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Article: A Practical Guide for Compliance with the QFC Stay Rules

25 April 2019 | JDX Consulting Feed
 

22 April 2019
By DANIEL D’COSTA
In 2017, the Board of Governors of the Federal Reserve System (FRB) , the Federal Deposit Insurance Corporation (FDIC) , and the Office of the Comptroller of the Currency (OCC) each issued final regulations, commonly referred to as the “QFC Stay Rules ,” requiring contractual recognition of stays under Title II of the Dodd-Frank Act and the Federal Deposit Insurance Act. The QFC Stay Rules are designed to improve the resolvability and resilience of U.S. global systemically important banking organizations (G-SIBs) and the U.S. operations of foreign G-SIBs by mitigating the risk of destabilizing closeouts of qualified financial contracts (QFCs). In sum, these regulations require covered financial institutions to ensure their counterparties and the counterparties of their affiliates are temporarily stayed from exercising default rights and other remedies if certain of their affiliates enter proceedings under the U.S. Bankruptcy Code.

Scope of Covered Entities: Determining Which Entities are Covered by the Rules
The ISDA U.S. Resolution Stay Protocol is based on the ISDA 2015 Universal Resolution Stay Protocol, with certain changes and amendments to facilitate adherence by a broader range of market participants, including the buy-side. QFCs can include certain swap agreements, repurchase agreements, securities lending agreements, forward contracts, commodities contracts, and many other types of commonly used financial contracts. Between the Fed, FDIC and OCC QFC Stay Rules, all U.S. G-SIBs and their subsidiaries and all U.S. operations of non-U.S. G-SIBs are subject to the QFC Stay Rules, with limited exclusions. “Covered Entities” include:
• U.S. G-SIBs: The parent holding company and each of its U.S. and non-U.S. subsidiaries.
• Non-U.S. GSIBs: Each U.S. subsidiary, U.S. branch, and U.S. agency.
• National banks and federal savings associations with more than $700 billion in assets.
• Exclusions: Certain subsidiaries held under merchant banking, DPC, and related authorities.

Having a Document Remediation Plan
Determining whether a contract falls within the definition of a QFC requires a careful analysis of several important factors including the type of contract, entity classification, jurisdiction/governing law and other relevant factors. Given the complexity and high volume of contracts that an entity has executed with numerous counterparties it is imperative to have a document remediation plan in place to help ensure for a smooth transition. The steps to create a plan are detailed below.
1. Create a Playbook: The first step in creating a remediation plan is to draft a playbook for reviewing existing documentation. This playbook will contain a step-by-step process to determine if a contract qualifies as a QFC, and if so, what information needs to be extracted from these contracts. It is important to note that the playbook should be circulated to the proper internal stakeholders for approval. The QFC stay rules will have ramifications for several different internal departments besides the legal department. For example, the limitation on close-out rights in financial contracts will impact the financial positions of the trading desk by delaying the collections/winding-up process when a contract is terminated. Another example of the impact of the QFC stay rules is the squeeze on the liquidity and flexibility of the internal treasury and collateral/operations related to the requirement the FDIC must transfer all QFCs (and related claims) of the counterparty and its affiliates to a bridge company or other third party. Furthermore, the QFC stay rules add new obligations and limitations to legal such as preventing the exercise of early termination rights which increases the overall risk classification of a given contract and counterparty. Therefore, having proper review and approval from all relevant internal stakeholders is vital.
2. Training: The next step would be to train staff members to follow the approved steps in the playbook when reviewing documentation. Project managers should be assigned to help train staff members and address any blocking points that may require internal escalation.
3. Technology: One can only imagine the volume of contracts that may need to be reviewed for regulatory compliance. Several institutions have opted to either create an internal legal software tool or utilize a third-party service provider to help aide in narrowing the scope of contracts that need to be reviewed. Legal software tools have advanced to not only identify which contracts are relevant but can also automatically extract the relevant information (e.g., contact information, governing law, entity type, etc.) from documents and populate a data sheet for use by institution stakeholders and negotiators.

