# Restrictions on Qualified Financial Contracts of Systemically Important U.S. Banking Organizations and the U.S. Operations of Systemically Important Foreign Banking Organizations; Revisions to the Definition of Qualifying Master Netting Agreement and Related Definitions

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URL: https://www.frixlaw.com/law-library/documents/fr%3A2016-11209

## Record

- **Collection:** Federal Register
- **Document type:** Proposed Rule
- **Published:** May 11, 2016
- **Citation:** 81 FR 29169

## Text

FEDERAL RESERVE SYSTEM
12 CFR Parts 217, 249, and 252
[Regulations Q, WW, and YY; Docket No. R-1538]
RIN 7100 AE-52
Restrictions on Qualified Financial Contracts of Systemically Important U.S. Banking Organizations and the U.S. Operations of Systemically Important Foreign Banking Organizations; Revisions to the Definition of Qualifying Master Netting Agreement and Related Definitions

AGENCY:

Board of Governors of the Federal Reserve System (Board).

ACTION:

Notice of proposed rulemaking.

SUMMARY:

The Board is inviting comment on a proposed rule to promote U.S. financial stability by improving the resolvability and resilience of systemically important U.S. banking organizations and systemically important foreign banking organizations pursuant to section 165 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act). Under the proposed rule, any U.S. top-tier bank holding company identified by the Board as a global systemically important banking organization (GSIB), the subsidiaries of any U.S. GSIB (other than national banks and federal savings associations), and the U.S. operations of any foreign GSIB (other than national banks and federal savings associations) would be subjected to restrictions regarding the terms of their non-cleared qualified financial contracts (QFCs). First, a covered entity would generally be required to ensure that QFCs to which it is party, including QFCs entered into outside the United States, provide that any default rights and restrictions on the transfer of the QFCs are limited to the same extent as they would be under the Dodd-Frank Act and the Federal Deposit Insurance Act. Second, a covered entity would generally be prohibited from being party to QFCs that would allow a QFC counterparty to exercise default rights against the covered entity based on the entry into a resolution proceeding under the Dodd-Frank Act, Federal Deposit Insurance Act, or any other resolution proceeding of an affiliate of the covered entity. The proposal would also amend certain definitions in the Board's capital and liquidity rules; these amendments are intended to ensure that the regulatory capital and liquidity treatment of QFCs to which a covered entity is party is not affected by the proposed restrictions on such QFCs. The Office of the Comptroller of the Currency is expected to issue a proposed rule that would subject national banks and federal savings associations that are GSIB subsidiaries to requirements substantively identical to those proposed here.

DATES:

Comments should be received by August 5, 2016.

ADDRESSES:

You may submit comments, identified by Docket No. R-1538 and RIN No. 7100 AE-52, by any of the following methods:

•
Agency Web site: http://www.federalreserve.gov.
Follow the instructions for submitting comments at
http://www.federalreserve.gov/generalinfo/foia/ProposedRegs.cfm.

•
Federal eRulemaking Portal: http://www.regulations.gov.
Follow the instructions for submitting comments.

•
Email: regs.comments@federalreserve.gov.
Include the docket number in the subject line of the message.

•
Fax:
(202) 452-3819 or (202) 452-3102.

•
Mail:
Robert deV. Frierson, Secretary, Board of Governors of the Federal Reserve System, 20th Street and Constitution Avenue NW., Washington, DC 20551.

All public comments will be made available on the Board's Web site at
http://www.federalreserve.gov/generalinfo/foia/ProposedRegs.cfm
as submitted, unless modified for technical reasons. Accordingly, your comments will not be edited to remove any identifying or contact information. Public comments may also be viewed electronically or in paper form in Room 3515, 1801 K Street (between 18th and 19th Streets NW.) Washington, DC 20006, between 9:00 a.m. and 5:00 p.m. on weekdays.

FOR FURTHER INFORMATION CONTACT:

Felton Booker, Senior Supervisory Financial Analyst, (202) 912-4651, or Mark Savignac, Supervisory Financial Analyst, (202) 475-7606, Division of Banking Supervision and Regulation; or Will Giles, Counsel, (202) 452-3351, or Lucy Chang, Attorney, (202) 475-6331, Legal Division, Board of Governors of the Federal Reserve System, 20th and C Streets NW., Washington, DC 20551. For the hearing impaired only, Telecommunications Device for the Deaf (TDD) users may contact (202) 263-4869.

SUPPLEMENTARY INFORMATION:

Table of Contents

I. Introduction

A. Background

B. Overview of the Proposal

C. Consultation With U.S. Financial Regulators, the Council, and Foreign Authorities

D. Overview of Statutory Authority

II. Proposed Restrictions on QFCs of GSIBs

A. Covered Entities

B. Covered QFCs

C. Definition of “Default Right”

D. Required Contractual Provisions Related to the U.S. Special Resolution Regimes

E. Prohibited Cross-Default Rights

F. Process for Approval of Enhanced Creditor Protections

III. Transition Periods

IV. Costs and Benefits

V. Revisions to Certain Definitions in the Board's Capital and Liquidity Rules

VI. Regulatory Analysis

A. Paperwork Reduction Act

B. Regulatory Flexibility Act: Initial Regulatory Flexibility Analysis

C. Riegle Community Development and Regulatory Improvement Act of 1994

D. Solicitation of Comments on the Use of Plain Language

I. Introduction

A. Background

This proposed rule, which is part of a set of actions by the Board to address the “too-big-to-fail” problem, addresses one of the ways in which the failure of a major financial firm can destabilize the financial system. The failure of a large, interconnected financial company could cause severe damage to the U.S. financial system and, ultimately, to the economy as a whole, as illustrated by the failure of Lehman Brothers in September 2008. Protecting the financial stability of the United States by helping to address this too-big-to-fail problem is a core objective of the Dodd-Frank Wall Street Reform and Consumer Protection

Act (Dodd-Frank Act),
1

which Congress passed in response to the 2007-2009 financial crisis and the ensuing recession. The Dodd-Frank Act and the actions that U.S. financial regulators have taken to implement it and to otherwise protect U.S. financial stability help to address the too-big-to-fail problem in two ways: by reducing the probability that a systemically important financial company will fail, and by reducing the damage that such a company's failure would do if it were to occur. The second of these strategies centers on measures designed to help ensure that a failed company's passage through a resolution proceeding—such as bankruptcy or the special resolution process created by the Dodd-Frank Act—would be more orderly, thereby helping to mitigate destabilizing effects on the rest of the financial system.
2

1
The Dodd-Frank Act was enacted on July 21, 2010 (Pub. L. 111-203). According to its preamble, the Dodd-Frank Act is intended “[t]o promote the financial stability of the United States by improving accountability and transparency in the financial system, to end `too big to fail', [and] to protect the American taxpayer by ending bailouts.”

2
The Dodd-Frank Act itself pursues this goal through numerous provisions, including by requiring systemically important financial companies to develop resolution plans (also known as “living wills”) that lay out how they could be resolved in an orderly manner if they were to fail and by creating a new resolution regime, the Orderly Liquidation Authority, applicable to systemically important financial companies. 12 U.S.C. 5365(d), 5381-5394. Moreover, section 165 of the Dodd-Frank Act directs the Board to promote financial stability through regulation by subjecting large bank holding companies and nonbank financial companies designated for Board supervision to enhanced prudential standards “[i]n order to prevent or mitigate risks to the financial stability of the United States that could arise from the material financial distress or failure, or ongoing activities, of large, interconnected financial institutions.” 12 U.S.C. 5365(a)(1).

This proposed rule is intended as a further step to increase the resolvability of U.S. global systemically important banking organizations (GSIBs) and foreign GSIBs that operate in the United States. The proposal complements the Board's recent notice of proposed rulemaking on total loss-absorbing capacity, long-term debt, and clean holding company requirements for GSIBs (TLAC proposal)
3

and the ongoing work of the Board and the FDIC on resolution planning requirements for GSIBs. The current proposal focuses on improving the orderly resolution of a GSIB by limiting disruptions to a failed GSIB through its financial contracts with other companies.

3
80 FR 74926 (Nov. 30, 2015). For further high-level background on post-crisis regulatory reforms aimed at addressing the too-big-to-fail problem, see the preamble to the TLAC proposal.
Id.
at 74926-74928.

The largest financial firms are interconnected with other financial firms through large volumes of financial contracts of various types, including derivatives transactions. The failure of one entity within a large financial firm can trigger disruptive terminations of these contracts, as the counterparties of both the failed entity and other entities within the same firm exercise their contractual rights to terminate the contracts and liquidate collateral. These terminations, especially if counterparties lose confidence in the GSIB quickly and in large numbers, can destabilize the financial system and potentially spark a financial crisis through several channels. They can destabilize the failed entity's otherwise solvent affiliates, causing them to fail and thereby potentially causing their counterparties to fail in a chain reaction that can ripple through the system. They also may result in firesales of large volumes of financial assets, such as the collateral that secures the contracts, which can in turn weaken and cause stress for other firms by lowering the value of similar assets that they hold.

For example, the triggering of default rights by counterparties of Lehman Brothers in 2008 was a key driver of its destabilization that resulted from its failure.
4

At the time of its failure, Lehman was party to very large volumes of financial contracts, including over-the-counter derivatives contracts.
5

When its holding company declared bankruptcy, Lehman's counterparties exercised their default rights.
6

Lehman's default “caused disruptions in the swaps and derivatives markets and a rapid, market-wide unwinding of trading positions.”
7

Meanwhile, “out-of-the-money counterparties, which owed Lehman money, typically chose not to terminate their contracts” and instead suspended payment, reducing the liquidity available to the bankruptcy estate.
8

The complexity and disruption associated with Lehman's portfolios of financial contracts led to a disorderly resolution of Lehman.
9

This proposal is meant to help avoid a repeat of the systemic disruptions caused by the Lehman failure by preventing the exercise of default rights in financial contracts from leading to such disorderly and destabilizing failures in the future.

4

See
“The Orderly Liquidation of Lehman Brothers Holdings Inc. under the Dodd-Frank Act” 3, FDIC Quarterly (2011) (“The Lehman bankruptcy had an immediate and negative effect on U.S. financial stability and has proven to be a disorderly, time-consuming, and expensive process.”), available at
https://www.fdic.gov/bank/analytical/quarterly/2011_vol5_2/lehman.pdf.

5

See
Michael J. Fleming and Asani Sarkar, “The Failure Resolution of Lehman Brothers,” FRBNY Economic Policy Review 185 (December 2014), available at
https://www.newyorkfed.org/medialibrary/media/research/epr/2014/1412flem.pdf.

6

See id.

7
“The Orderly Liquidation of Lehman Brothers Holdings Inc. under the Dodd-Frank Act” 3, FDIC Quarterly (2011), available at
https://www.fdic.gov/bank/analytical/quarterly/2011_vol5_2/lehman.pdf.

8
Michael J. Fleming and Asani Sarkar, “The Failure Resolution of Lehman Brothers,” FRBNY Economic Policy Review 185 (December 2014), available at
https://www.newyorkfed.org/medialibrary/media/research/epr/2014/1412flem.pdf.

9

See
Mark J. Roe and Stephen D. Adams, “Restructuring Failed Financial Firms in Bankruptcy: Selling Lehman's Derivatives Portfolio,” Yale Journal on Regulation (2015) (“Lehman's failure exacerbated the financial crisis, especially after AIG's collapse in the days afterwards prompted counterparties to close out positions, sell collateral, and thereby depress and freeze markets. Many financial players stopped trading for fear that their counterparty would be the next Lehman or that their counterparty had large unseen exposures to Lehman that would make the counterparty itself fail. Such was the case with the Reserve Primary Fund, a money market fund that held too many defaulting obligations of Lehman. That reaction led to a further panic, a threat of a run on money market funds, and a government guarantee of all money market funds to stem the ongoing financial degradation throughout the economy.”).

This proposal is intended to respond to the threat to financial stability posed by such default rights in two ways. First, the proposal reduces the risk that courts in foreign jurisdictions would disregard statutory provisions that would stay the rights of a failed firm's counterparties to terminate their contracts when the firm enters a resolution proceeding under one of the special resolution frameworks for failed financial firms created by Congress under the Federal Deposit Insurance Act (FDI Act) and the Dodd-Frank Act. Second, the proposal would facilitate the resolution of a large financial entity under the U.S. Bankruptcy Code and other resolution frameworks by ensuring that the counterparties of solvent affiliates of the failed entity could not unravel their contracts with the solvent affiliate based solely on the failed entity's resolution.

