25 February 2014

Enforceability of close-out netting of privately negotiated derivatives transactions in china

On 20 February 2014, International Swaps and Derivatives Association, Inc. published the new Legal memorandum on enforceability of close-out netting of privately negotiated derivatives transactions under ISDA Master Agreements in the PRC (the “New Legal Memo”) and its Chinese translation version, both prepared by King & Wood Mallesons.

ISDA published the relevant legal memo on the enforceability of close-out netting under ISDA Master Agreements in the PRC years ago. The new legal memo is prepared on the basis of the development of the Chinese derivative market and the revision of the relevant Chinese laws and regulations during the past ten years, and echoing the relevant discussion in the market. 

During the past years, the Chinese derivative market developed rapidly. The 2008 global financial crisis did not block this process materially. The derivative instruments rose and matured smoothly. At the same time, the Chinese judicial authorities and financial supervisors have been keeping to support the development of this market with the new rules, policies and actions. The National Association of Financial Market Institutional Investors (NAFMII), an organization supervised and instructed by the People’s Bank of China, published the 2009 version of the China Inter-bank Market Financial Derivatives Transactions Master Agreement in 2009, which adopted the “single agreement” concept and close-out netting mechanism for onshore derivatives transactions. The China Banking Regulatory Commission also expressed its support on the adoption of close-out netting provisions in onshore banks’ derivatives transactions in various ways. The Supreme Court, in its guidance note, requests the courts, when assessing the legality and validity of cases involving financial innovative products, to respect the specific features, customary concepts and norms applicable to the relevant commercial transaction, to consult the opinions of the PRC financial regulators, and not to simply hold a transaction to be invalid based on the ground of lack of clarity under the PRC law or regulation.

Subject to the assumptions and qualifications set out in the New Legal Memo, the views in the New Legal Memo include:

1. If (i) the parties to an ISDA Master Agreement have not selected Automatic Early Termination to apply in relation to a party who is an institution incorporated in the PRC, and (ii) the transactions under the ISDA Master Agreement have not been effectively terminated before the commencement of the bankruptcy proceeding of the Chinese counterparty, the non-defaulting party’s contractual right to terminate all the transactions by notice designating an early termination date under Section 6(a) would be subject to the administrator’s cherry-picking right under Article 18 of the PRC Enterprise Bankruptcy Law.

2. While not expressly addressed in the Bankruptcy Law or tested in PRC courts, we are of the view that the election of Automatic Early Termination in respect of a Chinese counterparty would not be subject to the administrator’s cherry-picking right under Article 18 of the Bankruptcy Law, and would be enforceable and upheld by PRC courts in a bankruptcy proceeding in respect of the Chinese counterparty under PRC law provided that:(1)there is certainty on the occurrence of the specified bankruptcy event triggering the Automatic Early Termination; (2)there is certainty on the timing of the occurrence of the early termination date; and (3)the early termination date occurs, or is deemed to have occurred, prior to the commencement of the bankruptcy proceeding in respect of the Chinese counterparty.

3. Close-out netting is not a legal concept expressly recognized under the PRC law, nor is it a concept addressed under the Bankruptcy Law. We believe that the PRC courts are likely to apply the “set-off” regulations under PRC law to determine the enforceability of close-out netting. If the early termination date of an ISDA Master Agreement occurs, or is deemed to have occurred, before the commencement of the bankruptcy proceeding in respect of the Chinese counterparty, the close-out netting provisions in determining a single lump-sum termination amount upon default of a party as contemplated in Section 6(e) is effective as a matter of contract between the parties. However, contractual set-off exercised within six months prior to the commencement of a bankruptcy proceeding may be challenged by the administrator and held to be invalid based on one of the grounds under Article 40 of the Bankruptcy Law. In the event that the calculation of the amount payable under Section 6(e) (the “Early Termination Payment”) is not completed and the statement required under Section 6(d)(i) is not served on the Chinese counterparty prior to the commencement of the bankruptcy proceeding in respect of the Chinese counterparty, determination of the close-out netting provisions in Section 6(e) may also be subject to the statutory set-off provisions under the Bankruptcy Law. If (i) the early termination date of an ISDA Master Agreement occurs on or after the commencement of the bankruptcy proceeding in respect of the Chinese counterparty or (ii) the relevant early termination date occurs before the commencement of such bankruptcy proceeding, but the calculation of the Early Termination Payment is not completed and the statement required under Section 6(d)(i) is not served on the Chinese counterparty before the commencement of such bankruptcy proceeding, the close-out netting provisions in Section 6(e) would be subject to the statutory set-off provisions under the Bankruptcy Law. Exercise of the non-defaulting party’s right of set-off pursuant to Article 40 of the Bankruptcy Law is capable of achieving the same economic effect as close-out netting under Section 6(e), although the process of asserting set-off right and the administrator’s right of challenge may cause delay and uncertainty in completing the statutory set-off procedure.

We are to hold seminars to discuss the New Legal Memo and the derivative business. Look forward to meeting you soon!

For further information, please contact:

刘志刚 | 合伙人

D +86 10 5878 5126

F +86 10 5878 5599

E [email protected]

张婷 | 合伙人

D +86 10 5878 5119

F +86 10 5878 5599

E [email protected]

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