House of Representatives

Explanatory Memorandum

(Circulated by authority of the Minister for Small Business and Assistant Treasurer, the Hon Kelly O'Dwyer MP)

Glossary

The following abbreviations and acronyms are used throughout this explanatory memorandum.

General outline and financial impact

The Financial System Legislation Amendment (Resilience and Collateral Protection) Bill 2016 (the Bill) amends the Payment Systems and Netting Act 1998 (PSN Act) and associated provisions in other Acts so that financial institutions in Australia can comply with internationally-agreed margining requirements when dealing in over-the-counter (OTC) derivatives. More specifically, it ensures that they can give, and enforce rights in respect of, margin provided by way of security.

The Bill also provides legal certainty about the operation of Australian law in relation to termination rights (also known as close out rights) under certain financial market transactions; and approved Real Time Gross Settlement (RTGS) systems, approved netting arrangements and netting markets (more specifically, market netting contracts) in all market conditions.

Date of effect: The amendments will commence on the 28th day after the Bill receives Royal Assent.

Proposal announced: The Government announced, in its response to the Financial System Inquiry (the Inquiry), on 20 October 2015 its intention to amend legislation to support globally coordinated policy efforts and facilitate the ongoing participation of Australian entities in international capital markets.

Financial impact: The measures have no financial impact on Commonwealth expenditure or revenue.

Human rights implications: This Bill does not raise any human rights issue. See Statement of Compatibility with Human Rights - Chapter 3.

Compliance cost impact: There is no regulatory compliance cost associated with this Bill.

Chapter 1 - Enforcing security, close-out netting, stays on close-out rights, approved RTGS systems, approved netting arrangements and market netting contracts

Outline of chapter

1.1 The Bill amends the Payment Systems and Netting Act 1998 (PSN Act) and associated provisions in other Acts so that financial institutions in Australia can comply with internationally-agreed margining requirements when dealing in OTC derivatives. More specifically, it ensures that they can give, and enforce rights in respect of, margin provided by way of security.

1.2 The Bill also provides legal certainty about the operation of Australian law in relation to termination rights (also known as close out rights) under certain financial market transactions; and approved RTGS systems, approved netting arrangements and netting markets (more specifically, market netting contracts) in all market conditions.

1.3 The Bill also makes consequential amendments to the Banking Act 1959 (Banking Act), Financial Sector (Business Transfer and Group Restructure) Act 1999 (Business Transfer Act), Insurance Act 1973 (Insurance Act), Life Insurance Act 1995 (Life Insurance Act), and Private Health Insurance (Prudential Supervision) Act 2015 (PHI Act).

Context of amendments

Part 1 - Enforcing security in certain financial market transactions

G20 derivatives reform

1.4 In the aftermath of the recent financial crisis, the Group of Twenty (G20) initiated a reform agenda to improve transparency in derivatives markets, mitigate systemic risk and protect against market abuse.^[1] In 2011, the G20 agreed to add margin requirements on non-centrally cleared derivatives to the OTC derivative reform agenda. Margin requirements are intended to reduce systemic risk and promote central clearing. It is anticipated that margin requirements would reduce the contagion and spill over effects experienced in the global financial crisis by ensuring that 'collateral is available to offset losses caused by the default of a derivatives counterparty'.^[2]

1.5 The margin requirements for non-centrally cleared derivatives published by Basel Committee on Banking Supervision (BCBS) and Board of the International Organization of Securities Commissions (IOSCO) (BCBS-IOSCO Margin Requirements) set out an internationally consistent framework, to be implemented by national regulators. In their Report on the Australian Derivatives Market - November 2015, the Council of Financial Regulators (CFR) stated that Australia intends to implement the BCBS-IOSCO Margin Requirements framework and the associated risk mitigation standards in its regulatory regime. It is understood that this will initially be done through the Australian Prudential Regulation Authority's (APRA) prudential standards (as a prudential standard on margining). In February 2016, APRA released a draft prudential standard, and discussion paper, on margining and risk mitigation. The draft prudential standard and discussion paper provide that margin requirements will be imposed on authorised deposit-taking institutions (ADIs), general insurers, life insurers, and 'RSE licensees' (as defined in the Superannuation Industry (Supervision) Act 1993) of registrable superannuation entities that transact in non-centrally cleared derivatives.