Qualified financial contracts, default rights, and financial stability. In particular, this proposal pertains to several important classes of financial transactions that are collectively known as “qualified financial contracts” (QFCs).
10

QFCs include derivatives, repurchase agreements (also known as “repos”) and reverse repos, and securities lending and borrowing agreements.
11

GSIBs enter into QFCs for

a variety of purposes, including to borrow money to finance their investments, to lend money, to manage risk, and to enable their clients and counterparties to hedge risks, make markets in securities and derivatives, and take positions in financial investments.

10
The proposal would adopt the definition of “qualified financial contract” set out in section 210(c)(8)(D) of the Dodd-Frank Act, 12 U.S.C. 5390(c)(8)(D).
See
proposed rule § 252.81.

11
The definition of “qualified financial contract” is broader than this list of examples, and the default rights discussed are not common to all types of QFC.

QFCs play a role in economically valuable financial intermediation when markets are functioning normally. But they are also a major source of financial interconnectedness, which can pose a threat to financial stability in times of market stress. This proposal focuses on a context in which that threat is especially great: the failure of a GSIB that is party to large volumes of QFCs, likely including QFCs with counterparties that are themselves systemically important.

By contract, a party to a QFC generally has the right to take certain actions if its counterparty defaults on the QFC (that is, if it fails to meet certain contractual obligations). Common default rights include the right to suspend performance of the non-defaulting party's obligations, the right to terminate or accelerate the contract, the right to set off amounts owed between the parties, and the right to seize and liquidate the defaulting party's collateral. In general, default rights allow a party to a QFC to reduce the credit risk associated with the QFC by granting it the right to exit the QFC and thereby reduce its exposure to its counterparty upon the occurrence of a specified condition, such as its counterparty's entry into a resolution proceeding.

Where the defaulting party is a GSIB entity, the private benefit of allowing counterparties of GSIBs to take certain actions must be weighed against the harm that these actions cause by encouraging the disorderly failure of a GSIB and increasing the threat to the stability of the U.S. financial system as a whole. For example, if a significant number of QFC counterparties exercise their default rights precipitously and in a manner that would impede an orderly resolution of a GSIB, all QFC counterparties and the financial system may potentially be worse off and less stable.

This may occur through several channels. First, the exits may drain liquidity from a troubled GSIB, forcing the GSIB to rapidly sell off assets at depressed prices, both because the sales must be done within a short timeframe and because the elevated supply may push prices down. These asset firesales may cause or deepen balance-sheet insolvency at the GSIB, causing a GSIB to fail more suddenly and reducing the amount that its other creditors can recover, thereby imposing losses on those creditors and threatening their solvency. The GSIB may also respond to a QFC run by withdrawing liquidity that it had offered to other firms, forcing them to engage in firesales. Alternatively, if the GSIB's QFC counterparty itself liquidates the QFC collateral at firesale prices, the effect will again be to weaken the GSIB's balance sheet.
12

The counterparty's rights to set off amounts owed, terminate the contract, and suspend payments may allow it to further drain the GSIB's capital and liquidity by withholding payments that it would otherwise owe to the GSIB. The GSIB may also have rehypothecated collateral that it received from QFC counterparties, for instance in repo or securities lending transactions that fund other client arrangements, in which case demands from those counterparties for the early return of their rehypothecated collateral could be especially disruptive.
13

12

See
“The Orderly Liquidation of Lehman Brothers Holdings Inc. under the Dodd-Frank Act” 8, FDIC Quarterly (2011), available at
https://www.fdic.gov/bank/analytical/quarterly/2011_vol5_2/lehman.pdf
(“A disorderly unwinding of [qualified financial contracts] triggered by an event of insolvency, as each counterparty races to unwind and cover unhedged positions, can cause a tremendous loss of value, especially if lightly traded collateral covering a trade is sold into an artificially depressed, unstable market. Such disorderly unwinding can have severe negative consequences for the financial company, its creditors, its counterparties, and the financial stability of the United States.”).

13

See generally
Adam Kirk, James McAndrews, Parinitha Sastry, and Phillip Weed, “Matching Collateral Supply and Financing Demands in Dealer Banks,” FRBNY Economic Policy Review 127 (December 2014), available at
http://www.newyorkfed.org/medialibrary/media/research/epr/2014/1412kirk.pdf.

The asset firesales discussed above can also spread contagion throughout the financial system by increasing volatility and by lowering the value of similar assets held by other firms, potentially causing these firms to suffer mark-to-market losses, diminished market confidence in their own solvency, margin calls, and creditor runs (which could lead to further firesales, worsening the contagion). Finally, the early terminations of derivatives that the surviving entities of the failed GSIB relied on to hedge their risks could leave those entities with major risks unhedged, increasing the entities' potential losses going forward.

Where there are significant simultaneous terminations and these effects occur contemporaneously, such as upon the failure of a GSIB that is party to a large volume of QFCs, they may pose a substantial risk to financial stability. In short, QFC continuity is important for the orderly resolution of a GSIB because it helps to ensure that the GSIB entities remain viable and to avoid instability caused by asset firesales.

Consequently, the Board and the Federal Deposit Insurance Corporation (FDIC) have identified the exercise of certain default rights in financial contracts as a potential obstacle to orderly resolution in the context of resolution plans filed pursuant to section 165(d) of the Dodd-Frank Act,
14

and have instructed the most systemically important firms to demonstrate that they are “amending, on an industry-wide and firm-specific basis, financial contracts to provide for a stay of certain early termination rights of external counterparties triggered by insolvency proceedings.”
15

14
12 U.S.C. 5365(d).

15
Board and FDIC, “Agencies Provide Feedback on Second Round Resolution Plans of `First-Wave' Filers” (August 5, 2014), available at
http://www.federalreserve.gov/newsevents/press/bcreg/20140805a.htm. See

also
Board and FDIC, “Agencies Provide Feedback on Resolution Plans of Three Foreign Banking Organizations” (March 23, 2015), available at
http://www.federalreserve.gov/newsevents/press/bcreg/20150323a.htm;
Board and FDIC, “Guidance for 2013 165(d) Annual Resolution Plan Submissions by Domestic Covered Companies that Submitted Initial Resolution Plans in 2012” 5-6 (April 15, 2013), available at
http://www.federalreserve.gov/newsevents/press/bcreg/bcreg20130415c2.pdf.

Direct defaults and cross-defaults. This proposal focuses on two distinct scenarios in which a non-defaulting party to a QFC is commonly able to exercise the rights described above. These two scenarios involve a default that occurs when either the GSIB legal entity that is a direct party
16

to the QFC or an affiliate of that legal entity enters a resolution proceeding.
17

The first

scenario occurs when a GSIB entity that is itself a direct party to the QFC enters a resolution proceeding; this preamble refers to such a scenario as a “direct default” and refers to the default rights that arise from a direct default as “direct default rights.” The second scenario occurs when an affiliate of the GSIB entity that is a direct party to the QFC (such as the direct party's parent holding company) enters a resolution proceeding; this preamble refers to such a scenario as a “cross-default” and refers to default rights that arise from a cross-default as “cross-default rights.” For example, a GSIB parent entity might guarantee the derivatives transactions of its subsidiaries and those derivatives contracts could contain cross-default rights against a subsidiary of the GSIB that would be triggered by the bankruptcy filing of the GSIB parent entity even though the subsidiary continues to meet all of its financial obligations.
18

16
In general, a “direct party” refers to a party to a financial contract other than a credit enhancement (such as a guarantee). The definition of “direct party” and related definitions are discussed in more detail below on page 38.

17
This preamble uses phrases such as “entering a resolution proceeding” and “going into resolution” to encompass the concept of “becoming subject to a receivership, insolvency, liquidation, resolution, or similar proceeding.” These phrases refer to proceedings established by law to deal with a failed legal entity. In the context of the failure of a systemically important banking organization, the most relevant types of resolution proceeding include the following: for most U.S.-based legal entities, the bankruptcy process established by the U.S. Bankruptcy Code (Title 11, United States Code); for U.S. insured depository institutions, a receivership administered by the Federal Deposit Insurance Corporation (FDIC) under the Federal Deposit Insurance Act (12 U.S.C. 1821); for companies whose “resolution under otherwise applicable Federal or State law would have serious adverse effects on the financial stability of the United States,” the Dodd-Frank Act's Orderly Liquidation Authority (12 U.S.C. 5383(b)(2)); and, for entities based outside the United States, resolution proceedings created by foreign law.

18

See
Michael J. Fleming and Asani Sarkar, “The Failure Resolution of Lehman Brothers,” FRBNY Economic Policy Review 185 (December 2014), available at
https://www.newyorkfed.org/medialibrary/media/research/epr/2014/1412flem.pdf.

Importantly, this proposal does not affect all types of default rights, and, where it affects a default right, the proposal does so only temporarily for the purpose of allowing the relevant resolution authority to take action to continue to provide for continued performance on the QFC. Moreover, the proposal is concerned only with default rights that run
against
a GSIB—that is, direct default rights and cross-default rights that arise from the entry into resolution of a GSIB entity. The proposal would not affect default rights that a GSIB entity (or any other entity) may have against a counterparty that is not a GSIB entity. This limited scope is appropriate because, as described above, the risk posed to financial stability by the exercise of QFC default rights is greatest when the defaulting counterparty is a GSIB entity.

Single-point-of-entry resolution. Cross-default rights are especially significant in the context of a GSIB failure because GSIBs typically enter into large volumes of QFCs through different entities controlled by the GSIB. For example, a U.S. GSIB is made up of a U.S. bank holding company and numerous operating subsidiaries that are owned, directly or indirectly, by the bank holding company. From the standpoint of financial stability, the most important of these operating subsidiaries are generally a U.S. insured depository institution, a U.S. broker-dealer, and similar entities organized in other countries.

Many complex GSIB have developed resolution strategies that rely on the single-point-of-entry (SPOE) resolution strategy. In an SPOE resolution of a GSIB, only a single legal entity—the GSIB's top-tier bank holding company—would enter a resolution proceeding. The losses that led to the GSIB's failure would be passed up from the operating subsidiaries that incurred the losses to the holding company and would then be imposed on the equity holders and unsecured creditors of the holding company through the resolution process.
19

This strategy is designed to help ensure that the GSIB subsidiaries remain adequately capitalized, and that operating subsidiaries of the GSIB are able to continue to meet their financial obligations without defaulting or entering resolution themselves. The expectation that the holding company's equity holders and unsecured creditors would absorb the GSIB's losses in the event of failure would help to maintain the confidence of the operating subsidiaries' creditors and counterparties (including their QFC counterparties), reducing their incentive to engage in potentially destabilizing funding runs or margin calls and thus lowering the risk of asset firesales. A successful SPOE resolution would also avoid the need for separate resolution proceedings for separate legal entities run by separate authorities across multiple jurisdictions, which would be more complex and could therefore destabilize the resolution.

19
The Board's TLAC proposal would address the need for adequate external loss-absorbing capacity at the holding company level by requiring the top-tier holding companies of the U.S. GSIBs and the U.S. intermediate holding companies of foreign GSIBs to maintain outstanding required levels of unsecured long-term debt and TLAC, which is defined to include both tier 1 capital and eligible long-term debt.
See
80 FR 74926, 74931-74944. The TLAC proposal also discussed, but did not propose, a potential framework for internal loss-absorbing capacity that could be used to transfer losses from the operating subsidiaries that incur them to the top-tier holding company.
See
80 FR 74926, 74948-74949.

The Board's TLAC proposal is intended to help, though not exclusively, to lay the foundation necessary for the SPOE resolution of a GSIB by requiring the top-tier holding companies of U.S. GSIBs and the U.S. intermediate holding companies of foreign GSIBs to maintain loss-absorbing capacity that could be used for resolution and to adopt a “clean holding company” structure, under which certain financial activities that could pose obstacles to orderly resolution would be off-limits to the holding company and could only be conducted by its operating subsidiaries.
20

20

See
80 FR 74926, 74944-74948.

