The Bilateral Netting Law and its Impact on the IBC – By Arjun Sathees

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The Bilateral Netting Law and its Impact on the IBC

Arjun Sathees

 Netting

The Bilateral Netting of Qualified Financial Contracts Act, 2020 (“Netting Law”) was notified on 28th September 2020.[1] The Statement of Objects and Reasons of the Netting Law stipulates that the law has been enacted with an aim to create an unambiguous legal framework of close-out netting which would reduce credit exposure of banks and other financial institutions from gross to net exposure, which would allow greater capital savings, reduce overall risk and thereby contribute to financial stability.[2]

Netting is defined under section 2(1) (j)-

”netting” means determination of net claim or obligations after setting off or adjusting all the claims or obligations based or arising from mutual dealings between the parties to qualified financial contracts and includes close-out netting;

Netting when applied to a single transaction is effectively a set-off of claims. However, the concept of close-out netting is slightly different. A close-out netting term in a netting agreement allows the parties to net out all claims irrespective of whether they are due or not. This would effectively mean terminating the contract by accelerating all obligations under the contract and arriving at a final single settlement to be made by one party to another.[3] Such net amount shall be determined as per the procedure under section 6(2) which includes acceleration of obligations and calculating estimated values. As per section 7, this final settlement or net amount shall be decided as per the existing netting agreement if any, and in its absence by a mutual agreement of the parties. If no such agreement can be reached then the parties shall decide the net amount through arbitration.

To better understand the significance of netting the concept of a credit-default swap (CDS) needs to be examined. A CDS is a privately negotiated derivative contract, wherein the seller agrees to make a payment to the buyer if the underlying financial instrument defaults, in exchange for a premium. The financial instrument could be a mortgage-backed security or asset-backed security (corporate debt).[4] For example, a Bank has loaned 10 crores to a debtor who has furnished his house valued at 6 crores as security. The Bank, later on, has reason to believe that the debtor is likely to default on the debt and to mitigate that risk, buys a CDS from an investor which assures payment of 8 crores upon default by the debtor in exchange for a premium paid monthly by the Bank. Now under the earlier regime, the Bank would have to provision for the entire 10 crores loan amount which is the gross exposure. But under the Netting Law, the Bank has to provision for only the netted or net exposure which is 2 crores.

Thus, the Netting Law effectively incentivizes banks and financial institutions to hedge their risks by entering to CDS-like arrangements, which would release greater capital for other functions such as granting new loans or carrying out investments and thereby increase financial stability.

 

Applicability of the Netting Law

As per section 3, the Netting Law applies to a qualified financial contract (“QFC”) entered into on a bilateral basis between the qualified financial market participant (“QFMP”) via a netting agreement or otherwise.

QFMP are defined under 2(1) (k) and include:

“qualified financial market participant” includes,—

(i)a banking institution, or a non-banking financial company, or such other financial institution which is subject to regulation or prudential supervision by the Reserve Bank of India;
(ii) an individual, partnership firm, company, or any other person or body corporate whether incorporated under any law for the time being in force in India or under the laws of any other country and includes any international or regional development bank or other international or regional organisation;
(iii) an insurance or reinsurance company which is subject to regulation or prudential supervision by the Insurance Regulatory and Development Authority of India established under the Insurance Regulatory and Development Authority Act, 1999;
(iv) a pension fund regulated by the Pension Fund Regulatory and Development Authority established under the Pension Fund Regulatory and Development Authority Act, 2013;
(v) a financial institution regulated by the International Financial Services Centres Authority established under the International Financial Services Centres Authority Act, 2019
; and
(
vi) any other entity notified by the relevant authority under clause (b) of section 4;

However for the Netting Law to apply, section 3 mandates that at least one party to the agreement must be an entity regulated by an authority specified in the First Schedule, namely the RBI, IRDA, PFRDA, IFSCA, or SEBI. Under section 4, these authorities may, by notification, designate any agreement or transaction as a QFC and designate any entity regulated by them as a QFMP.

Impact on IBC

The Netting Law has a significant impact over IBC in a scenario where one of the parties to the QFC becomes insolvent. The Netting Law effectively overrides the IBC and several other statutes including the Companies Act 2013.  This has been made explicit in multiple provisions of the extremely compact legislation.

Section 5(3) stipulates that agreements containing close-out netting agreements will be enforced irrespective of whether an administration practitioner is being appointed, notwithstanding any provision in the IBC or any other law which applies to the insolvent party.

Section 5(4) stipulates that close-out netting obligation will circumvent any moratorium, order of liquidation, or order of winding up under any law for the time being in force.

