇▇▇▇▇▇▇▇▇▇ and ▇▇▇▇▇▇ ▇▇▇▇ (n 91) 331 at 331-333. See also the legal definition of close-out netting under Article 2 (1) (98) of Directive 2014/59/EU of the European Parliament and of the Council of 15 May 2014 establishing a framework for the recovery and resolution of credit institutions and investment firms; Article 2 (1) (n) (i) of FCD. 99 Close-out netting can be distinguished from ‘set-off’. ‘Set-off’ refers to a settlement of mutual debt between a creditor and a debtor through offsetting transaction claims. See also general- ly, Muscat (n 75); ▇▇▇▇▇▇▇▇▇ et al (n 97) 316. 100 Paech (n 30) 1 at 36-39. applicable. These safe harbours thus serve to protect the parties’ enforcement of the contractual arrangements against insolvency law. Close-out netting is thereby said to have a practical effect comparable to a ‘super priority’ in that it is exempted to some extent from the equal treatment of creditors (pari passu) because of set-off, which results in full payment of claims.101 The natural playing field of close-out netting provisions are the industry standard master agreements, which contain clauses for contractual termination and liquidation of the specific transaction as one of their most important elements.102 Bankruptcy is indeed a triggering event that allows the non-de- faulting party to ‘close-out’ all outstanding claims.103 The non-defaulting party does not have to wait, there is no concern for other creditors and no consideration is given to reorganising the defaulting debtor.104 In addition, provided the parties are within scope,105 the protection of close-out netting against the commencement of traditional insolvency proceedings is also enforced under Article 7 of the Financial Collateral Directive. The global importance of close-out netting cannot be overemphasised. Virtually all entities operating in the shadow banking sector cover virtually all collateral trans- actions with a close-out netting provision. Close-out netting is, therefore, a crucial form of protection. Close-out netting is therefore viewed by market participants as an im- portant risk mitigation tool that reduces the exposures to a counterparty and, as a consequence, counterparty risk. In particular, close-out netting has been argued to reduce systemic risk in the financial markets. The derivatives market, for instance, has expanded significantly over the past decades. Because derivat- ive transactions are systemically risky, primarily due to the value of the derivative contract being derived from the underlying asset – which can cause the value of the derivative contract to substantially fluctuate – defaults in the derivatives markets are perceived to cause systemic damage to the financial markets. Close-out netting can therefore “reduce the gross exposures incurred 101 ▇▇▇▇▇▇▇▇▇▇▇ and ▇▇▇▇▇▇ ▇▇▇▇ (n 91) 331 at 337. See also, Article 8 of FCD; ▇ ▇▇▇▇▇▇▇, ▇ ▇▇▇▇▇▇▇, E ▇▇▇▇▇▇ and ▇ ▇▇▇▇▇▇▇, The Law of Financial Collateral (2016) 436-438; UNIDROIT, Principles on the Operation of Close-out Netting Provisions (2013), Principle 7 on the Operation of Close-out Netting Provisions in Insolvency and Resolution; Haentjens et al (n 97) 286; ▇ ▇ ▇▇▇▇▇, “Liquidity, Systemic Risk and the Bankruptcy Treatment of Financial Contracts” (2015) Brooklyn Journal of Corporate, Financial and Commercial Law 1 at 20. 102 Paragraph 10 of the GMRA 2011; Paragraph 11 GMSLA 2010; Paragraphs 4 (b) and 6, 1995 ISDA English Law CSA and Paragraphs 4 (b) and 6, 2016 English Law CSA for Variation Margin. See also, ▇▇▇▇▇▇▇▇▇▇▇ and ▇▇▇▇▇▇ ▇▇▇▇ (n 91) 331 at 337. Also, please see preceding sections above for the respective close-out netting provisions and how they operate under the respective master agreement. 103 Ibid. 104 ▇▇▇▇▇▇ (n 78) 147 and 149. 105 This relates to both ‘material’ scope and ‘personal’ scope under the Financial Collateral Directive. See Chapter 3 for a more in-depth discussion. in derivative transactions to net exposure and, consequently, the systemic risk in the derivatives market is reduced”.106 According to ▇▇▇▇▇▇▇▇▇ and others, Figure 15 below illustrates that the notional amount of outstanding OTC derivative contracts by end December 2018 was USD 544 trillion, the gross credit exposure was USD 2.3 trillion and the gross market value (the cost of replacing the derivative contract at market value) was USD 9.7 trillion.107 by deducting the gross credit exposure from the gross market value reflects valid and enforceable close-out netting arrange- ments and importantly, these calculations show that close-out netting can significantly reduce counterparty exposure, by approximately 75%, which consequently has a positive effect on financial stability.108 Figure 15: Outstanding OTC Derivatives Amounts Source: Bank for International Settlements109 3.4.3.1 Close-out netting: some observations