Other orderly resolution strategies. This proposal would also yield benefits for other approaches to resolution. For example, preventing early terminations of QFCs would increase the prospects for an orderly resolution under a multiple-point-of-entry (MPOE) strategy involving a foreign GSIB's U.S. intermediate holding company going into resolution or a resolution plan that calls for a GSIB's U.S. insured depository institution to enter resolution under the Federal Deposit Insurance Act. As discussed above, this proposal would help support the continued operation of affiliates of an entity experiencing resolution to the extent the affiliate continues to perform on its QFCs.

U.S. Bankruptcy Code. When an entity goes into resolution under the Bankruptcy Code, attempts by the debtor entity's creditors to enforce their debts through any means other than participation in the bankruptcy proceeding (for instance, by suing in another court, seeking enforcement of a preexisting judgment, or seizing and liquidating collateral) are generally blocked by the imposition of an automatic stay.
21

A key purpose of the automatic stay, and of bankruptcy law in general, is to maximize the value of the bankruptcy estate and the creditors' ultimate recoveries by facilitating an orderly liquidation or restructuring of the debtor. The automatic stay thus solves a collective action problem in which the creditors' individual incentives to become the first to recover as much from the debtor as possible, before other creditors can do so, collectively cause a value-destroying disorderly liquidation of the debtor.
22

21

See
11 U.S.C. 362.

22

See, e.g.,

Aiello
v.
Providian Financial Corp.,
239 F.3d 876, 879 (7th Cir. 2001).

However, the Bankruptcy Code largely exempts QFC
23

counterparties from the automatic stay through special “safe harbor” provisions.
24

Under these provisions, any rights that a QFC counterparty has to terminate the contract, set off obligations, and liquidate collateral in response to a

direct default are not subject to the stay and may be exercised against the debtor immediately upon default. (The Bankruptcy Code does not itself confer default rights upon QFC counterparties; it merely permits QFC counterparties to exercise certain rights created by other sources, such as contractual rights created by the terms of the QFC.)

23
The Bankruptcy Code does not use the term “qualified financial contract,” but the set of transactions covered by its safe harbor provisions closely tracks the set of transactions that fall within the definition of “qualified financial contract” used in Title II of the Dodd-Frank Act and in this proposal.

24
11 U.S.C. 362(b)(6), (7), (17), (27), 362(o), 555, 556, 559, 560, 561. The Bankruptcy Code specifies the types of parties to which the safe harbor provisions apply, such as financial institutions and financial participants.
Id.

The Bankruptcy Code's automatic stay also does not prevent the exercise of cross-default rights against an affiliate of the party entering resolution. The stay generally applies only to actions taken against the party entering resolution or the bankruptcy estate,
25

whereas a QFC counterparty exercising a cross-default right is instead acting against a distinct legal entity that is not itself in resolution: The debtor's affiliate.

25

See
11 U.S.C. 362(a).

Title II of the Dodd-Frank Act and the Orderly Liquidation Authority. Title II of the Dodd-Frank Act imposes somewhat broader stay requirements on QFCs that enter resolution under that Title. In general, no financial firm (regardless of size) is too-big-to-fail and a U.S. bank holding company (such as the top-tier holding company of a U.S. GSIB) that fails would be resolved under the Bankruptcy Code. Congress recognized, however, that a financial company might fail under extraordinary circumstances in which an attempt to resolve it through the bankruptcy process would have serious adverse effects on financial stability in the United States. Title II of the Dodd-Frank Act establishes the Orderly Liquidation Authority (OLA), an alternative resolution framework intended to be used rarely to manage the failure of a firm that poses a significant risk to the financial stability of the United States in a manner that mitigates such risk and minimizes moral hazard.
26

Title II authorizes the Secretary of the Treasury, upon the recommendation of other government agencies and a determination that several preconditions are met, to place a financial company into a receivership conducted by the FDIC as an alternative to bankruptcy.
27

26
Section 204(a) of the Dodd-Frank Act, 12 U.S.C. 5384(a).

27

See
section 203 of the Dodd-Frank Act, 12 U.S.C. 5383.

Title II empowers the FDIC to transfer the QFCs to a bridge financial company or some other financial company that is not in a resolution proceeding and should therefore be capable of performing under the QFCs.
28

To give the FDIC time to effect this transfer, Title II temporarily stays QFC counterparties of the failed entity from exercising termination, netting, and collateral liquidation rights “solely by reason of or incidental to” the failed entity's entry into OLA resolution, its insolvency, or its financial condition.
29

Once the QFCs are transferred in accordance with the statute, Title II permanently stays the exercise of default rights for those reasons.
30

28

See
12 U.S.C. 5390(c)(9).

29
12 U.S.C. 5390(c)(10)(B)(i)(I). This temporary stay generally lasts until 5:00 p.m. eastern time on the business day following the appointment of the FDIC as receiver.

30
12 U.S.C. 5390(c)(10)(B)(i)(II).

Title II addresses cross-default rights through a similar procedure. It empowers the FDIC to enforce contracts of subsidiaries or affiliates of the failed covered financial company that are “guaranteed or otherwise supported by or linked to the covered financial company, notwithstanding any contractual right to cause the termination, liquidation, or acceleration of such contracts based solely on the insolvency, financial condition, or receivership of” the failed company, so long as the FDIC takes certain steps to protect the QFC counterparties' interests by the end of the business day following the company's entry into OLA resolution.
31

31
12 U.S.C. 5390(c)(16).

These stay-and-transfer provisions of the Dodd-Frank Act are intended to mitigate the threat posed by QFC default rights. At the same time, the provisions allow for appropriate protections for QFC counterparties of the failed financial company. The provisions stay only the exercise of default rights based on the failed company's entry into resolution, the fact of its insolvency, or its financial condition. And the stay period is brief, unless the FDIC transfers the QFCs to another financial company that is not in resolution (and should therefore be capable of performing under the QFCs) or, if applicable, provides adequate protection that the QFCs will be performed.

The Federal Deposit Insurance Act. Under the FDI Act, a failing insured depository institution would generally enter a receivership administered by the FDIC.
32

The FDI Act addresses direct default rights in the failed bank's QFCs with stay-and-transfer provisions that are substantially similar to the provisions of Title II of the Dodd-Frank Act discussed above.
33

However, the FDI Act does not address cross-default rights, leaving the QFC counterparties of the failed depository institution's affiliates free to exercise any contractual rights they may have to terminate, net, and liquidate collateral based on the depository institution's entry into resolution. Moreover, as with Title II of the Dodd-Frank Act, there is a possibility that a court of a foreign jurisdiction might decline to enforce the FDI Act's stay-and-transfer provisions under certain circumstances.

32
12 U.S.C. 1821(c).

33

See
12 U.S.C. 1821(e)(8)-(10).

B. Overview of the Proposal

The Board invites comment on all aspects of this proposed rulemaking, which is intended to increase GSIB resolvability by addressing two QFC-related issues. First, the proposal seeks to address the risk that a court in a foreign jurisdiction may decline to enforce the QFC stay-and-transfer provisions of Title II and the FDI Act discussed above. Second, the proposal seeks to address the potential disruption that may occur if a counterparty to a QFC with an affiliate of a GSIB entity that goes into resolution under the Bankruptcy Code or the FDI Act is provided cross-default rights.

Scope of application. The proposal's requirements would apply to all “covered entities.” “Covered entity” would include: Any U.S. top-tier bank holding company identified as a GSIB under the Board's rule establishing risk-based capital surcharges for GSIBs (GSIB surcharge rule);
34

any subsidiary of such a bank holding company; and any U.S. subsidiary, U.S. branch, or U.S. agency of a foreign GSIB. Covered entity would not include certain entities that are supervised by the Office of the Comptroller of the Currency (OCC) (covered bank). The OCC is expected to issue a proposed rule that would subject covered banks to requirements substantively identical to those proposed here for covered entities.

34
12 CFR 217.402; 80 FR 49106 (August 14, 2015).
See
proposed rule § 252.81.

“Qualified financial contract” or “QFC” would be defined to have the same meaning as in section 210(c)(8)(D) of the Dodd-Frank Act,
35

and would include, among other things, derivatives, repos, and securities lending agreements. Subject to the exceptions discussed below, the proposal's requirements would apply to any QFC to which a covered entity is party (covered QFC).

35
12 U.S.C. 5390(c)(8)(D).
See
proposed rule § 252.81.

Required contractual provisions related to the U.S. special resolution regimes. Covered entities would be required to ensure that covered QFCs include contractual terms explicitly providing that any default rights or restrictions on the transfer of the QFC are limited to the same extent as they

would be pursuant to the U.S. special resolution regimes—that is, the OLA and the FDI Act.
36

The proposed requirements are not intended to imply that the statutory stay-and-transfer provisions would not in fact apply to a given QFC, but rather to help ensure that all covered QFCs—including QFCs that are governed by foreign law, entered into with a foreign party, or for which collateral is held outside the United States—would be treated the same way in the context of an FDIC receivership under the Dodd-Frank Act or the FDI Act. This provision would address the first issue listed above and would decrease the QFC-related threat to financial stability posed by the failure and resolution of an internationally active GSIB. This section of the proposal is also consistent with analogous legal requirements that have been imposed in other national jurisdictions
37

and with the Financial Stability Board's “Principles for Cross-border Effectiveness of Resolution Actions.”
38

36

See
proposed rule § 252.83.

37

See, e.g.,
Bank of England Prudential Regulation Authority, Policy Statement, “Contractual stays in financial contracts governed by third-country law” (November 2015), available at
http://www.bankofengland.co.uk/pra/Documents/publications/ps/2015/ps2515.pdf.

38
Financial Stability Board, “Principles for Cross-border Effectiveness of Resolution Actions” (November 3, 2015), available at
http://www.fsb.org/wp-content/uploads/Principles-for-Cross-border-Effectiveness-of-Resolution-Actions.pdf.

The Financial Stability Board (FSB) was established in 2009 to coordinate 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 to advance financial stability. The FSB brings together national authorities responsible for financial stability in 24 countries and jurisdictions, as well as international financial institutions, sector-specific international groupings of regulators and supervisors, and committees of central bank experts.
See generally
Financial Stability Board, available at
http://www.fsb.org.

Prohibited cross-default rights. A covered entity would be prohibited from entering into covered QFCs that would allow the exercise of cross-default rights—that is, default rights related, directly or indirectly, to the entry into resolution of an affiliate of the direct party—against it.
39

Covered entities would similarly be prohibited from entering into covered QFCs that would provide for a restriction on the transfer of a credit enhancement supporting the QFC from the covered entity's affiliate to a transferee upon the entry into resolution of the affiliate.

39

See
proposed rule § 252.83(b).

The Board does not propose to prohibit covered entities from entering into QFCs that contain direct default rights. Under the proposal, a counterparty to a direct QFC with a covered entity also could, to the extent not inconsistent with Title II or the FDI Act, be granted and could exercise the right to terminate the QFC if the covered entity fails to perform its obligations under the QFC.

As an alternative to bringing their covered QFCs into compliance with the requirements set out in this section of the proposed rule, covered entities would be permitted to comply by adhering to the ISDA 2015 Resolution Stay Protocol.
40

The Board views the ISDA 2015 Resolution Stay Protocol as consistent with the requirements of the proposed rule.

40

See
proposed rule § 252.85(a).

The purpose of this section of the proposal is to help ensure that, when a GSIB entity enters resolution under the Bankruptcy Code or the FDI Act,
41

its affiliates' covered QFCs will be protected from disruption to a similar extent as if the failed entity had entered resolution under the OLA. In particular, this section would facilitate resolution under the Bankruptcy Code by preventing the QFC counterparties of a GSIB's operating subsidiary from exercising default rights on the basis of the entry into bankruptcy by the GSIB's top-tier holding company or any other affiliate of the operating subsidiary. This section generally would not prevent covered QFCs from allowing the exercise of default rights upon a failure by the direct party to satisfy a payment or delivery obligation under the QFC, the direct party's entry into resolution, or the occurrence of any other default event that is not related to the entry into a resolution proceeding or the financial condition of an affiliate of the direct party.

41
The FDI Act does not stay cross-default rights against affiliates of an insured depository institution based on the entry of the insured depository institution into resolution proceedings under the FDI Act.

Process for approval of enhanced creditor protection conditions. The proposal would allow the Board, at the request of a covered entity, to approve as compliant with the proposal covered QFCs with creditor protections other than those that would otherwise be permitted under section 252.84 of the proposal.
42

The Board could approve such a request if, in light of several enumerated considerations,
43

the alternative approach would mitigate risks to the financial stability of the United States presented by a GSIB's failure to at least the same extent as the proposed requirements.

