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  1. Derivatives legislation and litigation Penny MillerJoanne HallAntony HainsworthVictoria Fox IFLR Conference – 26 April 2012

  2. What we will cover – Derivatives regulation and litigation • EMIR • Overview of EMIR and practical considerations for firms • Extraterritoriality • International co-ordination and consistency of OTC derivatives reform – EMIR, Dodd Frank and beyond • Section 2(a)(iii) of the ISDA Master Agreement • Impact of client litigation in relation to Section 2(a)(iii)

  3. G20 statement in Pittsburgh • “All standardized OTC derivative contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties by end-2012 at the latest. OTC derivative contracts should be reported to trade repositories. Non-centrally cleared contracts should be subject to higher capital requirements.” • September 2009

  4. What we will cover – territorial scope US Dodd Frank EU EMIR MiFID2 Asia Hong KongSingapore Korea

  5. What we will cover - clearing and exchange-trading EMIR Clearing obligation Clearing obligation Reporting obligation Risk mitigation for uncleared trades Requirements for CCPs and trade repositories MiFID2/MiFIR Exchange trading

  6. Timeline - EMIR • Level 1 text • March 2012 • Finalised text expected Q2 2012 Level 2 measures – discussion papers so far ESMA: reporting obligation, mandatory clearing obligation, requirements for CCPs and risk mitigation of uncleared trades EBA: capital requirements for CCPs EBA/ESA: margin requirements for uncleared trades • Level 2 measures – the future • Further consultation Q2/Q3 2012 • Level 2 measures – final versions • Binding technical standards finalised by September 2012 • Introduced by end of 2012

  7. The clearing obligation

  8. Bilateral OTC Market Centrally Cleared Market Dealer 1 Dealer 1 ‘Novation’ CCP Dealer 2 Dealer 2 How central clearing works – Dealer to Dealer Clearing In central clearing, each dealer ‘gives up’ / ‘novates their half of the trade to the CCP. The CCP has credit exposure to each party against which it takes margin: the dealers have none to each other. For each trade the CCP has with a Dealer it will have an off-setting trade with another Dealer.

  9. How central clearing works – client clearing Bilateral OTC Market Centrally Cleared Market ClearingArrangement Clearing member Dealer 2 Client 1 Client 1 Dealer 2 Dealer 1 CCP Dealer 3 Dealer 4 Dealer 3 Dealer 4 Most Clients who are not large dealers cannot (or will not want to) face the CCP as a clearing member so they will use a Clearing Member to clear for them.

  10. How central clearing works – Default of a Clearing Member • CCP closes out Clearing Member’s house positions & uses margins and/or default fund contributions to cover losses • It is vitally important that the Clearing House is financially robust Bank A Clearing member Bank B Clearing member Client 1 Bank F Clearing member CCP Bank C Clearing member Bank E Clearing member Bank D Clearing member Default Protected from direct losses due to clearing membership

  11. How central clearing works – Default of a Clearing Member • Client positions will either be: • Ported to another Clearing Member – ability to port will depend on level of segregation chosen by Client • Liquidated – margin returned directly to Client by CCP if suitable protections in place • Default of a Client will be handled by Clearing Member

  12. How will a product become subject to mandatory clearing? • ESMA can determine that a contract already cleared by a CCP is subject to mandatory clearing (bottom-up approach) • ESMA can determine a product must be cleared (top-down approach) • Once mandatory clearing enforced, all newly executed contracts of the determined type must be cleared • Frontloading: contracts entered into after bottom-up process begins but before mandatory clearing takes effect must also be cleared

  13. What products will become subject to mandatory clearing? • Standardised and liquid enough to warrant mandatory clearing • Overarching aim of clearing is to reduce systemic risk. • Eligibility considerations: • Standardisation of contractual terms and operational procedures • Volume and liquidity of contracts • Availability of fair, reliable and generally accepted pricing information • Structured/complex OTC Trades will not be subject to clearing but will be subject to risk mitigation for uncleared trades

  14. Which entities are subject to mandatory clearing? • Threshold to be set by ESMA in forthcoming regulatory technical standards • Transactions designed to reduce risks to commercial activity or treasury financing activity do not count towards clearing threshold Non financial counterparties above clearing threshold Financial counterparties Third country entities equivalent to above

  15. EU – The clearing obligation • Two entities established in third countries would be subject to clearing obligation if they were in the EU provided the contract has a “direct, substantial and foreseeable effect within EU”.

