My name is Marjorie Gross and I am a Senior Vice President and Associate General Counsel of The Chase Manhattan Bank, with responsibility for legal matters for The Chase Manhattan Corporation and its subsidiaries that involve the capital markets -- that includes dealing in foreign exchange and derivatives, and underwriting and dealing in securities. Iím pleased to be here today on behalf of The Financial Services Roundtable to support the Financial Institutions Insolvency Improvement Act.
The purpose of the Act is to strengthen the provisions of the Federal Deposit Insurance Act ("FDIA") that protect the enforceability of contractual rights to terminate and close out certain capital markets transactions, net the amounts payable by each party, and foreclose on any collateral. It also would harmonize the FDIAís close-out provisions with similar provisions in the Bankruptcy Code.
The amendments are more in the nature of technical changes than large substantive or policy changes. They do not extend the scope of insolvency laws beyond those envisioned by existing legislation. However, they are very important to banks. They cover a variety of capital markets transactions that are vital financing and risk management tools, including foreign exchange transactions, securities contracts, forward contracts, commodity contracts, repurchase agreements (also known as repos) and swaps and options on interest and exchange rates, credit defaults, and equity and commodity prices. Although they are technical in nature, they will reduce legal uncertainty, reduce risk to individual banks, reduce systemic risk by making it less likely that a large default by a single financial institution will have a domino effect on other institutions, and enhance the liquidity of the financial markets.
For over a decade, banks and other participants in the capital markets have been developing master agreements to cover their capital markets transactions. Whether these master agreements cover a single product or many, they share certain common elements. They allow two parties to agree orally to new transactions and to transmit brief written confirmations of the financial terms, relying on the master agreement to supply the other terms. But more important, they include events of default or termination events that allow the non-defaulting party to terminate the transactions under the master agreement, value each partyís transactions, translate payment obligations denominated in different currencies into a single base currency, set off or net the amounts owing by the two parties to determine a single net amount, and liquidate any margin or collateral to cover the net payment amount.
When the bankruptcy law governing a defaulting party allows the enforcement of close-out and netting provisions of a master agreement and doesnít make them subject to any stays, or allow the conservatory or receiver to "cherry pick" -- that is, enforce transactions that are favorable to the defaulting financial institution but repudiate transactions that are favorable to the non-defaulting party -- it has a number of beneficial effects.
First, it allows credit providers under these contracts to calculate their exposure to their counterparties with certainty. At any moment in time, they can calculate the amount the counterparty would owe, without fear that the counterparty or its receiver or conservator can demand performance of transactions where the defaulting party owes money, but disavow transactions where the defaulting party is owed money.
Second, it reduces risk, by reducing the credit providerís exposure from the gross to the net amount. This makes it more likely that creditors will continue to do transactions with counterparties whose credit is deteriorating, which can be important to allow them to manage their risks as they attempt to strengthen their financial position. It also makes it less likely that a single large default will have a ripple effect throughout the financial system. One statistic will show you how important netting can be. My own institution is a major dealer in financial products, most of which fall within the definition of swap agreements under the Act. As a result of the legal certainty provided by FDIA for close-out and netting, my institution is able to reduce its risk to domestic financial institutions in the neighborhood of 90%.
Third, under the risk-based capital rules of the banking regulators, reduction in counterparty obligations through netting of obligations and close-out and set-off of collateral enables banks to reduce their capital needs, which enables them to reduce their prices.
Finally, by increasing certainty and reducing risk and cost, it enhances the liquidity of the global financial markets.
Congress has recognized the vital economic role that these financial contracts perform by providing protections for them in the nationís bankruptcy laws. Unfortunately, the pace of innovation in the financial markets has outstripped current law. In addition, the bankruptcy laws governing banks and those covering non-bank corporations are in two separate statutes -- the FDIA and the Bankruptcy Code, and there are now some inconsistencies between the two statutes. That means that, sometimes, the enforceability of a creditorís rights under a master agreement can depend on what type of entity its counterparty is.
The Act would fix these problems. Iíd like to highlight some of the beneficial things the Act would do.
First, the Act would amend the FDIA definitions of qualified financial contract, securities contract, commodity contract, forward contract, repurchase agreement and swap agreement to make them consistent with the definitions in the Bankruptcy Code.