42

See
proposed rule § 252.85.

43

See
proposed rule § 252.85(c).

Amendments to certain definitions in the Board's capital and liquidity rules. The proposal would also amend certain definitions in the Board's capital and liquidity rules to help ensure that the regulatory capital and liquidity treatment of QFCs to which a covered entity is party is not affected by the proposed restrictions on such QFCs. Specifically, the proposal would amend the definition of “qualifying master netting agreement” in the Board's regulatory capital and liquidity rules and would similarly amend the definitions of the terms “collateral agreement,” “eligible margin loan,” and “repo-style transaction” in the Board's regulatory capital rules.

C. Consultation With U.S Financial Regulators, the Council, and Foreign Authorities

In developing this proposal, the Board consulted with the FDIC, the OCC, the Financial Stability Oversight Council (Council), and other U.S. financial regulators. The proposal reflects input that the Board received during this consultation process. The Board also intends to consult with the Council and other U.S. financial regulators after it reviews comments on the proposal. Furthermore, the Board has consulted with, and expects to continue to consult with, foreign financial regulatory authorities regarding this proposal and the establishment of other standards that would maximize the prospects for the cooperative and orderly cross-border resolution of a failed GSIB on an international basis.

The OCC is expected to issue for public comment a notice of proposed rulemaking that would subject covered banks, including the national bank subsidiaries of GSIBs, to requirements substantively identical to those proposed here for covered entities. The Board and the OCC coordinated the development of their respective proposals in order to avoid redundancy.

D. Overview of Statutory Authority

The Board is issuing this proposal under the authority provided by section 165 of the Dodd-Frank Act.
44

Section 165 instructs the Board to impose enhanced prudential standards on bank holding companies with total consolidated assets of $50 billion or more “[i]n order to prevent or mitigate risks to the financial stability of the United States that could arise from the material financial distress or failure, or ongoing activities, of large, interconnected financial institutions.”
45

These enhanced prudential standards must increase in stringency based on the

systemic footprint and risk characteristics of covered firms.
46

Section 165 requires the Board to impose enhanced prudential standards of several specified types and also authorizes the Board to establish “such other prudential standards as the Board of Governors, on its own or pursuant to a recommendation made by the Council, determines are appropriate.”
47

44
12 U.S.C. 5365.

45
12 U.S.C. 5365(a)(1).

46
12 U.S.C. 5365(a)(1)(B), (b)(3)(A)-(D).

47
12 U.S.C. 5365(b)(1)(B)(iv).

Enhanced prudential standards in the proposal are intended to prevent or mitigate risks to the financial stability of the United States that could arise from the material financial distress or failure of a GSIB. In particular, the proposed requirements would improve the resolvability of U.S. GSIBs under the Bankruptcy Code, Title II of the Dodd-Frank Act, or, with reference to insured depository institutions that are GSIB subsidiaries, the FDI Act, and reduce the potential that resolution of the firm will be disorderly and lead to disruptive asset sales and liquidations.

The proposal would also improve the resilience of the U.S. operations of foreign GSIBs, and thereby increase the likelihood that a failed foreign GSIB with U.S. operations would be successfully resolved by its home jurisdiction authorities without the failure of the foreign GSIB's U.S. operating entities and with limited effect on the financial stability of the United States.

The Board has tailored this proposal to apply only to those banking organizations whose disorderly failure would likely pose the greatest risk to U.S. financial stability: The U.S. GSIBs and the U.S. operations of foreign GSIBs.

Question 1: The Board invites comment on all aspects of this section.

II. Proposed Restrictions on QFCs of GSIBs

A. Covered Entities (Section 252.82(a) of the Proposed Rule)

The proposed rule would apply to “covered entities,” which include (a) any U.S. GSIB top-tier bank holding company, (b) any subsidiary of such a bank holding company that is not a “covered bank,” and (c) the U.S. operations of any foreign GSIB with the exception of any “covered bank.” The term “covered bank” would be defined to include certain entities, such as certain national banks, that are supervised by the OCC. While covered banks would be exempt from the requirements of this proposal, the OCC is expected to issue a proposed rule that would impose substantively identical requirements for covered banks in the near future.
48

48
Section 252.88 of the Board's proposal also clarifies that covered entities are not required to conform covered QFCs with respect to a part of a covered QFC that a covered bank also would be required to conform under the proposed rule that the OCC is expected to issue. Such overlap could occur, for example, where a bank holding company that is a covered entity guarantees a swap between a subsidiary that is a covered bank and the covered bank's counterparty.

U.S. GSIB bank holding companies. Covered entities would include the entities identified as U.S. GSIB top-tier holding companies under the Board's GSIB surcharge rule.
49

Under the GSIB surcharge rule, a U.S. top-tier bank holding company subject to the advanced approaches rule must determine whether it is a GSIB by applying a multifactor methodology established by the Board.
50

The methodology evaluates a banking organization's systemic importance on the basis of its attributes in five broad categories: Size, interconnectedness, cross-jurisdictional activity, substitutability, and complexity.

49
12 CFR 217.402; 80 FR 49106 (August 14, 2015).
See
proposed rule § 252.82(a)(1).

50

Id.;
12 CFR part 217, subpart E.

Accordingly, the methodology provides a tool for identifying those banking organizations whose failure or material distress would pose especially large risks to the financial stability of the United States. Improving the orderly resolution and resolvability of such firms, including by reducing risks associated with their QFCs, would be an important step toward achieving the goals of the Dodd-Frank Act. The proposal's focus on GSIBs is also in keeping with the Dodd-Frank Act's mandate that more stringent prudential standards be applied to the most systemically important bank holding companies.
51

Moreover, several of the attributes that feed into the determination of whether a given firm is a GSIB incorporate aspects of the firm's QFC activity. These attributes include the firm's total exposures, its intra-financial system assets and liabilities, its notional amount of over-the-counter derivatives, and its cross-jurisdictional claims and liabilities.

51
12 U.S.C. 5365(a)(1)(B).

Under the GSIB surcharge rule's methodology, there are currently eight U.S. GSIBs: Bank of America Corporation, The Bank of New York Mellon Corporation, Citigroup Inc., Goldman Sachs Group, Inc., JPMorgan Chase & Co., Morgan Stanley Inc., State Street Corporation, and Wells Fargo & Company. This list may change in the future in light of changes to the relevant attributes of the current U.S. GSIBs and of other large U.S. bank holding companies.

U.S. GSIB subsidiaries. Covered entities would also include all subsidiaries of the U.S. GSIBs (other than covered banks).
52

U.S. GSIBs generally enter into QFCs through subsidiary legal entities rather than through the top-tier holding company.
53

Therefore, in order to increase GSIB resolvability by addressing the potential obstacles to orderly resolution posed by QFCs, it is necessary to apply the proposed restrictions to the U.S. GSIBs' subsidiaries.

52

See
proposed rule § 252.82(a).

53
Under the clean holding company component of the Board's recent TLAC proposal, the top-tier holding companies of U.S. GSIBs would be prohibited from entering into direct QFCs with third parties.
See
80 FR 74926, 74945.

In particular, to facilitate the resolution of a GSIB under an SPOE strategy, in which only the top-tier holding company would enter a resolution proceeding while its subsidiaries would continue to meet their financial obligations, or an MPOE strategy where an affiliate of an entity that is otherwise performing under a QFC enters resolution, it is necessary to ensure that those subsidiaries or affiliates do not enter into QFCs that contain cross-default rights that the counterparty could exercise based on the holding company's or affiliate's entry into resolution (or that any such cross-default rights are stayed when the holding company enters resolution). Moreover, including U.S. and non-U.S. entities of a U.S. GSIB as covered entities should help ensure that such cross-default rights do not affect the ability of performing and solvent entities of a GSIB—regardless of jurisdiction—to remain outside of resolution proceedings.

U.S. operations of foreign GSIBs. Finally, covered entities would include all U.S. operations of foreign GSIBs that are not covered banks, including U.S. subsidiaries, U.S. branches, and U.S. agencies. Under the proposal, the term “global systemically important foreign banking organization” (which this preamble will shorten to “foreign GSIB”) would be defined to include any foreign banking organization that (a) would be designated as a GSIB under the Board's GSIB surcharge rule if it were subject to that rule on a consolidated basis or (b) would be designated as a GSIB under the methodology for identifying GSIBs adopted by the Basel Committee on

Banking Supervision (global methodology).
54

54

See
proposed rule § 252.87. The Basel Committee on Banking Supervision (BCBS) is a committee of bank supervisory authorities established by the central bank governors of the Group of Ten countries in 1975. The committee's membership consists of senior representatives of bank supervisory authorities and central banks from Argentina, Australia, Belgium, Brazil, Canada, China, France, Germany, Hong Kong SAR, India, Indonesia, Italy, Japan, Korea, Luxembourg, Mexico, the Netherlands, Russia, Saudi Arabia, Singapore, South Africa, Spain, Sweden, Switzerland, Turkey, the United Kingdom, and the United States. In 2011, the BCBS adopted the global methodology to identify global systemically important banking organizations and assess their systemic importance.
See
“Global systemically important banks: Assessment methodology and the additional loss absorbency requirement,” available at
http://www.bis.org/publ/bcbs207.htm.
In 2013, the BCBS published a revised document, which provides certain revisions and clarifications to the global methodology.
See
“Global systemically important banks: Updated assessment methodology and the higher loss absorbency requirement,” available at
http://www.bis.org/publ/bcbs255.htm.

In November 2015, the FSB and the BCBS published an updated list of banking organizations that are GSIBs under the assessment methodology. The list includes the eight U.S. GSIBs and the following 22 foreign banking organizations: Agricultural Bank of China, Bank of China, Barclays, BNP Paribas, China Construction Bank, Credit Suisse, Deutsche Bank, Groupe BPCE, Groupe Crédit Agricole, Industrial and Commercial Bank of China Limited, HSBC, ING Bank, Mitsubishi UFJ FG, Mizuho FG, Nordea, Royal Bank of Scotland, Santander, Société Générale, Standard Chartered, Sumitomo Mitsui FG, UBS, and Unicredit Group. See FSB, “2015 update of list of global systemically important banks” (November 3, 2015), available at
http://www.fsb.org/wp-content/uploads/2015-update-of-list-of-global-systemically-important-banks-G-SIBs.pdf.

As discussed above, the Board's GSIB surcharge rule identifies the most systemically important banking organizations on the basis of their attributes in the categories of size, interconnectedness, cross-jurisdictional activity, substitutability, and complexity. While the GSIB surcharge rule applies only to U.S. bank holding companies, its methodology is equally well-suited to evaluating the systemic importance of foreign banking organizations. The global methodology generally evaluates the same attributes and would identify the same set of GSIBs as the Board's methodology.

As with U.S. GSIBs, the proposal's focus on those foreign banking organizations that qualify as GSIBs is in keeping with the Dodd-Frank Act's mandate that more stringent prudential standards be applied to the most systemically important banking organizations.
55

Moreover, the use of the GSIB surcharge rule to identify foreign GSIBs as well as U.S. GSIBs promotes a level playing field between U.S. and foreign banking organizations.

55
12 U.S.C. 5365(a)(1)(B).

The proposal would cover only the U.S. operations of foreign GSIBs. As with the coverage of subsidiaries of U.S. GSIBs, coverage of the U.S. operations of foreign banks will enhance the orderly resolution of the foreign bank and its U.S. operations. In particular, covering QFCs that involve any U.S. subsidiary, U.S. branch, or U.S. agency of a foreign GSIB will reduce the potentially disruptive cancellation of those QFCs if the foreign bank or any of its subsidiaries enters resolution.
56

56
Under the clean holding company component of the Board's recent TLAC proposal, the U.S. intermediate holding companies of foreign GSIBs would be prohibited from entering into QFCs with third parties.
See
80 FR 74926, 74945.

Question 2: The Board invites comment on the proposed definition of the term “covered entity.”

Question 3: The Board invites comment on alternative approaches for determining the scope of application of the proposed restrictions.

Question 4: The Board invites comment on whether the proposal should be expanded to cover banking organizations that are not GSIBs but that engage in especially high levels of QFC activity. If so, what specific metrics should be used to identify such banking organizations?

