2021.05.07 ZHU, Jiayin (Jay)
Recently, the Futures Law of the People's Republic of China (Draft) (the “Draft Futures Law”) was issued for public comments for the first time, which immediately garnered wide attention from the industry. It has many promising aspects, conducive to the development of a unified financial derivatives market. In particular, a separate chapter governing “Other Derivatives Trading” (i.e., any non-standardized OTC trading aside from listed futures) embeds provisions related to single agreement and close-out netting mechanisms for the first time in a law at a national level. Below are our observations and preliminary views of the relevant key provisions of the Draft Futures Law.
Article 35 of the Draft Futures Law stipulates that “the master agreement filed pursuant to provisions of this Law, all supplementary agreements thereunder, together with agreements entered into by the parties with respect to each specific trading, shall constitute an entire single agreement between the parties and shall be legally binding”. This article relates to one of the pillars of derivatives transactions, the single agreement mechanism, which is designed to combat the administrator from cherry-picking favorable agreements under Article 18 of the Enterprise Bankruptcy Law of the People's Republic of China (the “Bankruptcy Law”) . To be specific, the single agreement mechanism prevents each specific derivative transaction entered into between the parties under a single master agreement from being treated as individual separate contracts, thereby preventing the administrator’s discretion in determining to continue to perform transactions favorable to the insolvent enterprise while terminating those unfavorable ones. Notably, the Draft Futures Law recognizes in principle that the single agreement mechanism shall apply to the Other Derivatives Trading.
The Draft Futures Law further sets out a prerequisite for the adoption of the single agreement mechanism, that is, only the master agreement filed for record in accordance with this Law may constitute, together with its supplementary agreements and agreements with respect to each specific trading, an effective single agreement. Article 34 of the Draft Futures Law also stipulates that industry associations or institutions that organize Other Derivatives Trading, shall file the master agreement and other such standard agreements adopted in the Other Derivatives Trading with the department authorized by the State Council. Given that master agreements issued by industry associations in China in general have already been filed with the relevant department authorized by the State Council, the aforesaid filing requirements may not impact these master agreements issued by the domestic industry associations, e.g., Master Agreement on the Financial Derivatives Trading in the Inter-bank Market of China released by the National Association of Financial Market Institutional Investors.
Notwithstanding the above, it is noteworthy that the filing requirements set out in the Draft Futures Law have not been tailor-made for the master agreements issued by international industry associations. Unlike domestic master agreements, master agreements formulated by international industry associations have a long history and have never been authorized or approved by the relevant Chinese regulatory authorities when they were first issued. Therefore, requiring international industry associations to file the master agreements with PRC regulators would inevitably cause certain practical problems. As the master agreements of international industry associations are widely used in the market (for example, the master agreements issued by the International Swaps and Derivatives Association (ISDA)) for various derivatives transactions under the administration and supervision by different regulatory authorities, the Draft Futures Law and its detailed implementation rules, once formally promulgated, should be proactively prepared to address the issue of whether master agreements issued by international industry associations shall be filed and how they would be filed with the PRC regulators. In addition, as a practical matter, the financial institutions engaging in derivatives transactions may formulate its own master agreement template. To ensure the binding force of the single agreement provision under such a template, the financial institutions shall, based on the type of derivative transactions covered under its template, determine whether to file such master agreements with the relevant regulatory authorities, or to alternatively use the prevailing standard master agreement filed by industry associations.
Furthermore, out of various practical considerations, the financial institutions engaging in some simple derivative transactions (e.g., foreign exchange forward transactions) may not enter into any master agreement at all with its trading counterparties. In judicial practice, some courts have ruled that any derivative transaction conducted without a separate master agreement entered into between the trading counterparties shall not deny a de facto contractual relationship between the parties with respect to the derivative transaction. However, in accordance with the principle provided by Article 35 of the Draft Futures Law, such multiple derivative transactions entered into between the parties in the absence of a master agreement will be exposed to a relatively high legal risk regarding whether the single agreement mechanism can be applied thereto.
On the basis of the conditional recognition of the single agreement mechanism, Article 37 of the Draft Futures Law further recognizes the close-out netting mechanism. It is specified that the Other Derivatives Trading conducted by entering into a single agreement as stipulated under this Law, may be terminated upon occurrence of agreed circumstances, and the net amount of gains and losses arising from all trading activities under such agreements shall be settled. Meanwhile, it is further clarified that the aforesaid applied close-out netting shall not be invalidated or rescinded as a result of the commencement of bankruptcy procedures with respect to either trading counterparty. Whether the PRC law recognizes the enforceability of close-out netting has long been a concern of the global derivatives industry. In judicial practice, although several PRC courts have explicitly ruled in favor of close-out netting in the absence of any bankruptcy circumstance , it is still uncertain whether the close-out netting involving multiple derivative transactions under a master agreement can be recognized by PRC courts in the event of the bankruptcy of the trading counterparty. In a joint white paper titled “Use of RMB-denominated Chinese Government Bonds as Margin for Derivatives Transactions” released by the China Central Depository & Clearing Co., Ltd. and the ISDA in September 2020, the international market still considers China a jurisdiction that does not support the use of close-out netting.