An amendment to the definition of repurchase agreement makes clear that the definition includes repos on qualified foreign government securities. Foreign government securities are increasingly used as the underlying asset in repos. It would also include repos on mortgage-related securities and mortgage loans. These instruments are commonly financed with repos.
The definition of swap agreement would also be amended in a way that provides more legal certainty for numerous additional transactions. In the field of foreign exchange, it would include not only spot and forward FX transactions, but also same day-tomorrow and tomorrow next agreements. For the first time, it would include derivatives on equities and credit spreads, swaps and options. These latter products were developed or became more prevalent since the last amendment to FDIA. The amendment will allow parties to effect contractual netting across transactions that are economically similar. It would also allow the flexibility for future developments in risk management tools by including within the definition of swap agreement similar swap, future or option transactions that may in the future be regularly entered into in the swap market.
There are two beneficial changes that protect rights under credit enhancements. One amends the definition of swap agreement and makes it clear that credit enhancements are deemed to be swap agreements and may therefore be terminated, liquidated and set off. The second amendment is to the receivership and conservatorship provisions of FDIA. It makes clear that FDIA protects rights under credit enhancements related to qualified financial contracts. These include set-off rights, letters of credit, guarantees and similar agreements.
The Act contains a number of amendments that clarify the rights of the FDIC as receiver or conservator. Although several of these merely codify positions taken in a policy statement on QFC's issued by the FDIC in 1989, the amendments provide legal certainty on a number of points, including clarifying the relationship between FDIA and FDICIA. They also make clear that no disaffirmance, repudiation or transfer authority of the FDIC may be exercised to "cherry-pick" the QFC's between the defaulting depository institution and its counterparty or an affiliate of the counterparty.
The Act also would give increased certainty to cross-product netting under a master agreement. This is important because the market is increasingly using a single master agreement to document multiple products, thereby maximizing the amount of netting that can take place between the parties.
Another important change is a change in FDICIA, which currently gives protection to netting agreements only if they are between defined financial institutions and only if they governed by the laws of the US or a US state. The change would extend the protections of FDICIA to agreements between US financial organizations and foreign banks, even if they are governed by foreign law. It is common for agreements with foreign banks to be covered by foreign law, particularly English law.
The last change Iíd like to highlight is an amendment to Section 13(e)(2) of FDIA to provide that an agreement for the collateralization of governmental deposits, bankruptcy estate funds and one or more QFCís is not deemed invalid solely because the agreement was not entered into contemporaneously with the acquisition of the collateral or because of pledges, delivery or substitution of the collateral made under the agreement. Section 13(e), which codifies the so-called "DíOench Duhme" doctrine, has been particularly troublesome in the context of collateralized QFCís, which require the posting and return of collateral on an ongoing basis based on the mark-to-market value of the transaction at any time. Legal opinions regarding the enforceability of such collateral often have been reasoned, based on an FDIC policy statement. The amendment will provide some much-needed legal certainty.
The concepts embodied in the Act are a result of a collaborative effort between the President's Working Group on Financial Markets and a broad coalition of participants in the financial services industry, including several Roundtable member companies. The President's Working Group reiterated the importance of these provisions in its recent report on hedge funds, "Hedge Funds, Leverage, and the Lessons of Long-Term Capital Management" (April 1999). Noting that the President's Working Group had urged Congress last year to expand and improve provisions in the Bankruptcy Code that are similar to the provisions in the Act, the report states:
"[H]ad termination not been available to the LTCM Fund's counterparties in the bankruptcy process, the uncertainty as to whether these contracts would be performed would have created great uncertainty and disruptions in these same markets, coupled with substantial uncontrollable market risk to the counterparties. The inability to exercise closeout netting rights could well have resulted in an even worse market situation if the LTCM Fund had filed for bankruptcy than the exercise of such rights in this situation."
These conclusions apply equally to the amendments provided for in this bill. In summary, the provisions of the Act are mostly technical and entirely consistent with the existing safe harbors in the FDIA that protect capital markets transactions from the powers of the receiver or conservator to stay or repudiate contracts. But they are extremely important changes that would increase legal certainty, reduce risks to individual counterparties and to the system as a whole, and should enhance the liquidity of the capital markets. We urge you to resolve the jurisdictional disputes that have affected the passage of bankruptcy reform legislation, including the Act, and to pass these laws quickly.
I am happy to have had this opportunity to provide these views on behalf of The Financial Services Roundtable, and would be glad to answer any questions.
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