B. Covered QFCs

General definition. The proposal would apply to any “covered QFC,” generally defined as any QFC that a covered entity enters into, executes, or otherwise becomes party to.
57

“Qualified financial contract” or “QFC” would be defined as in section 210(c)(8)(D) of Title II of the Dodd-Frank Act and would include swaps, repo and reverse repo transactions, securities lending and borrowing transactions, commodity contracts, and forward agreements.
58

57

See
proposed rule § 252.83(a). For convenience, this preamble generally refers to “a covered entity's QFCs” or “QFCs to which a covered entity is party” as shorthand to encompass this definition.

58

See
proposed rule § 252.81; 12 U.S.C. 5390(c)(8)(D).

The proposed definition of “covered QFC” is intended to limit the proposed restrictions to those financial transactions whose disorderly unwind has substantial potential to frustrate the orderly resolution of a GSIB, as discussed above. By adopting the Dodd-Frank Act's definition, the proposed rule would extend the benefits of the stay and transfer protections to the same types of transactions in the event the covered entity enters bankruptcy. In this way, the proposal enhances the prospects for an orderly resolution in bankruptcy (as opposed to resolution under Title II of the Dodd-Frank Act) of a covered entity.

Question 5: The Board invites comment on the proposed definitions of “QFC” and “covered QFC.” Are there financial transactions that could pose a similar risk to U.S. financial stability if a GSIB were to fail but that would not be included within the proposed definitions of QFC and covered QFC? Are there transactions that would be included within the proposed definitions but that would not present risks justifying the application of this proposal? Please explain.

Exclusion of cleared QFCs. The proposal would exclude from the definition of “covered QFC” all QFCs that are cleared through a central counterparty.
59

The issues that the proposal is intended to address with respect to non-cleared QFCs may also exist in the context of centrally cleared QFCs. However, clearing through a central counterparty also provides unique benefits to the financial system as well as unique issues related to the cancellation of cleared contracts. Accordingly, the Board continues to consider the appropriate treatment of centrally cleared QFCs, in light of differences between cleared and non-cleared QFCs with respect to contractual arrangements, counterparty credit risk, default management, and supervision. The Board is also considering whether to propose a regulatory regime that would address the continuity of cleared QFCs during the resolution of a GSIB within the broader context of safeguarding GSIB access to financial market utilities, including central counterparties, during the orderly resolution of the GSIB.

59

See
proposed rule § 252.82(b).

Question 6: The Board invites comment on the proposed exclusion of cleared QFCs, including the potential effects on the financial stability of the United States of excluding cleared QFCs as well as the potential effects on U.S. financial stability of subjecting covered entities' relationships with central counterparties to restrictions analogous to this proposal's restrictions on covered entities' non-cleared QFCs.

Exclusion of certain QFCs under multi-branch master agreements of foreign banking organizations. To avoid imposing unnecessary restrictions on QFCs that are not closely connected to the United States, the proposal would exclude from the definition of “covered QFC” certain QFCs of foreign GSIBs that lack a close connection to the foreign GSIB's U.S. operations.
60

The proposed definition of “QFC” includes master agreements that apply to QFCs.
61

Master

agreements are contracts that contain general terms that the parties wish to apply to multiple transactions between them; having executed the master agreement, the parties can then include those terms in future contracts through reference to the master agreement. Moreover, the Dodd-Frank Act's definition of “qualified financial contract,” which the proposal would adopt, treats master agreements for QFCs together with all supplements to the master agreement (including underlying transactions) as a single QFC.
62

60

See
proposed rule § 252.86.

61

See
proposed rule § 252.81.

62
12 U.S.C. 5390(c)(8)(D)(viii);
see also
12 U.S.C. 1821(e)(8)(D)(vii); 109 H. Rpt. 31, Prt. 1 (April 8, 2005) (explaining that a “master agreement for one or more securities contracts, commodity contracts, forward contracts, repurchase agreements or swap agreements will be treated as a single QFC under the FDIA or the FCUA (but only with respect to the underlying agreements are themselves QFCs)”).

Foreign banks have master agreements that permit transactions to be entered into both at a U.S. branch or U.S. agency of the foreign bank and at a non-U.S. location of the foreign bank (such as a foreign branch). Notwithstanding the proposal's general treatment of a master agreement and all QFCs thereunder as a single QFC, the proposal would exclude QFCs under such a “multi-branch master agreement” that are not booked at a covered entity and for which no payment or delivery may be made at a covered entity.
63

The multi-branch master agreement would still be a covered QFC with respect to QFC transactions that are booked at a covered entity or for which payment or delivery may be made at a covered entity.

63

See
proposed rule § 252.86(a). With respect to a U.S. branch or U.S. agency of a foreign GSIB, a multi-branch master agreement that is a covered QFC solely because the master agreement permits agreements or transactions that are QFCs to be entered into at one or more U.S. branches or U.S. agencies of the foreign GSIB will be considered a covered QFC for purposes of this proposal only with respect to such agreements or transactions booked at such U.S. branches and U.S. agencies or for which a payment or delivery may be made at such U.S. branches or U.S. agencies.

The purpose of this exclusion is to help ensure that, where a foreign GSIB has a multi-branch master agreement, the foreign GSIB will only have to conform those QFCs entered into under the multi-branch master agreement that could directly affect the obligations of the covered U.S. branch or U.S. agency of the foreign GSIB and that could therefore have the most direct effect on the financial stability of the United States.

Question 7: The Board invites comment on the proposed exclusion, including the potential benefits and detriments to U.S. financial stability of eliminating the proposed exclusion, the reduction in compliance burden that would be produced by the proposed exclusion, and the proposed exclusion's effect on netting under multi-branch master agreements.

C. Definition of “Default Right”

As discussed above, a party to a QFC generally has a number of rights that it can exercise if its counterparty defaults on the QFC by failing to meet certain contractual obligations. These rights are generally, but not always, contractual in nature. One common default right is a setoff right: the right to reduce the total amount that the non-defaulting party must pay by the amount that its defaulting counterparty owes. A second common default right is the right to liquidate pledged collateral and use the proceeds to pay the defaulting party's net obligation to the non-defaulting party. Other common rights include the ability to suspend or delay the non-defaulting party's performance under the contract or to accelerate the obligations of the defaulting party. Finally, the non-defaulting party typically has the right to terminate the QFC, meaning that the parties would not make payments that would have been required under the QFC in the future. The phrase “default right” in the proposed rule is broadly defined to include these common rights as well as “any similar rights.”
64

Additionally, the definition includes all such rights regardless of source, including rights existing under contract, statute, or common law.

64

See
proposed rule § 252.81.

However, the proposed definition excludes two rights that are typically associated with the business-as-usual functioning of a QFC. First, same-day netting that occurs during the life of the QFC in order to reduce the number and amount of payments each party owes the other is excluded from the definition of “default right.”
65

Second, contractual margin requirements that arise solely from the change in the value of the collateral or the amount of an economic exposure are also excluded from the definition.
66

The function of these exclusions is to leave such rights unaffected by the proposed rule. The exclusions are appropriate because the proposal is intended to improve resolvability by addressing default rights that could disrupt an orderly resolution, not to interrupt the parties' business-as-usual interactions under a QFC.

65

See id.

66

See id.

However, certain QFCs are also commonly subject to rights that would increase the amount of collateral or margin that the defaulting party (or a guarantor) must provide upon an event of default. The financial impact of such default rights on a covered entity could be similar to the impact of the liquidation and acceleration rights discussed above. Therefore, the proposed definition of “default right” includes such rights (with the exception discussed in the previous paragraph for margin requirements that depend solely on the value of collateral or the amount of an economic exposure).
67

67

See id.

Finally, contractual rights to terminate without the need to show cause, including rights to terminate on demand and rights to terminate at contractually specified intervals, are excluded from the definition of “default right” for purposes the proposed rule's restrictions on cross-default rights (section 252.84 of the proposed rule).
68

This is consistent with the proposal's objective of restricting only default rights that are related, directly or indirectly, to the entry into resolution of an affiliate of the covered entity, while leaving other default rights unrestricted.

68

See
proposed rule §§ 252.81, 252.84.

Question 8: The Board invites comment on all aspects of the proposed definition of “default right.” In particular, are the proposed exclusions appropriate in light of the objectives of the proposal? To what extent does the exclusion of rights that allow a party to terminate the contract “on demand or at its option at a specified time, or from time to time, without the need to show cause” create an incentive for firms to include these rights in future contracts to evade the proposed restrictions? To what extent should other regulatory requirements (e.g., liquidity coverage ratio or the short-term wholesale funding components of the GSIB surcharge rule) be revised to create a counterincentive? Would additional exclusions be appropriate? To what extent should it be clarified that the “need to show cause” includes the need to negotiate alternative terms with the other party prior to termination or similar requirements (e.g., Master Securities Loan Agreement, Annex III—Term Loans)?

D. Required Contractual Provisions Related to the U.S. Special Resolution Regimes (Section 252.83 of the Proposed Rule)

Under the proposal, a covered QFC would be required to explicitly provide both (a) that the transfer of the QFC (and any interest or obligation in or under it and any property securing it) from the

covered entity to a transferee would be effective to the same extent as it would be under the U.S. special resolution regimes if the covered QFC were governed by the laws of the United States or of a state of the United States and (b) that default rights with respect to the covered QFC that could be exercised against a covered entity could be exercised to no greater extent than they could be exercised under the U.S. special resolution regimes if the covered QFC were governed by the laws of the United States or of a state of the United States.
69

The proposal would define the term “U.S. special resolution regimes” to mean the FDI Act
70

and Title II of the Dodd-Frank Act,
71

along with regulations issued under those statutes.
72

69

See
proposed rule § 252.83.

70
12 U.S.C. 1811-1835a.

71
12 U.S.C. 5381-5394.

72

See
proposed rule § 252.81.

The proposed requirements are not intended to imply that a given covered QFC is not governed by the laws of the United States or of a state of the United States, or that the statutory stay-and-transfer provisions would not in fact apply to a given covered QFC. Rather, the requirements are intended to provide certainty that all covered QFCs would be treated the same way in the context of a receivership of a covered entity under the Dodd-Frank Act or the FDI Act. The stay-and-transfer provisions of the U.S. special resolution regimes should be enforced with respect to all contracts of any U.S. GSIB entity that enters resolution under a U.S. special resolution regime as well as all transactions of the subsidiaries of such an entity. Nonetheless, it is possible that a court in a foreign jurisdiction would decline to enforce those provisions in cases brought before it (such as a case regarding a covered QFC between a covered entity and a non-U.S. entity that is governed by non-U.S. law and secured by collateral located outside the United States). By requiring that the effect of the statutory stay-and-transfer provisions be incorporated directly into the QFC contractually, the proposed requirement would help ensure that a court in a foreign jurisdiction would enforce the effect of those provisions, regardless of whether the court would otherwise have decided to enforce the U.S. statutory provisions themselves.
73

For example, the proposed provisions should prevent a U.K. counterparty of a U.S. GSIB from persuading a U.K. court that it should be permitted to seize and liquidate collateral located in the United Kingdom in response to the U.S. GSIB's entry into OLA resolution. And the knowledge that a court in a foreign jurisdiction would reject the purported exercise of default rights in violation of the required provisions would deter covered entities' counterparties from attempting to exercise such rights.

73

See generally
Financial Stability Board, “Principles for Cross-border Effectiveness of Resolution Actions” (November 3, 2015), available at
http://www.fsb.org/wp-content/uploads/Principles-for-Cross-border-Effectiveness-of-Resolution-Actions.pdf.

This requirement would advance the proposal's goal of removing QFC-related obstacles to the orderly resolution of a GSIB. As discussed above, restrictions on the exercise of QFC default rights are an important prerequisite for an orderly GSIB resolution. Congress recognized the importance of such restrictions when it enacted the stay-and-transfer provisions of the U.S. special resolution regimes. As demonstrated by the 2007-2009 financial crisis, the modern financial system is global in scope, and covered entities are party to large volumes of QFCs with connections to foreign jurisdictions. The stay-and-transfer provisions of the U.S. special resolution regimes would not achieve their purpose of facilitating orderly resolution in the context of the failure of a GSIB with large volumes of such QFCs if QFCs could escape the effect of those provisions. To remove any doubt about the scope of coverage of these provisions, the proposed requirement would ensure that the stay-and-transfer provisions apply as a matter of contract to all covered QFCs, wherever the transaction. This will advance the resolvability goals of the Dodd-Frank Act and the FDI Act.

