New German Insolvency Code Amends Legal Basis for Contractual Close-out Netting | White & Case LLP International Law Firm, Global Law Practice
New German Insolvency Code Amends Legal Basis for Contractual Close-out Netting

New German Insolvency Code Amends Legal Basis for Contractual Close-out Netting

The German legislature has passed an amendment to the German Insolvency Code providing clarity on the status of netting arrangements in financial transactions which was cast into doubt by the German Federal Court of Justice in June last year. This article illustrates the background of the legislative amendments and provides an outlook as to the consequences of the new law in relation to contractual close-out netting arrangements.

 

Legal Background of the Law

The new law is – in its entirety – a reaction to the decision of the Federal Court of Justice dated 9 June 2016 (IX ZR 314/14). The decision has found netting provisions used throughout the financial industry, for example in the German Master Agreement for Financial Derivatives Transactions and the ISDA Master Agreement, to be invalid and thus confirmed doubts on the validity of such netting arrangements previously expressed by few legal authors, but generally perceived to be valid and thus coming as a surprise to many in the financial services industry.

The Federal Court of Justice held that contractual provisions on netting arrangements in a financial contract are invalid if they deviate from the mandatory provisions set out in Section 104 of the German Insolvency Code (Insolvenzordnung – "InsO"). Particularly the contractual calculation method for claims of non-performance in the case of insolvency by either party was declared invalid. Furthermore, the Federal Court of Justice decision left open whether a contractually agreed early termination right of a transaction may still be valid or whether this is an inadmissible deviation from Section 104 (1) and (2) InsO, which determines the opening of insolvency proceedings to be the relevant termination date.

On the same day that the Federal Court of Justice's decision was published, the German Federal Financial Supervisory Authority published a general decree seeking to diminish the potential legal impacts of the Federal Court of Justice's decision and the resulting uncertainty among market participants. The BaFin-Decree was limited in time and has automatically ceased to be effective on 31 December 2016.

 

The InsO Reform

A legislative reaction to the judgement was thus required to re-establish legal certainty for netting arrangements in the scope of German insolvency law. The new law amending the Insolvency Code was published in the Federal Gazette on 28 December 2016 and focuses on a revision of Sec. 104 InsO.

The revised version of Section 104 InsO now comprises five paragraphs instead of three. Thus, the structure of Sec. 104 InsO has been clarified and clearly differentiates between the statutory resolution mechanism for financial contracts in paragraphs 1 and 2 and the scope of possibilities to contractually amend the statutory concept in paragraphs 3 and 4. Paragraph 5 is a repetition of the former Sec. 104 para 3 sentence 3, which stipulates that the claim for non-performance by the contractual partner of the insolvent debtor can merely be asserted as an insolvency creditor.

 

Statutory Model for Automatic Resolution

The statutory model for resolving/settling financial contracts in case of insolvency remains conceptually unchanged. If the parties had agreed that delivery of goods with a market or stock exchange price or financial transactions are to take place on a fixed date or within a fixed period and if such date or expiry of the period occurs after the insolvency proceedings were opened, performance may not be claimed. However, claims for non-performance may still be made. A claim for non-performance shall cover the difference between the agreed price and the market or stock exchange price prevailing at a point in time agreed by the parties, at the latest, however, on the fifth working day after the opening of the insolvency proceedings at the place of performance for a contract with the agreed period of performance. If the parties do not enter into such an agreement, the second working day after the opening of the insolvency proceedings shall be the relevant date. The other party may bring such claim only as an insolvency creditor.

The list of financial transactions included in the statutory concept for settling such financial transactions was updated to reflect the current status of financial services supervision. The list of financial transactions included in the scope of Sec. 104 InsO is now defined with reference to annex I section C of directive 2014/65/EU (MiFID). However, this update does not materially affect the prior list, which was considered to be non-exhaustive in any case.

 

Possibilities to Deviate from the Statutory Model

The core of the reform is the new paragraph 4 of Section 104 InsO, which stipulates that counterparties may contractually agree on netting provisions that deviate from the statutory mechanism of termination and settlement of contracts regulated in Art. 104 InsO as long as these provisions are compatible with the essential principles of Sec. 104 InsO (vereinbar mit wesentlichen Grundgedanken), a methodology frequently used for testing the validity of general terms and conditions under German law (see Section 307 para. 2 no 1 German Civil Code – BGB). The German legislator's explanation of this test is that the provision may not contradict the purpose of the statutory termination and settlement mechanism. Pursuant to the official reasoning (Official Record – BT-Drucks. 18/9983, 9), the purpose of the statutory mechanism is to protect the counterparty of the insolvent party from the insecurity which would result from the right, the administrator is normally granted to choose performance or non-performance of the contract and would otherwise allow the administrator to speculate on price movements. This purpose allows parties to contractually agree on i) the details of the termination of the contracts, ii) the calculation of the claims for non-performance and iii) the netting arrangements. The new Section 104 para. 4 sentence 2 illustrates the ways in which the parties may deviate from the statutory requirements which are outlined in the following non-exhaustive examples (Regelbeispiele):

Firstly, the parties may agree that the effects of the netting arrangements (contract termination and the emergence of a single compensation claim) may be triggered prior to the opening of insolvency proceedings, in particular when a petition for the opening of insolvency proceedings is filed or when a reason for the opening of insolvency proceedings is present (Vorliegen eines Insolvenzgrundes), e.g. one party is over-indebted or insolvent.

Secondly, the parties may agree to include those financial transactions of Sec. 104 para. 1 InsO that will become due before the opening of insolvency proceedings, but after the point in time, agreed for the contractual termination according to Section 104 (4) sentence 2 no. 1 InsO. This explicitly clarifies that the parties may contractually deviate from the requirement of Sec. 104 para. 1 InsO that the performance of the contractual obligation had to be subsequent to the opening of insolvency proceedings in case there is a contractual termination. Thus the contractual termination may replace (as regards timing) the opening of the insolvency proceedings.

Thirdly, the parties may – for the purposes of determining the market value of the replacement transaction – agree, that the point of time of the contractual termination replaces the commencement of the insolvency proceedings. They can also agree for the replacement transaction to be executed by the 20th business day following the contractual termination in so far as this is required for a value-preserving transaction. In any case the parties may choose to select a point in time between the termination of the transaction and the fifth business day thereafter. It is also possible that the parties agree on a synthetic calculation of the market price based on several transactions, by way of an open, transparent and non-discriminatory auction process or by a financial model, which includes all factors relevant for determining the price and is consistent with recognized evaluation methodology for financial instruments.

 

Effects of the InsO-Reform

The new law provides a more robust solution following the general administrative act by the Federal Financial Supervisory Authority, which was published on the same day as the BGH decision and intended to provide an interim solution. It also provides new opportunities for structuring the netting arrangements in the master agreements. The Association of German Banks (Bankenverband) will certainly collaborate with market participants to explore the opportunities provided by the new law and provide an update of the German Master Agreement for Financial Derivatives Transactions in the medium term. We also expect new netting opinions to be required.

Due to a special structuring of the law in three Articles, the amendments with respect to the possibilities to contractually deviate from the statutory concept have retroactive effect as of 10 June 2016 (Art. 5 para. 2 InsO-Reform). Thus, the new law limits the effects of the decision of the Federal Court of Justice, which it considers to be one-sided when holding certain netting arrangements to be invalid, to transactions in which insolvency proceedings have already been initiated before the decision on 9 June 2016. For all other transactions the new law granting substantially more freedom to contractually amend the statutory termination concept needs to be applied.

 

THE DELTA REPORT
Derivatives Newsletter
January 2017

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