It is undoubtedly a breakthrough that the Draft Futures Law clearly recognized the enforceability of close-out netting if it has been completed before either party enters into the bankruptcy proceedings. However, the second paragraph of Article 37 seems only to specify that the completed close-out netting will not be invalidated or rescinded due to the bankruptcy proceedings, whilst providing no clarification on whether close-out netting can apply to a circumstance where either party enters into the bankruptcy proceedings before completion of close-out netting. In particular, completion of a close-out netting generally requires a series of steps. As an example, the ISDA Master Agreements allow the non-defaulting party to effectively initiate early termination of all the outstanding transactions thereunder upon occurrence of any Events of Default by serving an early termination notice and designating an early termination date, followed by providing a calculation statement specifying any early termination amount receivable or payable as soon as would be reasonably practical. Given that an Event of Default that submission and acceptance of a bankruptcy petition against the defaulting party may not be in the public domain, it is possible that a non-defaulting party with the right of early termination would serve the early termination notice after being aware that a bankruptcy petition against its counterparty has been filed and accepted by a PRC court (even if the “Automatic Early Termination” provision has been applied, the non-defaulting party usually can complete the close-out netting by providing the calculation statement only after the counterparty enters into bankruptcy proceedings). Therefore, we expect that the Draft Futures Law would clarify upon its official promulgation that after any trading counterparty enters into bankruptcy proceedings, the other counterparty can still initiate early termination of the derivative transactions and apply close-out netting as agreed under the master agreement, so that the close-out netting would not be subject to the relevant stipulations of the Bankruptcy Law (in particular, the administrator's right to cherry-pick favorable agreements under Article 18 and the restrictions on the statutory right of set-off under Article 40).
The proposed provisions of the Draft Futures Law pertaining to the single agreement mechanism and the close-out netting mechanism are a breakthrough and a solid step forward for the establishment of China’s own derivatives market ecosystem adapting to international practices. Nevertheless, the implementation of the proposed filing of derivative master agreements and the enforceability of the close-out netting mechanism still remain to be further considered and clarified by the PRC legislative authorities. We will continue to monitor the situation and keep our clients apprised of any important developments.
1. Article 3 of the Futures Law of the People's Republic of China (Draft): The term other derivatives referred to in this Futures Law means non-standardized forward delivery contracts whose value depends on the changes in the value of subjects, including non-standardized option contracts, swap contracts and forward contracts.
2. Article 18 of the Enterprise Bankruptcy Law of the People's Republic of China: After the commencement of a bankruptcy proceeding, the administrator has the power to determine whether to terminate or continue the performance of a contract that entered into prior to acceptance of the bankruptcy application and has not been fully performed by the debtor and its counterparty, subject to the administrator’s obligation to notify the counterparty. Where the administrator does not notify the counterparty of its decision at the earlier of two months after the commencement of the bankruptcy proceeding; or 30 days after the counterparty requests for such decision, the contract shall be deemed terminated.
3. Announcement of the National Association of Financial Market Institutional Investors  No. 5: The text of the Master Agreement, which has been resolved and adopted at the third meeting of the first standing council of the National Association of Financial Market Institutional Investors and has been filed with the People's Bank of China and the State Administration of Foreign Exchange, is hereby released to the public.
4. (2012)Sui Zhong Fa Min Si Chu Zi No.13
5. (2015) Pu Min Liu (Shang) Chu Zi No. S2958
6. Use of RMB-denominated Chinese Government Bonds as Margin for Derivatives Transactions issued by China Central Depository & Clearing Co., Ltd. and International Swaps and Derivatives Association: Although in recent years Chinese judicial authorities and regulators have expressed their support for close-out netting in principle on various occasions, many international market participants consider China a non-netting jurisdiction, as there is no netting legislation addressing the following issues. First, Chinese law currently does not expressly recognize the concept of ‘single agreement’ or offer statutory recognition of close-out netting in the event a Chinese counterparty enters into bankruptcy proceedings. As a result, there is a residual legal risk that a non-defaulting party’s right to early termination may be suspended or deemed unenforceable against an administrator’s right to cherry-pick favorable agreements. Second, implementing rules that apply the Bankruptcy Law to Chinese financial institutions have not so far been enacted. In addition, there are uncertainties about how close-out netting will be protected and enforced under a bank resolution regime. Third, the application of close-out netting in related capital rules is yet to be clarified.