This section of the proposal is consistent with efforts by regulators in other jurisdictions to address similar risks by requiring that financial firms within their jurisdictions ensure that the effect of the similar provisions under these foreign jurisdictions' respective special resolution regimes would be enforced by courts in other jurisdictions, including the United States. For example, the United Kingdom's Prudential Regulation Authority (PRA) recently required certain financial firms to ensure that their counterparties to newly created obligations agree to be subject to stays on early termination that are similar to those that would apply upon a U.K. firm's entry into resolution if the financial arrangements were governed by U.K. law.
74

Similarly, the German parliament passed a law in November 2015 requiring German financial institutions to have provisions in financial contracts that are subject to the law of a country outside of the European Union that acknowledge the provisions regarding the temporary suspension of termination rights and accept the exercise of the powers regarding such temporary suspension under the German special resolution regime.
75

Additionally, the Swiss Federal Council requires that banks “ensure at both the individual institution and group level that new agreements or amendments to existing agreements which are subject to foreign law or envisage a foreign jurisdiction are agreed only if the counterparty recognises a postponement of the termination of agreements in accordance with” the Swiss special resolution regime.
76

74

See
PRA Rulebook: CRR Firms and Non-Authorised Persons: Stay in Resolution Instrument 2015, available at
http://www.bankofengland.co.uk/pra/Documents/publications/ps/2015/ps2515app1.pdf; see

also
Bank of England, Prudential Regulation Authority, “Contractual stays in financial contracts governed by third-country law” (PS25/15) (November 2015), available at
http://www.bankofengland.co.uk/pra/Documents/publications/ps/2015/ps2515.pdf.
These PRA rules apply to PRA-authorized banks, building societies, PRA-designated investment firms, and their qualifying parent undertakings, including U.K. financial holding companies and U.K. mixed financial holding companies.

75

See
Gesetz zur Sanierung und Abwicklung von Instituten und Finanzgruppen, Sanierungs-und Abwicklungsgesetz [SAG] [German Act on the Reorganisation and Liquidation of Credit Institutions], Dec. 10, 2014, § 60a,
https://www.gesetze-im-internet.de/bundesrecht/sag/gesamt.pdf.

76

See
Verordnung über die Finanzmarktinfrastrukturen und das Marktverhalten im Effekten- und Derivatehandel [FinfraV] [Ordinance on Financial Market Infrastructures and Market Conduct in Securities and Derivatives Trading] Nov. 25, 2015, amending Bankenverordnung vom 30. April 2014 [BankV] [Banking Ordinance of 30 April 2014] Apr. 30, 2014, SR 952.02, art. 12 paragraph 2
bis
,
translation at

http://www.news.admin.ch/NSBSubscriber/message/attachments/42659.pdf; see also
Erläuterungsbericht zur Verordnung über die Finanzmarktinfrastrukturen und das Marktverhalten im Effekten- und Derivatehandel (Nov. 25, 2015) (providing commentary).

Question 9: The Board invites comment on all aspects of this section of the proposal.

E. Prohibited Cross-Default Rights (Section 252.84 of the Proposed Rule)

Definitions. Section 252.84 of the proposal pertains to cross-default rights in QFCs between covered entities and their counterparties, many of which are subject to credit enhancements (such as a guarantee) provided by an affiliate of the covered entity. Because credit enhancements on QFCs are themselves “qualified financial contracts” under the Dodd-Frank Act's definition of that term (which this proposal would adopt), the proposal includes the following additional definitions in order to facilitate a precise description of the relationships to which it would apply.

First, the proposal distinguishes between a credit enhancement and a “direct QFC,” defined as any QFC that is not a credit enhancement.
77

The proposal also defines “direct party” to mean a covered entity that is itself a party to the direct QFC, as distinct from an entity that provides a credit enhancement.
78

In addition, the proposal defines “affiliate credit enhancement” to mean “a credit enhancement that is provided by an affiliate of the party to the direct QFC that the credit enhancement supports,” as distinct from a credit enhancement provided by either the direct party itself or by an unaffiliated party.
79

Moreover, the proposal defines “covered affiliate credit enhancement” to mean an affiliate credit enhancement provided by a covered entity and defines “covered affiliate support provider” to mean the covered entity that provides the covered affiliate credit enhancement.
80

Finally, the proposal defines the term “supported party” to mean any party that is the beneficiary of a covered affiliate credit enhancement (that is, the QFC counterparty of a direct party, assuming that the direct QFC is subject to a covered affiliate credit enhancement).
81

77

See
proposed rule § 252.84(c)(2).

78

See
proposed rule § 252.84(c)(1).

79

See
proposed rule § 252.84(c)(3).

80

See
proposed rule § 252.84(f)(2).

81

See
proposed rule § 252.84(f)(4).

General prohibitions. Subject to the substantial exceptions discussed below, the proposal would prohibit a covered entity from being party to a covered QFC that allows for the exercise of any default right that is related, directly or indirectly, to the entry into resolution of an affiliate of the covered entity.
82

The proposal also would generally prohibit a covered entity from being party to a covered QFC that would prohibit the transfer of any credit enhancement applicable to the QFC (such as another entity's guarantee of the covered entity's obligations under the QFC), along with associated obligations or collateral, upon the entry into resolution of an affiliate of the covered entity.
83

82

See
proposed rule § 252.84(b)(1).

83

See
proposed rule § 252.84(b)(2). This prohibition would be subject to an exception that would allow supported parties to exercise default rights with respect to a QFC if the supported party would be prohibited from being the beneficiary of a credit enhancement provided by the transferee under any applicable law, including the Employee Retirement Income Security Act of 1974 and the Investment Company Act of 1940. This exception is substantially similar to an exception to the transfer restrictions in section 2(f) of the ISDA 2014 Resolution Stay Protocol (2014 Protocol) and the ISDA 2015 Universal Resolution Stay Protocol, which was added to address concerns expressed by asset managers during the drafting of the 2014 Protocol.

A primary purpose of the proposed restrictions is to facilitate the resolution of a GSIB outside of Title II, including under the Bankruptcy Code. As discussed above, the potential for mass exercises of QFC default rights is one reason why a GSIB's failure could do severe damage to financial stability. In the context of an SPOE resolution, if the GSIB parent's entry into resolution led to the mass exercise of cross-default rights by the subsidiaries' QFC counterparties, then the subsidiaries could themselves fail or experience financial distress. Moreover, the mass exercise of QFC default rights could entail asset firesales, which likely would affect other financial companies and undermine financial stability. Similar disruptive results can occur with an MPOE resolution of an affiliate of an otherwise performing entity triggers default rights on QFCs involving the performing entity.

In an SPOE resolution, this damage can be avoided if actions of the following two types are prevented: The exercise of direct default rights against the top-tier holding company that has entered resolution, and the exercise of cross-default rights against the operating subsidiaries based on their parent's entry into resolution. (Direct default rights against the subsidiaries would not be exercisable, because the subsidiaries would not enter resolution.) In an MPOE resolution, this damage occurs from exercise of default rights against a performing entity based on the failure of an affiliate.

Under the OLA, the Dodd-Frank Act's stay-and-transfer provisions would address both direct default rights and cross-default rights. But, as explained above, no similar statutory provisions would apply to a resolution under the Bankruptcy Code. This proposal attempts to address these obstacles to orderly resolution under the Bankruptcy Code by extending the stay-and-transfer provisions to any type of resolution of a covered entity. Similarly, the proposal would facilitate a transfer of the GSIB parent's interests in its subsidiaries, along with any credit enhancements it provides for those subsidiaries, to a solvent financial company by prohibiting covered entities from having QFCs that would allow the QFC counterparty to prevent such a transfer or to use it as a ground for exercising default rights.
84

84

See
proposed rule § 252.84(b).

The proposal also is intended to facilitate other approaches to GSIB resolution. For example, it would facilitate a similar resolution strategy in which a U.S. depository institution subsidiary of a GSIB enters resolution under the FDI Act while its subsidiaries continue to meet their financial obligations outside of resolution.
85

Similarly, the proposal would facilitate the orderly resolution of a foreign GSIB under its home jurisdiction resolution regime by preventing the exercise of cross-default rights against the foreign GSIB's U.S. operations. The proposal would also facilitate the resolution of the U.S. intermediate holding company of a foreign GSIB, and the recapitalization of its U.S. operating subsidiaries, as part of a broader MPOE resolution strategy under which the foreign GSIB's operations in other regions would enter separate resolution proceedings. Finally, the proposal would broadly prevent the unanticipated failure of any one GSIB entity from bringing about the disorderly failures of its affiliates by preventing the affiliates' QFC counterparties from using the first entity's failure as a ground for exercising default rights against those affiliates that continue meet to their obligations.

85
As discussed above, the FDI Act would prevent the exercise of direct default rights against the depository institution, but it does not address the threat posed to orderly resolution by cross-default rights in the QFCs of the depository institution's subsidiaries. This proposal would facilitate orderly resolution under the FDI Act by filling that gap.

The proposal is intended to enhance the potential for orderly resolution of a GSIB under the Bankruptcy Code, the FDI Act, or a similar resolution regime. By doing so, the proposal would advance the Dodd-Frank Act's goal of making orderly GSIB resolution workable under the Bankruptcy Code.
86

86

See
12 U.S.C. 5365(d).

The proposal could also benefit the counterparties of a subsidiary of a failed GSIB, by preventing the disorderly failure of the subsidiary and allowing it to continue to meet its obligations. While it may be in the individual interest of any given counterparty to exercise any available rights to run on a subsidiary of a failed GSIB, the mass exercise of such rights could harm the counterparties' collective interest by causing an otherwise-solvent subsidiary to fail. Therefore, like the automatic stay in bankruptcy, which serves to maximize creditors' ultimate recoveries by preventing a disorderly liquidation of the debtor, the proposal would mitigate this collective action problem to the benefit of the failed firm's creditors and counterparties by preventing a disorderly resolution. And because many creditors and counterparties of

GSIBs are themselves systemically important financial firms, improving outcomes for those creditors and counterparties would further protect the financial stability of the United States.

General creditor protections. While the proposed restrictions would facilitate orderly resolution, they would also diminish the ability of covered entities' QFC counterparties to include certain protections for themselves in covered QFCs. In order to reduce this effect, the proposal includes several substantial exceptions to the proposed restrictions.
87

These permitted creditor protections are intended to allow creditors to exercise cross-default rights outside of an orderly resolution of a GSIB (as described above) and therefore would not be expected to undermine such a resolution.

87

See
proposed rule § 252.84(e).

First, in order to ensure that the proposed prohibitions would apply only to cross-default rights (and not direct default rights), the proposal would provide that a covered QFC may permit the exercise of default rights based on the direct party's entry into a resolution proceeding, other than a proceeding under a U.S. or foreign special resolution regime.
88

This provision would help ensure that, if the direct party to a QFC were to enter bankruptcy, its QFC counterparties could exercise any relevant direct default rights. Thus, a covered entity's direct QFC counterparties would not risk the delay and expense associated with becoming involved in a bankruptcy proceeding, and would be able to take advantage of default rights that would fall within the Bankruptcy Code's safe harbor provisions.

88

See
proposed rule § 252.84(e)(1). Special resolution regimes typically stay direct default rights, but may not stay cross-default rights. For example, as discussed above, the FDI Act stays direct default rights, see 12 U.S.C. 1821(e)(10)(B), but does not stay cross-default rights, whereas the Dodd-Frank Act's OLA stays direct default rights and cross-defaults arising from a parent's receivership, see 12 U.S.C. 5390(c)(10)(B), 5390(c)(16).

The proposal would also allow covered QFCs to permit the exercise of default rights based on the failure of the direct party, a covered affiliate support provider, or a transferee that assumes a credit enhancement to satisfy its payment or delivery obligations under the direct QFC or credit enhancement.
89

Moreover, the proposal would allow covered QFCs to permit the exercise of a default right in one QFC that is triggered by the direct party's failure to satisfy its payment or delivery obligations under another contract between the same parties. This exception takes appropriate account of the interdependence that exists among the contracts in effect between the same counterparties.

89

See
proposed rule § 252.84(e)(2)-(3).

