A decision of the German Federal Court of Justice (“Bundesgerichtshof” - BGH) in June 2016 regarding the validity of liquidation netting agreements sparked widespread fear of a new banking crisis. It led to immediate action by the BaFin (German Federal Financial Supervisory Authority) and, only a few months later, amendment of the relevant statute by the German legislator. Whilst the amendment relieves the legal and potential systemic uncertainty caused by the BGH's decision as regards today's standard liquidation netting agreements, the new legislation creates its own uncertainties. All netting clauses should be tested for compliance with the new legislation but also to determine whether they might unexpectedly give rise to opportunities that were not originally envisaged.
It is widespread practice amongst financial institutions to agree provisions relating to liquidation netting (most commonly used is the ISDA (International Swaps and Derivatives Association) Master Agreement, and, in Germany, the German Master Agreement on Financial Derivatives Transactions of the Association of German Banks). These liquidation netting agreements provide that in the event of the insolvency of one party, all open claims between the contracting financial institutions should be netted off against each other. The result is that each individual claim does not need to be set-off but rather that the exercise gives rise to a total net balance between the parties. Such liquidation netting provisions could operate to reduce worldwide insolvency risk among financial institutions from a gross market exposure of USD 25 Trillion to a gross credit exposure of only USD 3.7 Trillion.1 By taking into account only the total net balance, financial institutions managed to comply with capital adequacy requirements of the banking regulator under reduced tie-up of securities and equity (as financial institutions are obliged to hold equity or securities as outlined in the Capital Requirements Directive of the European Union based upon the Third Basel Account agreed upon by the Basel Committee on Banking Supervision).
As a general rule, Sec. 103 InsO entitles an insolvency administrator to choose between performance or non-performance of a mutual contract. Sec. 104 provides a statutory exemption from this general principle: the administrator may not claim performance of contracts relating to the supply of goods and financial instruments which are due within a fixed time or period and which have a market or stock exchange price; the parties may only claim damages for non-performance. Several of such contracts may be combined by framework agreements in order to be treated as one. So far so good. But how is such a claim for non-performance regarding multiple financial instruments to be calculated?
Sec. 104 of the old version of the German insolvency code (InsO o.v.) prescribed a specific method by which to calculate such claims in insolvency: the difference between the agreed price and the market or stock exchange price at a time agreed between the parties (but which must be no later than five working day after the opening of the insolvency proceedings), or, if there was no such agreement, on the second working day after the opening of the relevant insolvency proceedings.
This calculation method was perceived in the finance world to be both unpractical and unsuitable as it exposed banks to a potentially significantly higher risk than they were likely to have foreseen under the master agreements by the banks' associations. Therefore, it was common to deviate from the calculation method in sec. 104 II InsO o.v. by way of master agreements, e.g. the ISDA Master Agreement.
Despite exposing the banks to such risks, the BGH in its decision of 9 June 2016 decided that the statutory calculation method set out in sec. 104 InsO o.v. must prevail - it was mandatory and parties may not agree to deviate from it to the detriment of the creditors. In order to preserve the debtor's estate as much as possible, German insolvency law, at sec. 119 InsO, explicitly prohibits any contractual deviations from the right of the insolvency administrator, pursuant to sec. 103 InsO et. seq, to cherry-pick, i.e. to choose performance or non-performance of contracts as well as to any statutory exceptions to sec. 103 InsO including sec. 104 InsO.
Whilst the legal assessment underlying the decision was not totally surprising, the immense outcry and the immediate actions taken by BaFin and the surprisingly swift action by the German legislator were unexpected. The BGH had historically shown a strong tendency to protect and strengthen the administrators' rights pursuant to sec. 103 InsO et. seq and this had been reiterated in a decision as recently as 2012. As always in law, some commentators considered that the deviating contractual arrangements in the case at hand were within the scope of the statute. One may well ask whether the legal uncertainty was really only created by the decision or whether it actually existed well beforehand.
Nonetheless, the decision triggered considerable concern in the market, particularly the fear that (systemically important) financial institutions may no longer have been able to comply with their capital adequacy requirements or might even have been at risk of default.