  16. Other exemptions • Sovereigns/MDBs • Non-EU sovereigns to be determined by ESMA • Pension funds • Will not apply until a suitable technical solution for transfer of non-cash collateral as variation margin is developed by CCPs • Ultimate aim is to have central clearing as soon as tenable • Transitional arrangements • Intra-group • an intra-group transaction will apply if entity is part of the same group provided that the counterparties are included in the same consolidation on a full basis and they are subject to an appropriate centralised risk evaluation, measurement and control procedures and that counterparty is established in the Union or, if it is established in a third country, the Commission has adopted an implementing act • FX • ESMA can decide not to require clearing of certain FX transactions

  17. The perceived benefits and risks of central clearing

  18. The reporting obligation

  19. The reporting obligation All entities Registeredtrade repository Reporting obligation of all derivatives A database to provide transparency Currently organised per asset class Examples: DTCC and Regis-TR for multiple asset classes, ICE Trade Vault for commodities

  20. The reporting obligation • Information to be reported to TRs: • the parties to the contract (or the beneficiary) • type of contract • maturity • notional value • price • settlement date • Reduces duplication by taking account of: • MiFID transaction reporting • REMIT reporting requirements

  21. Practical consideration • Who reports? • Both counterparties can report the same trade • By prior arrangement, one party can report on behalf of both counterparties • A third-party (such as a CCP or trading platform) • What must be reported? • All exchange and OTC derivative trades • Intragroup trades • Trades with retail investors • Trades with non-financial counterparties • Details of new contracts will need to be reported by the end of the business day following execution • Backloading – previously executed but still active contracts will also need to be reported by a specified date (likely late 2013 or early 2014)

  22. Risk mitigation for uncleared trades

  23. Risk mitigation for non-cleared trades • Contracts will be subject to risk mitigation if they: • Are not eligible for clearing, or • Are transacted between counterparties at least one of which is not required to clear • will be subject to risk mitigation • Limited exemptions for intra-group transactions • Detailed risk mitigation requirement to be set out in regulatory technical standards developed by ESMA and the other European Supervisory Authorities (ESAs)

  24. Requirements for risk mitigation • EMIR refers to certain basic requirements for financial counterparties and non-financial counterparties above clearing threshold: • Exchange of collateral • Holding of capital to cover risks not covered by exchange of collateral • Electronic confirmations • Portfolio reconciliation • Daily marking to market • Where not possible, prudent marking to model • Dispute resolution mechanisms

  25. Key current issues – ESA papers Variation margin Collateral exchanged between counterparties to reflect exposures resulting from actual changes in value of relevant transaction Initial Margin Collateral provided to cover potential future exposures arising from relevant transactions in interval between last exchange of margins and liquidation of relevant positions Variation margin likely to be exchanged; initial margin under consideration

  26. Exchange trading/position limits

  27. Exchange trading of OTC derivatives – MiFID/MIFIR • Financial counterparties and non-financial counterparties exceeding a threshold required to transact certain derivatives on: • Regulated markets (RMs) • Multilateral trading facilities (MTFs) • Organised trading facilities (OTFs) • Non EU trading venues that Commission determines are equivalent to EU trading venues (unless non-EU country does not provide equivalent reciprocal recognition of EU trading venues) • Trading obligation will also apply to: • Counterparties who enter into derivatives with third country financial institutions or other entities that would be the subject of clearing obligation if they were established in the EU • Contracts as between two third country entities, if contract has a direct, substantial and foreseeable effect within the EU or where a trading obligation is necessary to prevent evasion of MiFIR