The proposed exceptions for the creditor protections described above are intended to help ensure that the proposal permits a covered entity's QFC counterparties to protect themselves from imminent financial loss and does not create a risk of delivery gridlocks or daisy-chain effects, in which a covered entity's failure to make a payment or delivery when due leaves its counterparty unable to meet its own payment and delivery obligations (the daisy-chain effect would be prevented because the covered entity's counterparty would be permitted to exercise its default rights, such as by liquidating collateral). These exceptions are generally consistent with the treatment of payment and delivery obligations under the U.S. special resolution regimes.
90

90

See
12 U.S.C. 1821(e)(8)(G)(ii), 5390(c)(8)(F)(ii) (suspending payment and delivery obligations for one business day or less).

These exceptions also help to ensure that a covered entity's QFC counterparty would not risk the delay and expense associated with becoming involved in a bankruptcy proceeding, since, unlike a typical creditor of an entity that enters bankruptcy, the QFC counterparty would retain its ability under the Bankruptcy Code's safe harbors to exercise direct default rights. This should further reduce the counterparty's incentive to run. Reducing incentives to run in the lead up to resolution promotes orderly resolution, since a QFC creditor run (such as a mass withdrawal of repo funding) could lead to a disorderly resolution and pose a threat to financial stability.

Additional creditor protections for supported QFCs. The proposal would allow additional creditor protections for a non-defaulting counterparty that is the beneficiary of a credit enhancement from an affiliate of the covered entity that is also a covered entity under the proposal.
91

The proposal would allow these creditor protections in recognition of the supported party's interest in receiving the benefit of its credit enhancement. These creditor protections would not undermine an SPOE resolution of a GSIB.

91

See
proposed rule § 252.84(g).

Where a covered QFC is supported by a covered affiliate credit enhancement,
92

the covered QFC and the credit enhancement would be permitted to allow the exercise of default rights under the circumstances discussed below after the expiration of a stay period. Under the proposal, the applicable stay period would begin when the credit support provider enters resolution and would end at the later of 5:00 p.m. (eastern time) on the next business day and 48 hours after the entry into resolution.
93

This portion of the proposal is similar to the stay treatment provided in a resolution under the OLA or the FDI Act.
94

92
Note that the exception in § 252.84(g) of the proposed rule would not apply with respect to credit enhancements that are not covered affiliate credit enhancements. In particular, it would not apply with respect to a credit enhancement provided by a non-U.S. entity of a foreign GSIB, which would not be a covered entity under the proposal. Such credit enhancements would be excluded in order to help ensure that the resolution of a non-U.S. entity would not negatively affect the financial stability of the United States by allowing for the exercise of default rights against a covered entity.

93

See
proposed rule § 252.84(h)(1).

94

See
12 U.S.C. 1821(e)(10)(B)(I), 5390(c)(10)(B)(i), 5390(c)(16)(A). While the proposed stay period is similar to the stay periods that would be imposed by the U.S. special resolution regimes, it could run longer than those stay periods under some circumstances.

Under the proposal, default rights could be exercised at the end of the stay period if the covered affiliate credit enhancement has not been transferred away from the covered affiliate support provider and that support provider becomes subject to a resolution proceeding other than a proceeding under Chapter 11 of the Bankruptcy Code.
95

Default rights could also be exercised at the end of the stay period if the transferee (if any) of the credit enhancement enters a resolution proceeding, protecting the supported party from a transfer of the credit enhancement to a transferee that is unable to meet its financial obligations.

95

See
proposed rule § 252.84(g)(1). Chapter 11 (11 U.S.C. 1101-1174) is the portion of the Bankruptcy Code that provides for the reorganization of the failed company, as opposed to its liquidation, and, relative to special resolution regimes, is generally well-understood by market participants.

Default rights could also be exercised at the end of the stay period if the original credit support provider does not remain, and no transferee becomes, obligated to the same (or substantially similar) extent as the original credit support provider was obligated immediately prior to entering a resolution proceeding (including a Chapter 11 proceeding) with respect to (a) the credit enhancement applicable to the covered QFC, (b) all other credit enhancements provided by the credit support provider on any other QFCs between the same parties, and (c) all credit enhancements provided by the credit support provider between the direct party and affiliates of the direct

party's QFC counterparty.
96

Such creditor protections would be permitted in order to prevent the support provider or the transferee from “cherry picking” by assuming only those QFCs of a given counterparty that are favorable to the support provider or transferee. Title II and the FDI Act contain similar provisions to prevent cherry picking.

96

See
proposed rule § 252.84(g)(3).

Finally, if the covered affiliate credit enhancement is transferred to a transferee, then the non-defaulting counterparty could exercise default rights at the end of the stay period unless either (a) all of the support provider's ownership interests in the direct party are also transferred to the transferee or (b) reasonable assurance is provided that substantially all of the support provider's assets (or the net proceeds from the sale of those assets) will be transferred to the transferee in a timely manner. These conditions would help to assure the supported party that the transferee would be at least roughly as financially capable of providing the credit enhancement as the covered affiliate support provider. Title II contains a similar provision regarding affiliate credit enhancements.
97

97
12 U.S.C. 5390(c)(16)(A).

Creditor protections related to FDI Act proceedings. Moreover, in the case of a covered QFC that is supported by a covered affiliate credit enhancement, both the covered QFC and the credit enhancement would be permitted to allow the exercise of default rights related to the credit support provider's entry into resolution proceedings under the FDI Act
98

under the following circumstances: (a) After the FDI Act stay period,
99

if the credit enhancement is not transferred under the relevant provisions of the FDI Act
100

and associated regulations, and (b) during the FDI Act stay period, to the extent that the default right permits the supported party to suspend performance under the covered QFC to the same extent as that party would be entitled to do if the covered QFC were with the credit support provider itself and were treated in the same manner as the credit enhancement.
101

This provision is intended to ensure that a QFC counterparty of a subsidiary of a bank that goes into FDI Act receivership can receive the same level of protection that the FDI Act provides to QFC counterparties of the bank itself.

98
As discussed above, the FDI Act stays direct default rights against the failed depository institution but does not stay the exercise of cross-default rights against its affiliates.

99
Under the FDI Act, the relevant stay period runs until 5:00 p.m. (eastern time) on the business day following the appointment of the FDIC as receiver. 12 U.S.C. 1821(e)(10)(B)(I).

100
12 U.S.C. 1821(e)(9)-(10).

101

See
proposed rule § 252.84(i).

Prohibited terminations. In case of a legal dispute as to a party's right to exercise a default right under a covered QFC, the proposal would require that a covered QFC must provide that, after an affiliate of the direct party has entered a resolution proceeding, (a) the party seeking to exercise the default right bears the burden of proof that the exercise of that right is indeed permitted by the covered QFC and (b) the party seeking to exercise the default right must meet a “clear and convincing evidence” standard, a similar standard,
102

or a more demanding standard.

102
The reference to a “similar” burden of proof is intended to allow covered QFCs to provide for the application of a standard that is analogous to clear and convincing evidence in jurisdictions that do not recognize that particular standard. A covered QFC would not be permitted to provide for a lower standard.

The purpose of this proposed requirement is to deter the QFC counterparty of a covered entity from thwarting the purpose of this proposal by exercising a default right because of an affiliate's entry into resolution under the guise of other default rights that are unrelated to the affiliate's entry into resolution.

Agency transactions. In addition to entering into QFCs as principals, GSIBs may engage in QFCs as agent for other principals. For example, a GSIB subsidiary may enter into a master securities lending arrangement with a foreign bank as agent for a U.S.-based pension fund. The GSIB would document its role as agent for the pension fund, often through an annex to the master agreement, and would generally provide to its customer (the principal party) a securities replacement guarantee or indemnification for any shortfall in collateral in the event of the default of the foreign bank.
103

A covered entity may also enter into a QFC as principal where there is an agent acting on its behalf or on behalf of its counterparty.

103
The definition of QFC under Title II of the Dodd-Frank Act includes security agreements and other credit enhancements as well as master agreements (including supplements). 12 U.S.C. 5390(c)(8)(D).

This proposal would apply to a covered QFC regardless of whether the covered entity or the covered entity's direct counterparty is acting as a principal or as an agent. Section 252.83 and section 252.84 do not distinguish between agents and principals with respect to default rights or transfer restrictions applicable to covered QFCs. Section 252.83 would limit default rights and transfer restrictions that the principal and its agent may have against a covered entity consistent with the U.S. special resolution regimes.
104

Section 252.84 would ensure that, subject to the enumerated creditor protections, neither the agent nor the principal could exercise cross-default rights under the covered QFC against the covered entity based on the resolution of an affiliate of the covered entity.
105

104

See
proposed rule § 252.83(a)(3).

105

See
proposed rule § 252.84(d). If a covered entity (acting as agent) is a direct party to a covered QFC, then the general prohibitions of section 252.84(d) would only affect the substantive rights of the agent's principal(s) to the extent that the covered QFC provides default rights based directly or indirectly on the entry into resolution of an affiliate of the covered entity (acting as agent).
See also
proposed rule § 252.84(a)(3).

Compliance with the ISDA 2015 Resolution Stay Protocol. As an alternative to compliance with the requirements of section 252.84 that are described above, a covered entity would comply with the proposed rule to the extent its QFCs are amended by to the current ISDA 2015 Universal Resolution Stay Protocol, including the Securities Financing Transaction Annex and the Other Agreements Annex, as well as subsequent, immaterial amendments to the Protocol.
106

The Protocol “enables parties to amend the terms of their [contracts] to contractually recognize the cross-border application of special resolution regimes applicable to certain financial companies and support the resolution of certain financial companies under the United States Bankruptcy Code.”
107

The Protocol amends ISDA Master Agreements, which are used for derivatives transactions. Market participants that adhere to the Protocol would amend their master agreements for securities financing transactions pursuant to the

Securities Financing Transaction Annex to the Protocol and would amend all other QFCs pursuant to the Other Agreements Annex. Thus, a covered entity would comply with the proposed rule with respect to all of its covered QFCs through adherence to the Protocol and the annexes.

106
International Swaps and Derivatives Association, Inc., “ISDA 2015 Universal Resolution Stay Protocol” (November 4, 2015), available at
http://assets.isda.org/media/ac6b533f-3/5a7c32f8-pdf/.
The Protocol was developed by a working group of member institutions of the International Swaps and Derivatives Association, Inc. (ISDA), in coordination with the Board, the FDIC, the OCC, and foreign regulatory agencies. The Securities Financing Transaction Annex was developed by the International Capital Markets Association, the International Securities Lending Association, and the Securities Industry and Financial Markets Association, in coordination with ISDA. ISDA is expected to supplement the Protocol with ISDA Resolution Stay Jurisdictional Modular Protocols for the United States and other jurisdictions. A jurisdictional module for the United States that is substantively identical to the Protocol in all respects aside from exempting QFCs between adherents that are not covered entities or covered banks would be consistent with the current proposal.

107
Protocol Press Release at
http://www2.isda.org/functional-areas/protocol-management/protocol/22.

The Protocol has the same general objective as the proposed rule: To make GSIBs more resolvable by amending their contracts to, in effect, contractually recognize the applicability of U.S. special resolution regimes
108

and to restrict cross-default provisions to facilitate orderly resolution under the U.S. Bankruptcy Code. Moreover, the provisions of the Protocol largely track the requirements of the proposed rule.
109

108
The Protocol also includes other special resolution regimes. Currently, the Protocol includes special resolution regimes in place in France, Germany, Japan, Switzerland, and the United Kingdom. Other special resolution regimes that meet the definition of “Protocol-eligible Regime” may be added to the Protocol.

109
Sections 2(a) and (b) of the Protocol provide the stays required under paragraph (b)(1) of proposed rule § 252.84 for the most common U.S. insolvency regimes. Section 2(f) of the Protocol overrides transfer restrictions as required under paragraph (b)(2) of proposed rule § 252.84 for transfers that are consistent with the Protocol. The Protocol's exemptions from the stay for “Performance Default Rights” and the “Unrelated Default Rights” described in paragraph (a) of the definition are consistent with the proposal's general creditor protections permitted under paragraph (b) of proposed rule § 252.84. The Protocol's burden of proof provisions (see section 2(i) of the Protocol and the definition of Unrelated Default Rights) and creditor protections for credit enhancement providers in FDI Act proceedings (see Section 2(d) of the Protocol) are also consistent with the paragraphs (j) and (i), respectively, of proposed rule § 252.84. Note also that, although exercise of Performance Default Rights under the Protocol does not require a showing of clear and convincing evidence while these same rights under the proposal (proposed rule § 225.84(e)) would require such a showing, this difference between the Protocol and the proposal does not appear to be meaningful because clearly documented evidence for such default rights (
i.e.,
payment and performance failures, entry into resolution proceedings) should exist.