1.6 Under the BCBS-IOSCO Margin Requirements, covered entities are required to ensure that margin collected is 'immediately available to the collecting party in the event of the counterparty's default', but also that the collected margin is subject to arrangements that 'fully protect the posting party to the extent possible under applicable law in the event that the collecting party enters bankruptcy'.^[3] The BCBS-IOSCO Margin Requirements provide that counterparty risk exposures should be 'fully covered with a high degree of confidence' and that assets collected as collateral for initial and variation margin purposes need to be able to 'be liquidated in a reasonable amount of time to generate proceeds that could sufficiently protect collecting entities covered by the requirements from losses on non-centrally cleared derivatives in the event of a counterparty default'.^[4]

Current and future market practice for transferring margin

1.7 Participants in non-cleared derivatives markets (outside of the US markets) have traditionally transferred margin (otherwise described as collateral or credit support) by way of absolute transfer^[5] rather than by way of security.

1.8 One of the reasons why non-US market participants, including Australian market participants, have preferred to use collateral arrangements under which collateral is absolutely transferred is that the granting of security interests generally involves a number of additional enforceability, validity and perfection requirements (including, for example, registration, filing and stamping requirements). The Australian position has been further complicated by the existence of priority regimes which apply in respect of the assets of certain types of entities, stays on the enforcement of security on the commencement of certain insolvency proceedings and the introduction of the Personal Property Securities Act 2009 (PPSA) - which sets out new rules for the creation, priority and enforcement of security interests in personal property.

1.9 The requirement under the BCBS-IOSCO Margin Requirements for gross initial margin to be exchanged is likely to result in initial margin (at least) being transferred by way of security rather than by way of absolute transfer and there may be compelling reasons why market participants choose to provide both initial margin and variation margin by way of security rather than by way of absolute transfer (for example, because of benefits to the grantor/collateral provider on the secured party's insolvency).

International comparison

1.10 Many other industrialised countries (including, for example, the United Kingdom and other members of the European Union) have enacted similar legislation to clarify their securities laws to provide for 'rapid and non-formalistic enforcement procedures in order to safeguard financial stability and limit contagion effects in case of a default of a party' to certain financial markets contracts.^[6] In doing so, they both reduce possible risks for parties to certain contracts in respect of which margin is provided and remove impediments to the international competitiveness of their local financial institutions. For example, these reforms will reduce the risk that a secured party (which had based its evaluations of its counterparty credit risk on the expectation that its exposures were appropriately secured) actually loses priority to other parties on the counterparty's default.

1.11 In addition to protecting certain security-based collateral arrangements, the EU Financial Collateral Directive and UK Financial Collateral Arrangements Regulations also protect title transfer financial collateral arrangement and close-out netting provisions.^[7] The Bill does not address title transfer arrangements or close-out netting provisions, as Parts 4 and 5 of the PSN Act already provides robust protection to the process under a close-out netting contract or market netting contract by which particular obligations of the parties terminate or may be terminated, the termination values of the obligations are calculated or may be calculated and the termination values are netted, or may be netted, so that only a net cash amount (whether in Australian currency or some other currency) is payable (i.e. the close-out netting process). These protections already allow for transactions under a close-out netting contract such as an ISDA Master Agreement to be closed-out and for an outstanding obligation of the transferee to transfer equivalent collateral under a title transfer credit support arrangement (e.g. an obligation to pay an amount equivalent to the value of the credit support balance under an English law governed Credit Support Annex) to be the subject of the close-out netting process and included in the net amount which arises as a result of that process in accordance with the protections available under the PSN Act.

1.12 The fact that legislation protecting the enforcement of security in similar financial markets contracts has been thought appropriate elsewhere (including in the European Union), coupled with a concern that the absence of appropriate protections in Australia could affect the international competitiveness of Australian financial institutions, reinforces the need for this reform.

1.13 This legislation will allow Australia to maintain its position as a regional financial centre with a strong regulatory and legislative framework.

Existing Australian law (close-out netting contracts)

1.14 The objective underlying the framing of the PSN Act was to provide the utmost legal clarity and certainty that the netting arrangements established in relation to payment systems, transactions and facilities were legally valid and protected, including in situations where one of the participants or parties entered external administration.

1.15 The PSN Act provides a range of protections and carve-outs for certain retail payment systems, the RTGS system used in Australia to settle a number of important types of wholesale transactions, certain types of OTC transactions (called 'close-out netting contracts' in the PSN Act), and the contracts entered into by a central counterparty (CCP) in clearing bilateral trades or trades conducted on a financial market (called 'market netting contracts' in the PSN Act).

1.16 The PSN Act sets out a number of powerful provisions which may override other laws (e.g. insolvency laws) and contractual arrangements. Some sections of the PSN Act expressly provide that certain provisions have effect despite any other law. The paramountcy of the provisions in the PSN Act, even where a participant is subject to external administration, is critical in protecting systemic stability and ensuring the legal validity of the systems, activities and arrangements which are at the core of the financial system.