  28. Additional information? • See our Regulatory Revolution Tracker on EMIR which includes commentary on the EMIR regime

  29. IFLR Capital Markets ForumInternational coordination and consistency of OTC derivatives reform – EMIR, Dodd-Frank and beyond 26 April 2012 Antony Hainsworth, CIB Legal - European Regulatory Affairs

  30. International coordination – Beginning with the G20 • The roots of OTC derivatives reform under EMIR, Dodd-Frank and other initiatives lie in the commitments agreed by international leaders at the Pittsburgh summit of the G20 in September, 2009. • The agreement of a common set of regulatory commitments was designed to avoid regulatory arbitrage and avoid a “race to the bottom” in the creation of new laws and regulations applicable to OTC derivatives. • The key commitments were: • “All standardized OTC derivative contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties by end-2012at the latest. • OTC derivative contracts should be reported to trade repositories. • Non-centrally cleared contracts should be subject to higher capital requirements.” • The communique also added that “[w]e ask the FSB and its relevant members to assess regularly implementation and whether it is sufficient to improve transparency in the derivatives markets, mitigate systemic risk, and protect against market abuse.” 30

  31. International coordination – The role of the FSB • Financial Stability Board (the “FSB”) was established in April 2009 as a successor to the Financial Stability Forum (which began as a G7 body before its membership was extended to other countries). • The FSB describes its own mandate as follows: “The FSB has been established to coordinate at the international level the work of national financial authorities and international standard setting bodies and to develop and promote the implementation of effective regulatory, supervisory and other financial sector policies. It brings together national authorities responsible for financial stability in significant international financial centres, international financial institutions, sector-specific international groupings of regulators and supervisors, and committees of central bank experts.” • In this context, the FSB has been tasked with monitoring the progress of the G20’s regulatory reform agenda. • In its October 2011 progress report on OTC derivatives reform, the FSB reported that “with only just over one year until the end-2012 deadline for implementing the G20 commitments, few FSB members have the legislation or regulations in place to provide the framework for operationalising the commitments. While recognising the implementation challenges and the complexity of the needed laws and regulations, the report concludes that jurisdictions should aggressively push forward to meet the G-20 end-2012 deadline in as many reform areas as possible.” 31

  32. International coordination – Where we are now • Europe – On course for the G20 deadline (but many details still to be refined) • Indirect clearing recognised – but what will this mean for clearing in practice? • The role of ESMA in recognition of 3rd country trade infrastructure (e.g. CCPs). • Application to transactions with firms that would have been subject to the clearing obligation if established in Europe. • Australia – Initial legislative framework only published this week • The Australian Council of Financial Regulators (the Council) issued a discussion paper in mid 2011 looking at central clearing of OTC derivatives in the domestic market. Interestingly, the Council noted in its report that OTC derivatives were more relevant for Europe and the US, given the size of their OTC markets. • On April 18, 2012, The Treasury published a formal consultation with details of a proposed legislative framework. • Singapore – Consultations show an interest (but behind in timetabling terms) • The Monetary Authority of Singapore (the “MAS”) published a consultation on proposed regulation of OTC derivatives in February. The consultation closed in March, just over a month later. • Non-G20 – Will other countries follow suit? • Saudi Arabia is a G20 economy, but a number of other key nations with institutions active in derivatives business (e.g. Norway and the UAE) are not. • Note some other nations (e.g. Netherlands and Spain) participate indirectly only, e.g. through the EU. • Hong Kong –Legislative proposal shows willing • The Hong Kong Monetary Authority (the “HKMA”) have confirmed that the territory will “tentatively” introduce centralised clearing and reporting for OTC derivatives in January 2013. A joint consultation by the HKMA and the Securities and Futures Authority ended in November, 2011. • The principal legislative changes necessary will be implemented through amendments to the Securities and Futures Ordinance (the “SFO”). • United States – First past the post (but implementation work continues) • Ongoing work on definitions (e.g. swap / swap dealer) • Uncertainty over application to non-US firms • Sets up a potential battle over trade infrastructure (clearing houses, SEFs, etc). Where will international business end up being executed / cleared? 32

