On August 5, 2014, the Board of Governors of the Federal Reserve System (FRB) and the Board of Directors of the Federal Deposit Insurance Corporation (FDIC) issued a joint press release identifying shortcomings in the plans of large banks for a wind-down of their operations under the FDIC's orderly liquidation authority (OLA) in the event of material financial distress or failure (see Legal Update, Agencies Criticize Latest Round of Living Wills by the Largest Banks). The release indicates that regulators are requiring the 11 largest financial institutions in the US to amend their derivatives contracts to stay so-called early termination rights for up to 48 hours under those contracts. This requirement could drastically change a basic premise upon which most OTC derivatives contracts operate in the US.

According to the joint press release, the federal regulators, among other things,

Early termination is a key feature of the ISDA Master Agreement, which is used to document most OTC derivatives transactions (swaps). Early termination allows a party to the agreement to terminate the agreement and demand a settlement payment from its counterparty if the counterparty files for bankruptcy or if certain other insolvency or receivership events take place with respect to the counterparty. In the US, most contract provisions that permit termination or liquidation upon a bankruptcy or other insolvency-related event in this manner are prohibited ipso facto clauses under the Bankruptcy Code and not enforceable in a US bankruptcy proceeding. However, when included in certain types of contracts, including derivatives contracts, contractual early termination rights are protected by certain Bankruptcy Code safe harbors (see Guide to Bankruptcy Code Safe Harbors for Financial Contracts: Checklist: Safe Harbors Allowing Liquidation, Termination or Acceleration).

These safe harbors were originally intended to mitigate disruption and reduce systemic risk to the financial markets upon the failure of a major market participant. However, each payment made under an early termination clause reduces the amount available in the bankruptcy estate for the debtor's other creditors. This gives all creditors, including other financial institutions with large exposures to the debtor, the incentive to call outstanding balances they have with a failed financial counterparty under any available safe harbored early termination clause immediately upon the counterparty's bankruptcy or similar event. In the context of the largest and most interconnected financial institutions, the requirement to settle many large outstanding contracts immediately upon bankruptcy can cause widespread financial instability, as demonstrated by the Lehman failure in 2008.

Regulators therefore believe that early termination rights are a major impediment to the orderly liquidation of the largest financial institutions and one of the biggest contributors to "too big to fail." The FDIC has indicated that as long as early termination rights for counterparties to the largest financial institutions exist, any orderly resolution plan or living will of such institution is not credible. By limiting early termination rights from these contracts, regulators believe that bankruptcy will become a more viable option and allow for a true orderly liquidation that will have a smaller and less volatile impact on the financial markets at large.

However, one of the biggest advantages to derivatives transactions is that early termination clauses allow counterparties to these contracts to step in front of other creditors for full payment under the agreement, while other creditors must go through the bankruptcy process to receive payment on claims against the debtor. To the extent these rights are eliminated, derivatives contracts become less attractive , both as investments and as instruments for managing risk.

The 11 institutions named in the joint release include:

Because most US derivatives contracts are entered into with one of these major institutions, this would be a drastic change to the US derivatives market and to the rights of US swap counterparties under ISDA Master Agreements. This element of the guidance could therefore threaten much of the OTC derivatives business in the US.

For details on early termination under the ISDA Master Agreement, see Practice Note, The ISDA Master Agreement: Early Termination.

For more information on the FDIC's orderly liquidation authority, see Practice Notes, Summary of the Dodd-Frank Act: Resolution of Failing Financial Institutions and Summary of the Dodd-Frank Act: Swaps and Derivatives: The FDIC's Orderly Liquidation Authority Under Title II.