1.17 Part 4 of the PSN Act applies to financial market transactions covered by close-out netting contracts. Contracts which fall within the definition of a 'close-out netting contract' under the PSN Act are widely used in financial markets transactions such as currency (foreign exchange) derivatives, interest rate swaps and other interest rate derivatives, credit derivatives, equity derivatives, securities lending arrangements, repurchase agreements and other types of derivatives. These contracts contain terms which permit a party to the contract to terminate the contract if the counterparty becomes insolvent (or if some other condition is satisfied), to calculate the termination values of the obligations of the parties, and to net the termination values so calculated to arrive at a net amount payable by one party to the other.

1.18 The 'close-out netting contract' concept used in Part 4 of the PSN Act applies to a range of master agreements which govern the terms of derivatives transactions in respect of which margin requirements will be imposed.^[8]

1.19 With respect to close-out netting contracts, Part 4 of the PSN Act already provides that, despite any other law, obligations may be terminated, termination values may be calculated and a net amount become payable in accordance with the contract. The current provisions in the PSN Act therefore facilitate the termination of obligations to make payments and deliveries of margin under the close-out netting contract and the inclusion of the value of margin provided by way of title transfer in the calculation of the net amount payable under the relevant close-out netting contract. The reforms in the Bill to subsections 14(1) and 14(2) do not derogate from, or otherwise limit, the existing protections provided to the close-out netting process which occurs under close-out netting contracts (e.g. the process which occurs under subsection 6(e) of the ISDA Master Agreements and related title transfer credit support arrangements such as paragraph 6 of the English law governed Credit Support Annex).

Providing margin by way of security

1.20 Margin may also be provided by way of security rather than by way of absolute transfer. It is expected that at least initial margin will be provided by way of security under the margin requirements to be imposed on market participants in compliance with the key principles set out in the BCBS-IOSCO Margin Requirements. The transfer mechanism used in many of the documents under which margin is provided by way of security, such as the New York law governed Credit Support Annex and the English law governed Credit Support Deed, both published by International Swaps and Derivatives Association Inc. (ISDA), is economically similar to the way in which margin is transferred to title transfer arrangements (although it is noted that differences may arise with initial margin provided by way of security interest under forthcoming margin requirements).

1.21 However, the current protections provided under the PSN Act in respect of close-out netting contracts do not protect actions taken to enforce security (hence the preference for absolute transfer, as the inclusion of the value of the credit support balance provided under the title transfer credit support arrangements is protected under the existing close-out netting protections of Part 4 of the PSN Act). The amendments proposed in the Bill are designed to ensure that the security-based margin arrangements entered into to comply with margin requirements may be enforced in accordance with their terms, notwithstanding other contradictory laws, if they satisfy certain safeguards (such as insolvency law and inconsistent priority regimes). This will provide similar legal certainty to security-based margin arrangements as is currently provided for the netting and discharge of net obligations mechanisms inherent in close-out netting contracts supported by title transfer margin arrangements, making the legal protections broadly consistent with the economic effect of these two mechanisms.

1.22 It is vitally important to reduce risks of systemic instability and contagion effects. This means ensuring that the margin collected be immediately available to the collecting party (i.e. secured party/secured person/collateral taker) in the event of a counterparty's default and that the assets collected as collateral can be liquidated in a reasonable amount of time. It is particularly important that the collecting party can act without having to obtain consents from external administrators that may otherwise be required, and that the collecting party's rights in the collateral are not subordinated to the interests of other creditors due to the operation of other priority regimes. It is therefore necessary to amend the PSN Act to ensure that the enforcement of security (including in the case of a default or insolvency of the counterparty) is allowed, regardless of provisions in other legislation including the Corporations Act, Banking Act, Insurance Act and PPSA. Otherwise, there is a range of existing Australian law issues which could prevent the collecting party exercising its rights under security-based margin arrangements.

1.23 Some of the issues which arise in the context of creating and enforcing rights as a secured party under Australian law include:^[9]

•

the assets of an Australian ADI in Australia are subject to a priority regime which would prefer other creditors (e.g. holders of protected accounts) ahead of a secured party;^[10]

•

the assets of a foreign ADI in Australia are subject to a priority regime which would prefer liabilities of the foreign ADI in Australia ahead of a secured party;^[11]

•

the assets of a general insurer regulated under the Insurance Act in Australia are subject to a priority regime which would prefer other creditors ahead of a secured party;^[12]

•

a secured party is restricted from enforcing its security interest over an Australian company's property during the company's administration^[13] and an administrator is given certain rights in respect of dealing with property subject to circulating security interests;^[14]

•

certain stays may apply in respect of an entity due to the recognition of a foreign insolvency proceeding under the Cross-Border Insolvency Act 2008 (Cross-Border Insolvency Act);

•

client money and client property rules may affect the way in which a secured party must hold, and enforce rights against, collateral provided to it;

•

the PPSA imposes additional requirements governing the enforceability, validity and perfection of security interests;

•

the PPSA and Corporations Act set out priority rules which may result in a secured party losing priority in respect of secured assets^[15] and those Acts set out circumstances in which property secured by a security interest may vest in the grantor;^[16]

•

other security interests may arise in respect of the property of a grantor by operation of law;^[17]

•

security agreements may need to be stamped to be admissible in court proceedings; and

•

the PPSA sets out rules governing the enforcement of security interests (including procedural requirements and duties).