  33. International coordination – Key 3rd country issues • Territorial scope – Does the local legislation apply to overseas institutions and, if so, in what circumstances? • e.g. 722(d) of Dodd-Frank Act provides that “[t]he provisions of this Act relating to swaps… shall not apply to activities outside the United States unless those activities: (1) have a direct and significant connection with activities in, or effect on, commerce of the United States; or (2) contravene such rules or regulations as the Commission may prescribe or promulgate as are necessary or appropriate to prevent the evasion of any provision of this Act….’’ • Contrast this restriction to EMIR, which does not contain any general restriction on territorial scope, but does include a number of territorial restrictions in the core provisions and definitions, e.g. the term “financial counterparty” is defined exhaustively with reference to existing European legislation (e.g. MiFID, Banking Consolidation Directive, etc). • Treatment of cross-border transactions – What happens when a local entity wants to enter into a transaction with an entity based overseas? • e.g. The clearing obligation under Article 4 of EMIR will still apply in certain cases where EU financial counterparties (and non-financial counterparties over the clearing threshold) face non-EU counterparties, including an entity established in a third country that would be subject to the clearing obligation if it were established in the Union. In addition, the obligation will apply “between two entities established in one or more third countries that would be subject to the clearing obligation if they were established in the Union, provided that the contract has a direct, substantial and foreseeable effect within the Union or where such an obligation is necessary or appropriate to prevent the evasion of any provisions of this Regulation.” • Contrast this provision to Dodd-Frank, which does not afford non-US entities any express carve-out from key definitions and in some cases (e.g. the definition of “major swap participant”) may expressly bring non-US entities into scope. • CFTC Chairman Gary Gensler has expressly recognised the possibility of a “phased” implementation for non-US firms (e.g. as regards the requirement for swap dealer registration), but the lack of concrete action on this point has attracted criticism, including an open letter from Commissioner Barnier, published last week. 33

  34. International coordination – Key 3rd country issues • Recognition of 3rd country market infrastructure – Under what circumstances will 3rd country infrastructure (e.g. a third country CCP) be recognised as satisfying local requirements, e.g. where an EU entity wants to clear a transaction over a US CCP? • EMIR tackles the issue head-on. For example, Article 25 sets out the process for the European Securities and Markets Authority (“ESMA”) to recognise a third country CCP. The requirements for recognition include that the CCP is subject to effective supervision and enforcement ensuring a full compliance with the prudential requirements applicable in that third country; that there are cooperation arrangements between ESMA and the authority responsible for overseeing the relevant CCP; and that the CCP is established or authorised in a third country that is considered as having equivalent AML/CFT systems to the Union. Elsewhere, Article 77 contains requirements on recognition of third country trade repositories. • Dodd-Frank introduces a new concept of financial market utility (“FMU”), which is defined as “any person that manages or operates a multilateral system for the purpose of transferring, clearing, or settling payments, securities, or other financial transactions among financial institutions or between financial institutions and the person.” The definition of FMU will include derivatives clearing organisations (“DCOs”) as a subset. • Some third country entities (e.g. LCH.Clearnet) have registered as DCOs, even though this area of the act is not yet fully implemented. LCH’s clearing of interest-rate swaps, for example, pre-dated Dodd-Frank. In its application to register as a DCO with the SEC, LCH publicly confirmed to the SEC that the CFTC already reviews LCH’s clearing systems and mechanics, margin requirements and calculations and its compliance procedures (noting that US regulators’ role with respect to oversight of LCH will become more substantial once the Dodd-Frank Act is fully effective). • Whilst the recognition of third country market infrastructure is important to prevent fragmentation, consistency of rulemaking will remain important. This will equally apply looking forward to execution requirements (which Dodd-Frank tackles under the provisions on SEFs, but which Europe will only address under MiFID II / MiFIR, currently being negotiated and due to come into force 2013 – 2014. 34