Section 6(4) explicitly states that close-out netting obligations shall be applicable notwithstanding anything to the contrary in any of the laws mentioned in the Second Schedule of the Netting Law (which includes the IBC and Companies Act, 2013) or any other law. 

Section 10 further provides a general notwithstanding clause stating that the Netting Law shall have effect notwithstanding anything inconsistent in any other law for the time being in force.

Thus, the Netting Law has made it crystal clear that nothing in the IBC will prevent close-out netting obligations from being enforced even if one of the parties to the QFC is undergoing insolvency. This appears to be in stark contrast to the pari passu principle of insolvency law, whereby the non-insolvent party to a QFC who is owed a debt by the insolvent party is treated with super-priority. However, netting is a well-established practice adopted in 61 jurisdictions as per the International Swaps and Derivative Association (ISDA).[5] Netting has also been approved by the Basel Accords on capital requirements for banks.[6]

Limitation on the Powers of the Administration Practitioner

Section 5(5) stipulates that the close-out netting agreement shall bind not just the parties concerned but also the administration practitioner. Section 2(b) clarifies that the administration practitioner could be the IRP, RP, Liquidator, Bankruptcy Trustee, receiver, or conservator as the case may be. Section 8 places explicit limitations on the power of the administration practitioner by restricting her from rendering ineffective any transfer in relation to a netting agreement between the insolvent and non-insolvent party to a QFC. Even if the transfer falls under the ambit of a preference or undervalued transaction, the administration practitioner is prohibited from rendering it ineffective.

Procedure for Invocation of Close-out Netting

The procedure for invoking a close-out netting is laid out under section 6. Generally, a close-out netting may be commenced by sending a notice to the other party of the QFC upon the occurrence of a default or a termination event specified in the netting agreement. However, the proviso to section 6(1) provides that if any party to the QFC is subject to insolvency then neither such prior notice nor consent of such party (or the administration practitioner) is required.

It appears that the Netting Law is aimed at expeditious disposal of netting obligations. However, nothing further has been mentioned in the Netting Law. This is essentially where the lacuna lies. The actual modus operandi for close-out netting needs to be set out in detail. In the event of insolvency of one of the parties to the QFC, the procedure for applying for such close-out netting is vague. There is no clarity as to which authority an application is to be made or the manner in which such invocation must be carried out.

The Netting Law is clearly in its nascent stage and accordingly, section 11 enables the Central Government to cure any difficulty in connection to giving effect to the provisions of the Netting Law by passing suitable orders to that effect.

Addressing this procedural ambiguity is essential to give effect to the practice of netting in India. There might be a need to bring suitable amendments to the IBC as well to account for such netting, as any amount due under such netting agreement would not form part of the debtor’s asset pool which is to be used in the resolution process. The administration practitioner could be made suitably equipped to honour the netting agreement obligations.

Conclusion

Netting is a practice that is bound to reduce the NPA risks of the banks in the country and thereby promote financial stability. However, the Netting Law’s inherent conflict with IBC and the lack of a clear procedure to enforce closed-out netting will require immediate response by the authorities to ensure smooth implementation. It remains to be seen how netting will impact cross-border insolvencies as there might be claims from or against foreign creditors hailing from jurisdictions that do not follow the concept of netting.

About Author

Arjun Sathees is a LL.M (in Corporate and Financial Law and Policy) graduate from Jindal Global Law School, O.P. Jindal Global University, Sonipat, Haryana. He is currently engaged as a research scholar at O.P. Jindal Global University, Sonipat, Haryana under the Graduate Research Immersion Programme (GRIP) Scholarship.

 

Reference

[1] http://www.egazette.nic.in/WriteReadData/2020/222064.pdf

[2]https://www.prsindia.org/sites/default/files/bill_files/Bilateral%20netting%20of%20qualified%20financial%20contracts%20bill%2C%202020.pdf.

[3]https://www.investopedia.com/ask/answers/062515/what-difference-between-payment-netting-and-closeout-netting.asp.  

[4]https://www.cga.ct.gov/2008/rpt/2008-R-0668.htm#:~:text=A%20credit%20derivative%20is%20based,or%20other%20forms%20of%20credit.&text=Credit%20default%20swaps%20(CDS)%20and,value%20of%20the%20underlying%20item.; https://www.investopedia.com/terms/c/creditdefaultswap.asp.

[5] https://www.isda.org/2020/07/03/status-of-netting-legislation/.

[6] Basel Committee on Banking Supervision, International Convergence of Capital Measurement and Capital Standards – A Revised Framework, Comprehensive Version, June 2006, paras 117, 118, 139, and 188 available at https://www.bis.org/publ/bcbs128.pdf.

 

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