1.24 These legacy Australian law issues could prevent entities subject to Australian law from being able to give, or enforce rights in respect of, margin provided by way of security in the manner contemplated by the BCBS-IOSCO Margin Requirements.

1.25 The PSN Act is amended by this Bill to ensure that a party to a close-out netting contract can enforce security given over certain financial property, subject to safeguards to protect against abuse and limit the unintended consequences of such a powerful protection. The PSN Act is the preferred vehicle to make the proposed amendment because it covers the widest possible range of external administration proceedings conducted under Australian or foreign law and has the required authority to override provisions in any other legislation. The application of the PSN Act's protective framework 'despite any other law' (subject to clarifying the matters described in part 2 below and the existing carve-outs in subsections 14(3) and (5) of the PSN Act) provides a strong foundation for the protections to be provided in this Bill. The amendments to the PSN Act are not intended to create a comprehensive regime for particular types of security, but rather provide a facilitative mechanism for enforcement (which allows the secured party to enforce, and apply the proceeds, irrespective of any perfection, vesting, enforcement or priority issues which may have otherwise arisen without the PSN Act protections) if certain safeguards are satisfied.

1.26 Additionally, the protection provided under Part 4 in order for the termination of obligations, the netting of obligations and any payment made by a party under the contract to discharge a net obligation not to be void or voidable in the external administration will be extended to the enforcement of security (including the application of proceeds and irrespective of anything that may have otherwise happened to the security, such as vesting).

Subsection 14(3)

1.27 One related issue which has arisen during previous consultation processes in 2011 and 2014 relates to a drafting oversight in the PSN Act regarding existing subsection 14(3) which prevents a party to a close-out netting contract misusing the protections granted under the PSN Act. The current wording of subsection 14(3) of the PSN Act may not adequately prevent a party from abusing the PSN Act's protections. This Bill prevents such an outcome.

Expanded definition of 'external administration'

1.28 The existing definition of 'external administration' in existing section 5 of the PSN Act does not explicitly refer to certain types of resolution procedures that do not neatly fall into the traditional conception of an insolvency proceeding conducted for the benefit of creditors.

1.29 This Bill will expand the definition to explicitly cover resolution measures for bank and non-bank financial institutions, such as the statutory management regime for Australian ADIs under the Banking Act and the judicial management regime for life companies and general insurers under the Life Insurance Act and Insurance Act respectively.

1.30 Accordingly, the definition of 'external administration' will be amended to include all types of traditional insolvency proceedings and more recent processes in the nature of 'resolution' (the statutory management to which an ADI may be subject and the judicial management to which an insurer or life company may be subject).

Part 2 - Certainty for application of stays on close-out rights

Introduction

1.31 Currently, the stays imposed under the Banking Act, Business Transfer Act, Insurance Act and Life Insurance Act (Industry Acts) are potentially inconsistent with the crucial protections provided to close-out rights under derivatives arrangements under the PSN Act. Similarly, the operation of Australian resolution stays is not consistent with the approach adopted in other jurisdictions (such as the European Union).

1.32 This Bill sets out amendments to ensure, to the extent possible, that Australian law more closely reflects international best practice which has developed in recent years following the financial crisis.

1.33 The reforms in this Bill will clarify the ability of market participants to exercise certain termination rights (also known as close-out rights), and enforce security, in resolution proceedings and are intended to ensure that the Australian resolution stay regime applies in accordance with international best practice for resolution regimes. These reforms will ensure that an appropriate balance is struck between ensuring that counterparties can effectively manage their risks whilst also giving APRA the best chance to resolve an important financial institution, such as an Australian bank, which is in distress.

1.34 The concept of netting is internationally recognised as an effective way to minimise risk in high value financial transactions. Netting allows a party to a netting contract to replace a number of gross obligations with a single net position, substantially reducing the value at risk should one party default. The PSN Act was enacted in part to provide a certain legal basis for the effectiveness of defined categories of netting contracts in Australia. The ability of a party to net obligations has become increasingly important not only for managing credit risk but also for determining capital requirements.