  35. International coordination – Thank-you Antony Hainsworth, CIB Legal - European Regulatory Affairs +44(0)207 5952174 Thanks for listening. 35

  36. Recent derivatives litigation: useful clarity on key provisions Victoria Fox Barclays April 2012

  37. Section 2(a)(iii) of the ISDA Master Agreement Each obligation of each party under Section 2(a)(i) [obligation to make payments and deliveries] is subject to (1) the condition precedent that no Event of Default or Potential Event of Default with respect to the other party has occurred and is continuing, (2) the condition precedent that no Early Termination Date in respect of the relevant Transaction has occurred or been effectively designated and (3) each other condition precedent specified in this Agreement to be a condition precedent for the purpose of this Section 2(a)(iii). 37 | Litigation on Section 2(a)(iii) | April 2012

  38. Purpose of the condition precedent After an Event of Default, Non-defaulting Party (NDP) may designate an Early Termination Date, after which the market value of the transactions will be paid Payments under the ISDA are netted if due on the same day, in the same currency and (sometimes) under the same transaction 2(a)(iii) prevents Non-defaulting Party (NDP) from paying away money in circumstances where a counterparty has defaulted but the ISDA has not terminated What if the Defaulting Party (DP) becomes insolvent when the ISDA is in-the-money to it? 38 | Litigation on Section 2(a)(iii) | April 2012

  39. Conflicting decisions in lower courts Metavante (2009-US): NDP’s right to withhold payment constitutes an ipso facto provision that is unenforceable under US Bankruptcy Code. Right to terminate is not indefinite – failure to do so after a year constitutes a waiver Marine Trade v Pioneer (2010): 2(a)(iii) is a one-time test – if not satisfied on the payment date, the payment obligation never arises even if the default is subsequently cured Lomas v Firth Rixson (2011): suspended payment obligations are extinguished at the scheduled termination date of the transactions; NDP can only enforce the net obligation of the DP Pioneer v Cosco (2011): NDP can enforce the gross (rather than net) obligations of the DP Pioneer v TMT (2011): NDP can only enforce the net obligation of the DP 39 | Litigation on Section 2(a)(iii) | April 2012

  40. Useful clarity from the Court of Appeal NDP’s payment obligation is suspended (not extinguished) while a default is continuing; it will revive if the default is cured, even if after maturity NDP can rely indefinitely upon 2(a)(iii) If the ISDA is terminated after maturity of the transactions, any payments that would otherwise have been due should be taken into account when calculating termination payment NDP can only enforce for the net payment due from the DP; payment netting applies prior to application of the condition precedent (on the facts) 2(a)(iii) does not offend the anti-deprivation or pari passu principles 40 | Litigation on Section 2(a)(iii) | April 2012

  41. Open issues Notwithstanding court decisions, 2(a)(iii) is not safe May prevent orderly resolution of failing instititution December 2009: UK Treasury consultation called on ISDA to address “uncertainty” ISDA and market working on a proposal to amend 2(a)(iii) into a “use it or lose it” provision Debate over how long NDP should have What about mandatory set-off under Insolvency Rules? Approach in other jurisdictions Metavante creates uncertainty for US counterparties; US regulators may follow the UK approach Rest of the world? 41 | Litigation on Section 2(a)(iii) | April 2012

  42. Contact details • Penny MillerManaging AssociateT +44 20 7825 3532 E Joanne HallDirectorT +44 20 7568 1522 E Antony HainsworthCIB LegalT +44 20 7595 2174E Victoria FoxDirectorT +44 20 7773 4704E