The scope of the stay and transfer provisions in the Protocol are narrower than the stay and transfer provisions required under the proposal.
110

The Protocol also allows any non-defaulting counterparty to exercise its related default rights
111

under the agreement if an affiliate of its direct party enters resolution proceedings (other than U.S. Federal insolvency proceedings) while the top-tier U.S. parent of the counterparty's direct party remains outside of resolution proceedings.

110
The Protocol only stays default rights arising from proceedings under Chapters 7 and 11 of the Bankruptcy Code, the FDI Act, and the Securities Investor Protection Act (U.S. Federal insolvency proceedings). The stay required under proposed rule § 252.84 is broader; it requires a stay to apply under any receivership, insolvency, liquidation, resolution, or similar proceeding, and therefore includes applicable state and foreign insolvency proceedings.

111
Related default rights refer to default rights based solely on such insolvency or receivership of the affiliate.
See
paragraph (b) of the definition of Unrelated Default Rights in the Protocol.

The Protocol also provides a number of protections to supported parties that are additional to, or stronger versions of, the creditor protections the proposal otherwise permits for supported parties.
112

Specifically, the Protocol's protections require that the covered affiliate support provider or transferee to remain obligated to the “same extent” for its stay to remain effective,
113

and that the direct party remain duly registered and licensed by relevant regulatory bodies.
114

In addition, the Protocol is more specific than the proposal as to the form and timing of the assurance that the covered affiliate support provider's assets (or net proceeds therefrom) would be transferred to the transferee.
115

112
The Protocol is consistent with the creditor protections of paragraphs (e)(1) and (e)(2) of § 252.84. Section 2(b) of the Protocol requires the support provider to have entered only a Chapter 11 resolution proceeding. Section 2(b)(ii)(A)(II) requires the transferee to remain outside of resolution proceedings.

113
See paragraph (a) of the definition of DIP Stay Conditions and paragraphs (b) and (c) of the definition of Transfer Stay Conditions in the Protocol. In contrast, the proposal would not permit a covered QFC to exempt the non-defaulting party from the stay and transfer requirements of proposed rule § 252.84 if the covered affiliate support provider or transferee remains obligated to the same
or substantially similar extent
as the covered affiliate support provider was immediately prior to entering the resolution proceeding.
See
proposed rule § 252.84(g)(3).

114

See
section 2(b)(ii)(C)(I) and 2(b)(iii)(C) of the Protocol.

115
The proposal would not otherwise permit a QFC to be relieved from § 252.84's general prohibitions as long as the non-defaulting counterparty to receives “reasonable assurance” that the covered affiliate support provider's assets (or net proceeds therefrom) would be transferred to the transferee, as described above.
See
proposed rule § 252.84(g)(4). The Protocol requires that the bankruptcy court issue order to that effect at the end of the stay period. Section 2(b)(ii) of the Protocol.

A number of the additional creditor protections of the Protocol depend on whether credit enhancements have been transferred to another entity. Additional protections for situations in which the credit enhancements are transferred include the transferee satisfying all material payment and delivery obligations to each of its creditors during the stay period;
116

the transferee continuing to satisfy all financial covenants and other terms applicable to the credit enhancement provider under the agreement after the stay period;
117

and the transferee continuing to satisfy all provisions and covenants regarding the attachment, enforceability, perfection, or priority of property securing the obligations of the credit enhancement after the stay period.
118

Additional protections for situations in which the affiliate credit support provider remains obligated after the resolution proceeding include the bankruptcy court's issuance of an order by the end of the stay period providing supported parties with increased creditor priority in bankruptcy.
119

116
Section 2(b)(ii)(A)(II) of the Protocol.

117
Section 2(b)(ii)(C)(II) of the Protocol. This requirement only applies with respect to transfers to transferees that are not affiliated with the credit support provider. See
id.;
definition of Bankruptcy Bridge Company of the Protocol.

118
Section 2(b)(ii)(C)(III) of the Protocol.

119
Section 2(b)(iii)(B) and the definition of DIP Stay Conditions of the Protocol. The Protocol permits such closeout pursuant to section 2(c). The order would (1) include the grant of administrative expense status to the non-defaulting counterparty's claims against the credit enhancements the affiliate support provider has provided the counterparty; (2) allow the non-defaulting counterparty to exercise its default rights with respect to a direct QFCs supported by the affiliate support provider without further involvement from the bankruptcy court if the direct party or affiliate support provider fail to meet any material obligations to the counterparty under the agreement; and (3) allow the counterparty to exercise its default rights against the direct party and affiliate support provider without further involvement from the bankruptcy court if the direct party failed to pay or deliver to another party any close-out amount when due and the affiliate support provider does not satisfy its obligations under a credit enhancement that supports the direct QFC with the other party. Paragraphs (a)-(c) of the definition of Creditor Protection Order of the Protocol.

As compared to the creditor protections provided in the proposal, the Protocol's additional creditor protections appear to meaningfully increase a supported party's assurance that material payment and delivery obligations under its covered QFCs will continue to be performed and should meaningfully decrease the supported party's credit risk to its direct parties.
120

120

See
proposed rule § 252.85(d)(7), (9).

Moreover, the additional creditor protections do not appear to materially diminish the prospects for the orderly resolution of a GSIB entity because the Protocol includes a number of desirable features that the proposal lacks. First, when an entity (whether or not it is a covered entity) adheres to the Protocol, it necessarily adheres to the Protocol with respect to all covered entities that have also adhered to the Protocol rather than one or a subset of covered entities (as the proposal may otherwise permit).
121

Since many covered entities

have already adhered to the Protocol, any other entity that chooses to adhere will simultaneously adhere with respect to all covered entities.
122

This feature appears to allow the Protocol to address impediments to resolution on an industry-wide basis and increase market certainty, transparency, and equitable treatment with respect to default rights of non-defaulting parties.
123

Other features of the Protocol that the proposal otherwise lacks also reflect positively toward other proposed factors relevant to proposals for enhanced creditor protections: The Protocol amends all existing transactions of adhering parties;
124

does not provide the counterparty with default rights in addition to those provided under the underlying QFC,
125

and, as noted, applies to all QFCs.
126

These features also increase the chances that all or most of the QFC counterparties to a GSIB will be stayed to the same extent in the resolution of the GSIB and improve the chances that a GSIB could be resolved in an orderly manner. Finally, the Protocol is not limited to resolution under the U.S. Bankruptcy Code but also includes U.S. special resolution regimes and certain non-U.S. special resolution regimes, which should help facilitate the resolution of a GSIB across a broader range of scenarios.

121
Under section 4(a) of the Protocol, the Protocol is generally effective as between any two adhering parties, once the relevant effective date has arrived. Under section 4(b)(ii), an adhering party that is not a covered entity may choose to opt out of section 2 of the Protocol with respect to its contracts with any other adhering party that is also not a covered

entity. However, the Protocol will apply to relationships between any covered entity that adheres and any other adhering party.

122

See
proposed rule § 252.85(d)(3), (6).

123

See
proposed rule § 252.85(d)(3).

124

See
proposed rule § 252.85(d)(4). If a covered entity intends to continue to comply with the requirements of the proposal through the Protocol alternative after its initial adherence, the covered entity should ensure that future master agreements and credit enhancements also become subject to the terms of the Protocol.

125

See
proposed rule § 252.85(d)(10). Moreover, the Protocol overrides unexercised default rights in certain circumstances. Section 2(e) of the Protocol.

126

See
proposed rule § 252.85(d)(5).

The features, considered together, appear to advance the proposal's objective of increasing the likelihood that a resolution of a GSIB under a range of scenarios could be carried out in an orderly manner.
127

For these reasons, and consistent with the Board's objective of increasing GSIB resolvability, the proposed rule would allow a covered entity to bring its covered QFCs into compliance by amending them through adherence to the Protocol.

127

See
proposed rule § 252.85(d)(1)-(2).

Question 10: The Board invites comment on the proposed restrictions on cross-default rights in covered entities' QFCs. Is the proposal sufficiently clear, such that parties to a conforming QFC will understand what default rights are and are not exercisable in the context of a GSIB resolution? How could the proposed restrictions be made clearer?

Question 11: Are the proposed restrictions on cross-default rights under-inclusive, such that the proposed restrictions would permit default rights that would have the same or similar potential to undermine an orderly GSIB resolution and should therefore be subjected to similar restrictions?

Question 12: In particular, would it be appropriate for the prohibition to explicitly cover default rights that are based on or related to the “financial condition” of an affiliate of the direct party (for example, rights based on an affiliate's credit rating, stock price, or regulatory capital level)?

128

128

Cf.
12 U.S.C. 5390(c)(16) (staying “any contractual right to cause the termination, liquidation, or acceleration of such contracts based solely on the insolvency, financial condition, or receivership of the covered financial company”).

Question 13: The Board invites comment on whether the proposed restrictions should be expanded to cover contractual rights that a QFC counterparty may have to terminate the QFC at will or without cause, including rights that arise on a periodic basis. Could such rights be used to circumvent the proposed restrictions on cross-default rights? If so, how, if at all, should the proposed rule regulate such contractual rights?

Question 14: The Board invites comment on the proposed provisions permitting specific creditor protections in covered entities' QFCs. Does the proposal draw an appropriate balance between protecting financial stability from risks associated with QFC unwinds and maintaining important creditor protections? Should the proposed set of permitted creditor protections be expanded to allow for other creditor protections that would fall within the proposed restrictions? Is the proposed set of permitted creditor protections sufficiently clear?

Question 15: The Board invites comment on its proposal to treat as compliant with section 252.84 of the proposal any covered QFC that has been amended by the Protocol. Does adherence to the Protocol suffice to meet the goals of this proposal and appropriately safeguard U.S. financial stability?

Question 16: The Board invites comment on the proposed requirement for burden-of-proof provisions in covered QFCs. Is the proposed requirement drafted appropriately to advance the goals of this proposal? Would those goals be better advanced by alternative or complementary provisions?

Question 17: The Board invites comment on all aspects of the proposed treatment of agency transactions, including whether creditor protections should apply to QFCs where the direct party is acting as agent under the QFC.

F. Process for Approval of Enhanced Creditor Protections (Section 252.85 of the Proposed Rule)

As discussed above, the proposed restrictions would leave many creditor protections that are commonly included in QFCs unaffected. The proposal would also allow any covered entity to submit to the Board a request to approve as compliant with the rule one or more QFCs that contain additional creditor protections—that is, creditor protections that would be impermissible under the restrictions set forth above. A covered entity making such a request would be required to provide an analysis of the contractual terms for which approval is requested in light of a range of factors that are set forth in the proposed rule and intended to facilitate the Board's consideration of whether permitting the contractual terms would be consistent with the proposed restrictions.
129

The Board also expects to consult with the FDIC and OCC during its consideration of such a request.

129
Proposed rule § 252.85(d)(1)-(10).

The first two factors concern the potential impact of the requested creditor protections on GSIB resilience and resolvability. The next four concern the potential scope of the proposal: Adoption on an industry-wide basis, coverage of existing and future transactions, coverage of one or multiple QFCs, and coverage of some or all covered entities. Creditor protections that may be applied on an industry-wide basis may help to ensure that impediments to resolution are addressed on a uniform basis, which could increase market certainty, transparency, and equitable treatment. Creditor protections that apply broadly to a range of QFCs and covered entities would increase the chance that all of a GSIB's QFC counterparties would be treated the same way during a resolution of that GSIB and may improve the prospects for an orderly resolution of that GSIB. By contrast, proposals that would expand counterparties' rights beyond those afforded under existing QFCs would conflict with the proposal's goal of reducing the risk of mass unwinds of GSIB QFCs. The proposal also includes three factors that focus on the creditor protections specific to supported

parties. The Board may weigh the appropriateness of additional protections for supported QFCs against the potential impact of such provisions on the orderly resolution of a GSIB.

In addition to analyzing the request un

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Source: Frix Law Library, https://www.frixlaw.com/law-library/documents/fr%3A2016-11209. Public record. Not legal advice.