Potential inconsistency in law

1.35 Stakeholders have raised a concern that the PSN Act and the Industry Acts are inconsistent as to whether the appointment of a statutory manager or judicial manager (as applicable) to an ADI, life insurer and general insurer regulated by APRA (each, a Regulated Entity) allows a counterparty to a netting contract to legally terminate the contract, calculate the values of outstanding obligations, and aggregate these values so that only the net cash amount is payable / receivable (that is, 'close-out' transactions relating to the netting contract).

1.36 Currently, section 15C of the Banking Act provides that the fact that a statutory manager is in control of an ADI's business does not allow the contract, or a party to the contract, to do any of the following:

•

deny any obligations under that contract;

•

accelerate any debt under that contract; or

•

close-out any transaction relating to that contract.

1.37 Corresponding provisions exist in the Insurance Act and Life Insurance Act when a judicial manager is in control of an insurer; and in the Business Transfer Act when a compulsory transfer of business has been effected under that Act. Other provisions which have a similar effect are set out in the Industry Acts in respect of certain other resolution-related activities such as the giving of directions, the giving of recapitalisation directions and the taking of certain actions in respect of a recapitalisation. These other provisions are discussed in further detail in the 'Detailed explanation of new law' part of this memorandum.

1.38 Without such provisions, the regulatory actions described in the relevant sections of the Industry Acts could potentially constitute an 'event of default' or other 'specific event' under many commercial contracts. Such 'events' have the potential to trigger a number of contractual consequences, which may ultimately have an adverse effect on the financial position of the regulated entity and cause systemic disruption. The provisions in the Industry Acts are therefore designed to ensure that specified actions taken by APRA do not constitute such 'events' or trigger such consequences.

1.39 In contrast to the Industry Acts, subsections 14(2) and 16(2) of the PSN Act provide certain netting protections may apply if, respectively:

•

a person who is, or has been, a party to a close-out netting contract goes into external administration and Australian law governs either the external administration or the contract; or

•

a party to a market netting contract goes into external administration and Australian law governs either the external administration or the contract.

1.40 In general terms, subsections 14(2) and 16(2) of the PSN Act provide that, in certain circumstances, transactions under the close-out netting contract or market netting contract may be 'closed-out' if a party to a close-out netting contract or market netting contract goes into external administration.

1.41 The inconsistency between the protection given to close-out netting under the PSN Act and stay on closing out transactions under the Industry Acts creates uncertainty as to the capacity of a party to a netting contract to exercise a contractual right to close-out transactions relating to a contract with a Regulated Entity that is under statutory or judicial management. This uncertainty has the potential to impede the efficiency of the financial markets in Australia by making it more difficult for Australian entities to enter into hedging arrangements, as well as impeding the ability of the APRA to effectively manage distress in financial institutions and also impacting on the amount of capital required to be held by Regulated Entities.

1.42 Certainty of close-out netting rights is fundamental to domestic and foreign market participant's assessment of the risks associated with transacting with Australian Regulated Entities, and any uncertainty could inhibit Australian Regulated Entities' abilities to fully participate in global financial markets. However, this needs to be balanced with the need for a stay to apply in respect of certain termination rights which may be granted under contracts to which a regulated entity is party, to enable the resolution authority (e.g. APRA) to adequately resolve the Regulated Entity so that obligations continue to be met (whether in the existing Regulated Entity or through a transfer of business).

1.43 To address this inconsistency, this Bill sets out amendments to clearly define the extent to which a counterparty may exercise existing rights to close-out transactions under a close-out netting contract or market netting contract due to the appointment of a statutory or judicial manager (or occurrence of other regulatory action or circumstances described in the relevant section of the Industry Act) (if at all). The amendments are to provide certainty:

•

as to the circumstances in which a counterparty to a close-out netting contract or to certain related security is stayed from exercising close-out rights or enforcing security triggered solely by the appointment of a statutory or judicial manager or compulsory transfer of business, and the duration of any such stay; and

•

that the stays described in the Industry Acts do not apply to market netting contracts.

International developments

1.44 Since the global financial crisis, prudential regulators and legislatures have sought to develop resolution regimes for regulated financial institutions to improve the relevant regulator's ability to manage a financial institution which becomes distressed and limit any possible contagion effects of that distress.

1.45 One aspect of the resolution regimes which have been adopted, or are being developed, internationally is the ability of the resolution authority (e.g. the prudential regulator) of a regulated entity to suspend the termination rights (also called close-out rights) of counterparties under contracts, including derivatives contracts.