BaFin immediately stepped in to reinstate legal certainty and issued a general ruling under Paragraph 4a Wertpapierhandelsgesetz - WpHG (i.e. German Securities Trading Act) shortly after the BGH decision in order to confirm the validity of deviating netting agreements in existing master agreements subject to German insolvency law. The question of whether this ruling, as well as the decision of the BGH, was correct from a legal perspective is moot as the German legislator reacted so quickly.
The German Parliament's amendment to sec. 104 InsO came into force only half a year later on 29 December 2016. This haste was unusual and noteworthy.
In order to accommodate the practice of the master agreements, the new legislation now permits parties to calculate the compensation claim on the basis of the market or exchange price, and no longer the difference between agreed price and market or exchange price (see sec. 104 para 2 InsO n.v.). The market or exchange price is expressly defined as the market or exchange price of a substitute transaction taking place without delay and no later than five days after insolvency or, if no transaction has been made, a fictional substitute transaction taking place on the second day after the opening of proceedings. If the market does not allow for a substitute transaction, the market and exchange price is to be determined based on methods and procedures which can guarantee a fair evaluation (angemessene Bewertung).
The new legislation does not stop here. It extends this exception even further by introducing an "opening clause" (Öffnungsklausel) in the statutory text. The purported intention is to accommodate future developments.
The opening clause allows the parties to agree upon any deviating provisions provided that they are compatible with the "essential basic ideas" of the respective legal provision set out in sec. 104 para 4 InsO n.v. ("Die Vertragsparteien können abweichende Bestimmungen treffen, sofern diese mit den wesentlichen Grundgedanken der jeweiligen gesetzlichen Regelung vereinbar sind, (…)").
Further, the new legislation explicitly acknowledges - only by way of a non-exhaustive list of examples, and hence not limiting deviating provisions to those listed - that under this clause the parties may agree on a contractual termination before the insolvency proceedings are opened, e.g. upon the petition to open insolvency proceedings or upon the existence of an insolvency- event. To calculate the compensation claim, the parties may also agree that (i) the time of the contractual termination is decisive (instead of the opening of proceedings), (ii) the period for the substitute transaction is up to 20 days (instead of 5 days) and (iii) the time or period of the fictional substitute transaction is up to 5 days (instead of 2 days), both following the time of the contractual termination.
The legislator has clarified that parties may deviate - within limits - from the German liquidation netting rules in sec. 104 InsO and has thereby acknowledged the current practice pursued by way of master agreements.
The "opening clause" in the new legislation even seems to go beyond the current practice and to allow financial institutions to agree upon almost anything. This may be misleading. It will be very difficult to determine whether a deviating contractual provision complies with the "essential basic idea of the legal provision". This concept is quite vague and the BGH is strict in allowing exceptions which are potentially detrimental for creditors.
Only the above-mentioned explicit examples of lawful deviations to sec. 104 InsO seem to provide legal certainty. Beyond these, the new legislation's flexible approach will create more legal uncertainty than existed before. In particular, the determination of the market price and its "fair value" is subject to interpretation and will be likely to lead to disputes.
This flexible approach creates the opportunity to develop further liquidation netting schemes and to push the boundaries. On the one hand, all netting clauses should be tested in terms of compliance with the new legislation, in particular the above-mentioned explicit examples. On the other hand, any such situations should also be examined for potentially more favorable solutions and there should be due consideration of whether they are covered by the new opening clause.
Overall, the new opening clause may lead to new, cutting edge netting clauses which are, again, accompanied by legal uncertainty as to their validity pursuant to sec. 119, 103 and 104 InsO. This was precisely the situation which the legislator intended to avoid and which was feared for systemic risks. Hence, all good intentions to cater for future developments may actually make the situation worse.
Moreover, the ever-growing list of exemptions for financial institutions from the fundamental insolvency principle that creditors should be treated equally is subject to stark criticism. In this case, financial institutions are allowed to exempt themselves from this principle by contractual agreement and within limits which are quite vague.
The severe impact that was feared by the decision of the BGH as well as the breadth and speed of the subsequent administrative action and legislative change show once again that German insolvency law is subject to rapid change.
1 Bank for International Settlements, Monetary and Economic Department, OTC derivatives market activity in the first half of 2009, November 2009, 1; http://www.bis.org/publ/otc_hy0911.pdf