31 March, 2020
Due to the lack of specific netting legislation in Mainland China, there is a market perception that a non-defaulting party’s right to terminate transactions and net their termination values (close-out netting) under a derivatives master agreement may be unenforceable when a Mainland China counterparty is subject to bankruptcy proceedings. Consequently, Mainland China has often been dubbed a “non-netting” jurisdiction by many international participants.
Recent developments
Of late, there have been various positive developments in Mainland China to support the legal efficacy of close- out netting. First, the Shanghai People’s High Court, in its guidelines on bankruptcy trials (2019), requires the approval of the relevant regulator as a precondition for the filing of any bankruptcy petition of a financial institution (whether initiated by the financial institution itself or its creditors).
In addition, recent cases such as the takeover of Baoshang Bank in 2019 have confirmed that Mainland Chinese financial institutions will likely go through some form of administrative or receivership proceedings overseen by their regulators before the commencement of any bankruptcy proceedings. These developments have reinforced the belief that there will likely be adequate information on any defaulting financial institution and therefore sufficient time for a non-defaulting party to terminate transactions and thereby avoid the bankruptcy stay on termination rights, which kicks in upon the commencement of the bankruptcy proceedings of the Mainland Chinese financial institution.
In any event and as a last resort, a non-defaulting party can always rely on the automatic early termination (AET) provisions of the derivatives master agreement which usually provide that, if not terminated earlier, all the transactions will terminate “automatically” upon the occurrence of a specific event before the commencement of bankruptcy proceedings as specified by the parties.
To this end, the right to close-out netting of the non- defaulting party under any derivatives agreement has been much fortified by the use of AET provisions.
Significantly, in line with Basel capital rules and international developments, the China Banking and Insurance Regulatory Commission, the banking and insurance regulator, has promulgated the Rules for the Measurement of Default Risk Assets of Counterparties in the Trading of Derivatives (effective January 2019), which enable commercial banks in Mainland China to calculate risk capital for derivative transactions on a net basis.
Accordingly, it is evident that market demand for the use of close-out netting to mitigate credit risks in the burgeoning derivatives market in Mainland China coincides with the expectations and policy of regulators.
Linklaters article on the efficacy of AET
In light of this, we recently published an article entitled “Close-out Netting Provisions and the Application of the Bankruptcy Law” (“終止淨額計算條款對《破產法》的適用”) in the International Finance (“國際金融”), a financial magazine jointly managed by Bank of China and the China International Finance Society. In the article, we analysed the efficacy of close-out netting provisions under the Mainland Chinese Bankruptcy Law and other relevant laws and legal principles. Given that the article is only available in Chinese, we have produced below an English summary of the key messages.
Key messages:
- Close-out netting against a party before its bankruptcy is supported by China’s Contract Law and conflict of law principles.
- Close-out netting against a party at or after its bankruptcy:
- Right to close-out – The right of a non-defaulting party to terminate transactions would be subject to a stay upon the commencement of the bankruptcy of the Mainland Chinese entity (which is the acceptance of the bankruptcy petition of the entity by the court). Notwithstanding this, the parties are entitled to agree on an AET provision designating an event before the commencement of the bankruptcy proceeding (such as the approval of the regulator for bankruptcy petition, the submission of the bankruptcy petition or the registration of the petition with the court, each of which precedes the acceptance of the petition by the court) as the event that triggers AET, which provision would be enforceable in the bankruptcy of the Mainland entity. However, parties are advised not to use a “retroactive” AET provision where a termination is triggered upon the making of a bankruptcy order but the termination operates retroactively from (or backdated to) the time of submission of the bankruptcy petition. Any concerns over “frivolous” bankruptcy petitions may be addressed through designating an event such as the approval of the regulator of the bankruptcy petition or the registration of the petition with the court as the trigger for AET, since any frivolous and vexatious petition would likely have been filtered out by the regulator or the court.
- Right to net – The right to net termination values of terminated transactions would be enforceable as insolvency set-off under the Bankruptcy Law.
The article also addresses other misunderstandings of Mainland Chinese law and close-out netting issues, including:
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Lack of recognition for single agreement – Whilst it would be ideal, it is not a pre-requisite for the legal concept of “Single Agreement” to be recognised under Mainland Chinese law.
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Lack of specific netting legislation – In the absence of specific netting legislation, the enforceability of close-out netting under Mainland Chinese law would still be supported by a robust analysis of the contract, bankruptcy and financial law as well as judicial practice.
The article was published in Volume 1 of the 2020 edition International Finance magazine. Please click here to view the article in full.
For further information, please contact:
Chong Liew, Partner, Linklaters
chin-chong.liew@linklaters.com