1.46 In October 2011 the Financial Stability Board (FSB) released its Key Attributes of Resolutions Regimes for Financial Institutions (the Key Attributes), which outlined the core elements that would allow authorities to resolve financial institutions in an orderly manner without taxpayer exposure. In particular, the FSB stated that the legal framework governing netting contracts should be clear, transparent and enforceable during a crisis, and should not hamper the effective implementation of resolution measures.

1.47 The FSB Key Attributes recommended:^[18]

'The legal framework governing set-off rights, contractual netting and collateralisation agreements and the segregation of client assets should be clear, transparent and enforceable during a crisis or resolution of firms, and should not hamper the effective implementation of resolution measures.

Subject to adequate safeguards, entry into resolution and the exercise of any resolution powers should not trigger statutory or contractual set-off rights, or constitute an event that entitles any counterparty of the firm in resolution to exercise contractual acceleration or early termination rights provided the substantive obligations under the contract continue to be performed.

Should contractual acceleration or early termination rights nevertheless be exercisable, the resolution authority should have the power to stay temporarily such rights where they arise by reason only of entry into resolution or in connection with the exercise of any resolution powers'.^[19]

1.48 Another key development in the international approach to financial institution resolution has been that, in 2014, ISDA published the 2014 Resolution Stay Protocol (relaunched as the ISDA 2015 Universal Resolution Stay Protocol in November 2015) (Stay Protocol). It enables parties to amend the terms of certain agreements to contractually recognise 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. This is achieved by the parties to the Stay Protocol contractually recognising temporary stays of cross-default and early termination rights when a party to the contract is subject to a resolution action. The Stay Protocol sets out certain requirements which must be satisfied in order for the limitations on the exercise of particular default rights of parties to be applicable, including that the exercise of authority under the 'Protocol-eligible Regime' (as defined in the Stay Protocol) complies fully with each element of the 'Creditor Safeguards' (as defined in the Stay Protocol). One Creditor Safeguard is that, whilst resolution-based 'Default Rights' are, or at the discretion of the administrative authority may be, temporarily or permanently stayed, nullified, invalidated or otherwise overridden in the relevant context, the duration of a temporary stay on close-out rights must not exceed two business days.

1.49 Due to the increasing importance of cross-border resolution proceedings for large international financial institutions, it will be important that the stays imposed under Australian statutes, including the stay imposed under the Business Transfer Act, operate in accordance with international best practice, as described in the FSB Key Attributes of Effective Resolution Regimes and the Stay Protocol.

Stay on enforcing security

1.50 The stays currently set out in the Industry Act do not expressly prevent a regulated entity's counterparties from enforcing rights against any collateral that has been lodged as part of a security-based credit support arrangement on the grounds described in the relevant section of the Industry Act.

1.51 Accordingly, a risk arises that, if a Regulated Entity has lodged collateral with a counterparty as part of a security-based credit support arrangement, the terms of the security arrangement may provide for a right on the part of the counterparty to take action in realising or otherwise obtaining benefit from the security or collateral due to the appointment of the statutory manager or judicial manager or compulsory transfer of business. The enforcement of security (e.g. by liquidating a Regulated Entity's assets subject to the security) could exacerbate what would be the already fragile financial position of Regulated Entities in distress and frustrate measures taken by the Government to stabilise them and resolve the distress they are in.

1.52 In order to ensure that the enforcement of security is stayed under the Industry Acts in the same way as close-out netting rights are stayed, this Bill will amend section 15C of the Banking Act and the equivalent provisions in other Industry Acts to ensure that the mere appointment of a statutory manager or judicial manager to, or compulsory transfer of business from, the regulated entity does not trigger these terms.

Business Transfer Act amendments

1.53 The FSB's Key Attributes outline international best practice in the area of financial crisis resolution. One of the key attributes was that a resolution authority (such as APRA) should only be permitted to 'transfer all of the eligible contracts with a particular counterparty to a new entity and would not be permitted to select for transfer individual contracts with the same counterparty and subject to the same netting agreement' ('no cherry-picking' rule) (paragraph 2.1(iii) of Key Attributes). The Stay Protocol also treats obligations arising from related credit support arrangements (both title transfer-based and security-based collateral arrangements) in the same way as obligations relating to transactions documented under covered agreements. This is because counterparties generally based their credit assessments on not only the exposures under the master agreement itself but also the collateral provided under the associated credit support arrangements.

1.54 Effectively, cherry picking could allow APRA to select only those transactions with a positive value to the new entity, and leave behind all those transactions with a negative value, leaving the counterparty without netting protection. Cherry picking could also allow for transactions being transferred without the associated credit support (or the associated assets provided as credit support) being transferred without the associated transactions, leaving the counterparty without the protection which would otherwise arise from the associated credit support. Such an outcome would place counterparties at a substantial disadvantage during a transfer of business process. This risk would be taken into account as part of the credit risk process when a party considers whether to enter into a netting contract. The result could be to inhibit contracting and consequently reduce the benefits which can flow from netting contracts.