Adherence: Protocol vs. Bilateral Negotiation
After determining which contracts qualify as QFCs and extracting all the relevant information from these contracts, we are now ready to reach out to the counterparties to complete protocol adherence. The QFC Stay Rules allow parties to conform covered QFCs to the rules either by amending each QFC bilaterally to comply with the rules’ contractual requirements and restrictions or through an adherence letter via the ISDA Protocol. The preferred method of compliance by most market participants is adherence via the ISDA Protocol. However, as we have seen from past Dodd-Frank protocol adherence initiatives, more and more counterparties prefer to adhere to the protocol bilaterally. Therefore, it is important to train staff members to be able to facilitate protocol adherence by using all available online platforms while also being able to negotiate terms bilaterally. When distributing the counterparty responsibilities to staff members, it is important to be mindful of how many bilateral negotiations are assigned to each staff member. Bilateral negotiations can take weeks to complete, whereas, protocol adherence can typically be completed within a few days.

Deadlines
The QFC Stay Rules provide for a phased-in compliance period based on counterparty type.
• 1st Wave. Covered entities will have to conform covered QFCs with other covered entities by January 1, 2019.
• 2nd Wave. Covered entities will have to conform covered QFCs with financial counterparties other than small financial institutions as defined in the rules by July 1, 2019.
• 3rd Wave. Covered entities will have to conform covered QFCs with all other counterparties, including general corporate counterparties, small financial institutions, central banks and sovereign entities, by January 1, 2020.

Treatment of existing (legacy) contracts
The QFC Stay Rules treat continued trading (of any QFC, not just in-scope QFCs) after the first compliance date (January 1, 2019) as the trigger for requiring remediation of existing QFCs with all counterparty types. The phased-in compliance period only affects the deadline by which a covered QFC must be made compliant with the rules’ requirements. For example: if a covered entity enters into a QFC with a given counterparty on January 1, 2019, the new QFC and all existing QFCs entered into with that counterparty or the counterparty’s consolidated affiliates before January 1, 2019 are covered QFCs that must be conformed to the rules by no later than January 1, 2020.

Conclusion
The QFC Stay Rules are part of a host of efforts since 2010 to help improve the resiliency and resolvability of GSIBs after the Lehman Crisis. In Lehman, the Lehman parent entity guaranteed QFCs of its subsidiaries. Under the previous laws, Bankruptcy of a parent allows counterparties of its subsidiaries to exercise “cross default” rights (e.g., terminate, cease performance). The exercise of cross-default rights against subsidiaries en mass (altogether), which is what occurred in Lehman, resulted in liquidity drains, fire sales, capital reduction, and an overall failure of subsidiaries. The QFC Stay Rules are designed to: enhance capital requirements, improve liquidity requirements, increase single counterparty credit limits, and help with bankruptcy resolution planning. Although the cost of compliance is expensive on its face, regulators expect the long-term benefits to be far more worthwhile for the entire U.S. Financial market.

Bibliography:

12 C.F.R. §§ 252.2, 252.81-88
12 C.F.R. §§ 382.1-7
12 C.F.R. §§ 47.1-8
82 Fed. Reg. 56630 (Nov. 29, 2017) (OCC Rule); 82 Fed. Reg. 50228 (Oct. 30, 2017) (FDIC Rule); 82 Fed. Reg. 42882 (Sept. 12, 2017) (Federal Reserve Rule)
The full statutory definition of a QFC can be found at 12 U.S.C. 5390(c)(8)(D).
OCC Rule §§ 47.4 - 47.5; FDIC Rule §§ 382.3 - 382.4; Federal Reserve Rule §§ 252.83 - 252.84.
The 2018 list of GSIBs can be accessed via http://www.fsb.org/2018/11/2018-list-of-global-systemically-important-banks-g-sibs/.

For more information regarding the ISDA Protocol, see https://www.isda.org/protocol/isda-2018-us-resolution-stay-protocol/. 

12 C.F.R. §§ 252.82(f) (Federal Reserve), 47.3(f) (OCC), 382.2(f) (FDIC); see also 12 C.F.R. §§ 252.81 (Federal Reserve), 47.2 (OCC), 382.1 (FDIC) (defining “financial counterparty”).

1. https://www.davispolk.com/files/2017-12-21_final_qfc_stay_rule_visual_memo.pdf
2. https://www.sifma.org/wp-content/uploads/2018/12/Application-of-QFC-Stay-Rules-to-Underwriting-Agreements.pdf
3. https://www.isda.org/protocol/isda-2018-us-resolution-stay-protocol/
4. https://www.isda.org/a/hqREE/Part-I-Language.pdf
5. https://www.jdsupra.com/legalnews/the-qfc-stay-rules-what-they-are-and-75641/

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