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The Insolvency Institute of Canada (“IIC”) recently released a report prepared by an IIC Task Force struck to consider the treatment of derivatives in Canadian insolvency law. The IIC is a non-profit organization dedicated to the recognition and promotion of excellence in the field of insolvency. Its members are drawn from the most senior experienced members of the insolvency community in Canada. The IIC is Canada’s premier private sector insolvency organization.
The Task Force convened by the IIC examined the treatment of derivatives and other eligible financial contracts (together, “EFCs”) under Canadian insolvency law in response to the heightened international scrutiny directed at some derivatives as a result of the 2008 global financial and liquidity crisis. The Task Force undertook a comprehensive review of Canadian insolvency statutes and prepared a Report consisting of recommendations for revisions to, among other things, the EFC “safe harbours” found in the Bankruptcy and Insolvency Act and the Companies’ Creditors Arrangement Act, the two main Canadian insolvency statutes that apply to the insolvencies of commercial enterprises.
The Canadian insolvency regime for EFCs consists of a series of exemptions from the law that ordinarily applies to contracts upon the commencement of insolvency proceedings. The EFC safe harbours primarily provide an exemption from the stay of proceedings to permit the termination of EFCs by the non-defaulting counterparty, the determination of the net amount owing under the terminated EFCs and the realization upon financial collateral posted in respect of EFCs. The EFC provisions provide solvent counterparties with higher priority to financial collateral posted in respect of EFCs. As a general rule, the insolvent counterparty is forbidden from terminating EFCs upon its insolvency.
The Task Force reports that the EFC safe harbours exist primarily to prevent systemic risk. However, according to the Task Force, the current treatment of EFCs in the Canadian insolvency regime does not always strike the right balance between protecting against systemic risk and allowing insolvent commercial enterprises to restructure. The Task Force suggests that the current regime may in some cases impede the restructuring of insolvent enterprises by placing too much emphasis on attempting to reduce systemic risk.
The Task Force made several recommendations regarding the treatment of EFCs in Canadian insolvency law. The recommendations relate to the following broad categories:
- Allowing the insolvent counterparty (or its court appointed officer) to terminate EFCs after the expiry an appropriate period during which the non-defaulting counterparty has a unilateral right to terminate EFCs;
- Allowing the insolvent counterparty (or its court appointed officer) to assign EFCs after the expiry an appropriate period during which the non-defaulting counterparty has a unilateral right to terminate EFCs;
- Prohibiting or rendering ineffective walk-away clauses that may otherwise apply to the obligations under EFC contracts;
- Increasing the priority afforded to financial collateral posted in respect of EFCs while clarifying the scope of financial collateral that can be so posted;
- Protecting the central clearing of OTC derivatives; and
- Ensuring that the EFC safe harbours apply consistently in receiverships.
One of the more significant recommendations of the Task Force is that the insolvent counterparty be given the right to terminate an EFC. A non-defaulting counterparty currently has a unilateral right to terminate an EFC upon the insolvency of the other counterparty. The non-defaulting counterparty is most likely to select this option when it is in-the-money on the EFC. Upon default, the non-defaulting counterparty also has the option not to terminate the EFC, which would result in the suspension of obligations to make payments under the EFC but would not require the parties to determine a net termination value of the EFC. This is more likely to happen when the non-defaulting counterparty is out-of-the-money.
The Task Force argues that the inability of the insolvent counterparty to disclaim an EFC can create uncertainty for the insolvent party and may prevent it from realizing value, which is counterproductive to the objectives of the insolvency legislation. According to the Task Force, the ability of the non-defaulting counterparty to terminate an EFC need not be indefinite to protect against systemic risk. The Task Force observes that it is important that the insolvent entity be given an opportunity to attempt to restructure and emerge from the insolvency process as a viable business. The Task Force therefore recommends that the insolvent counterparty should have the right to terminate an EFC after an appropriate waiting period.
In addition, EFCs sometimes include walk-away clauses, which permit a non-defaulting counterparty to ‘walk away’ from its obligations to an insolvent counterparty. According to the Task Force, walk-away clauses have the potential to create significant windfalls for the non-defaulting counterparties that have the benefit of such clauses while causing significant harm to defaulting (insolvent) counterparties and their creditors. The Task Force argues that walk-away clauses are disproportionately favourable to the non-defaulting counterparty and do not protect against systemic risk. The Task Force recommends that Canadian insolvency statutes should be amended to render ineffective any provisions in an EFC that have the effect of providing for or permitting anything that is, in substance, equivalent to a walk-away clause.
The Report of the IIC Task Force on Derivatives can be found here.
For more information on the IIC, please refer to its website: http://www.insolvency.ca/en/
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