1.55 This Bill amends the Business Transfer Act to clarify that particular transactions under a particular close-out netting contract, market netting contract or approved netting arrangement cannot be transferred without the other transactions under that close-out netting contract, market netting contract or approved netting arrangement (i.e. 'cherry picking' is not to occur within a close-out netting contract, market netting contract or approved netting arrangement). Assets and liabilities which are subject to a security-based credit support arrangement in support of obligations under a close-out netting contract or market netting contract will be treated in a broadly similar way. Any such transfer will be void in respect of the relevant contract or arrangement and certain assets over which the security has been granted. This would also have the effect of voiding any partial transfer sought to separate the assets and liabilities under a particular close-out netting contract or market netting contract from the collateral provided in respect of that contract in a manner where the enforcement of the credit support arrangement would have been protected under the PSN Act. For example, in relation to assets that are property over which security is given in respect of an obligation of the transferring body under the close-out netting contract, the partial transfer would only be void to the extent the assets are financial property in the possession or control of the counterparty or its nominee. This avoids a situation where an all-assets security could otherwise obstruct APRA's ability to effectively arrange a compulsory transfer.

1.56 This amendment will not otherwise constrain or fetter the regulators' ability to pick and choose which assets and liabilities to transfer or otherwise affect the validity of the transfer generally. This reflects the FSB recommendation and applies regardless of whether a statutory manager or judicial manager is appointed.

Part 3 - Impact of non-terminal administrations on participation in approved RTGS systems and approved netting arrangements

Approved RTGS systems

1.57 In RTGS systems, individual payments are processed and settled continuously in real time. For example, under the Reserve Bank of Australia's RTGS system, known as the Reserve Bank Information and Transfer System (RITS), the processing of payments only occurs if the paying institution has funds available in its settlement account with the central bank. Settlement through an RTGS system prevents unintended credit risk arising from the settlement process, as the release of funds to the payee's account occurs at the time - or shortly after - the corresponding entries are passed to their institutions' accounts with the central bank. In this way the transaction is completed in all its elements - including settlement - immediately and irrevocably.

1.58 Part 2 of the PSN Act applies in respect of approved RTGS systems. An approved RTGS system is a payment or settlement system approved by the Reserve Bank of Australia (RBA), by legislative instrument, under section 9 of the PSN Act. Part 2 of the PSN Act was intended to overcome the effects of the Zero Hour Rule^[20] in relation to approved RTGS systems and ensure that transactions executed through an approved RTGS system are not declared to be void by a court or some other competent authority by virtue of section 468 of the Corporations Act (and other similar existing legislative provisions).

Modern resolution regimes and need for reform

1.59 In the years since the introduction of the PSN Act, external administration proceedings which are intended to be rehabilitative, rather than distributive, in nature have become more important, particularly in the context of systemically important financial institutions, such as banks, insurers and financial market infrastructure (FMI). These regimes, often described as 'resolution regimes', focus on resolution and reorganisation of the institution and aim to facilitate the institution continuing as a going concern. Examples of such regimes include the statutory management regime for ADIs set out in the Banking Act and the judicial management regimes for general insurers and life companies set out in the Insurance Act and Life Insurance Act respectively. More traditional external administration proceedings, such as administration under Part 5.3A of the Corporations Act, also have a rehabilitative aim and such proceedings do not necessarily end with the 'death' of the company which is subject to the proceeding. It has also been recognised that there is a possibility that an administrator may be appointed by the board of a Regulated Entity which is an Australian company before a statutory manager was appointed.

1.60 In order for these resolution measures to be effective in 'resolving' the Regulated Entity, the external administrator (e.g. the statutory manager, judicial manager or administrator) needs to be able to continue to operate the Regulated Entity's business. It may be beneficial to the Regulated Entity, other participants and financial system stability generally, if the Regulated Entity was able to continue to participate in the approved RTGS system. However, this can only occur if other participants can continue to transact with the participant that is subject to the resolution measure without risk that the payments or transfers that they receive from the Regulated Entity may be unwound.

1.61 Any inability of a Regulated Entity to access an approved RTGS system, such as RITS, could accelerate the failure of the Regulated Entity, which is the very outcome the resolution measure is trying to avoid. Accordingly, it is important that the protections provided to approved RTGS systems, and approved netting arrangements (described below), under the PSN Act allow a financial institution which is under the control of a statutory manager or judicial manager to continue to transact in key systems (e.g. RITS and certain other systemically important payment systems).

Approved netting arrangements

1.62 In addition to approved RTGS systems, some systemically important payment systems and multilateral netting arrangements crucial for the operation of the Australian financial systems are protected under the PSN Act as approved netting arrangements.^[21] Under approved netting arrangements, a series of gross payment obligations between parties are replaced by a single net position as between the parties.

1.63 Part 2 of the PSN Act applies to approved netting arrangements. An approved netting arrangement is a netting arrangement approved by the RBA under section 12 of the PSN Act. Under section 11, a person may apply to the RBA for approval of an arrangement that has more than two parties and under which the obligations owed by the parties to each other are netted and the RBA may approve the arrangement if it is satisfied of certain criteria.

1.64 Under section 10 of the PSN Act, if a party to an approved netting arrangement goes into external administration, the party may do anything permitted or required by the arrangement in order to net:

•

obligations incurred before or on the day on which the party goes into external administration; and

•

net obligations if the obligations that are directly or indirectly netted are incurred before or on the day on which the party goes into external administration.

1.65 As is the case in respect of approved RTGS systems, any inability of a Regulated Entity to access an approved netting arrangement such as the payment systems operated by Australian Payments Clearing Association (APCA) could accelerate the failure of the Regulated Entity. The reform set out in this Bill to Part 3 of the PSN Act in respect of non-terminal administrations is intended to ensure that a participant that is subject to a non-terminal administration may continue to participate in the approved netting arrangement, notwithstanding the non-terminal administration. For example, it is important that the operator of the approved netting arrangement may net obligations incurred by the resolution authority, on behalf of the participant, during the time at which the participant is subject to the non-terminal administration.

1.66 Accordingly, it is important that the protections provided to approved netting arrangements under the PSN Act allow a financial institution which is under the control of a statutory manager or judicial manager to continue to transact in these arrangements.

Part 4 - Cash market settlement activities in approved netting arrangements

1.67 Australia's cash equity settlement system is currently operated through a licensed clearing and settlement facility (i.e. the holder of an Australian Clearing and Settlement (CS) facility licence under the Corporations Act). The multilateral netting arrangement documented by the operating rules of the cash equity settlement system is approved by the RBA under section 12 of the PSN Act. The netting arrangement is therefore an 'approved netting arrangement' in terms of Part 3 of the PSN Act. Settlement occurs in the system through the simultaneous exchange of title to securities for payment (commonly known as 'delivery versus payment' or 'DvP') in the settlement facility on a deferred multilateral net basis (commonly referred to as 'daily batch' settlement).

1.68 If a participant in the system enters external administration, there may be a risk that transactions settled by the participant on or after the day on which it enters external administration (for example, because the transactions are settled on a deferred basis (e.g. t+2, t+3), settlement occurs after external administration) may be unwound under general Australian insolvency law. It may not be practicable to mitigate this risk by either obtaining the external administrator's prior consent, or suspending the participant from the settlement system immediately, without risking delays to settlement or liquidity problems for non-defaulting participants.

1.69 This Bill amends the PSN Act to clarify that the settlement by way of a payment or a transfer of property by a party under the arrangement to discharge a net obligation which arises under the arrangement by a participant is explicitly validated, where such settlements occur under an approved netting arrangement contained in the rules of, or contracts which relate to, a licensed CS facility (as defined in section 761A of the Corporations Act). Please also refer to impact of the amendments discussed in respect of the impact of non-terminal administrations on participation in approved RTGS systems and approved netting arrangements on the netting of certain obligations incurred during non-terminal administrations.

Part 5 - Market netting contracts and recovery regimes for netting markets

1.70 One part of the PSN Act deals with netting arrangements covered by market netting contracts. These include contracts used by certain stock exchanges, derivatives exchanges and clearing facilities, including CCPs. CCPs are highly important financial market infrastructure, particularly in modern markets as domestic and international regulation is mandating that certain transactions which were previously entered into on a bilateral basis be cleared through a CCP.

1.71 The PSN Act currently provides a range of powerful protections in respect of market netting contracts. These protections reflect the importance of these netting markets to financial system stability and encompass the protection of netting, the enforcement of security, and the transfer of property, rights and obligations (e.g. porting). To ensure that the insolvency of one member of the market does not have a systemic impact on all members of the market, it is extremely important that these arrangements are effective and legally certain.

1.72 CCPs across the world are implementing a comprehensive suite of 'recovery powers' that will enhance their ability to withstand extreme financial shocks. International regulatory guidance applicable to systemically important financial market infrastructures such as certain CCPs requires them to develop comprehensive and effective recovery plans (because the 'disorderly failure of such a CCP could lead to severe systemic disruptions') and ensure their recovery powers are 'reliable, timely, and have a sound legal basis'.^[22] It is important to ensure that a CCP's recovery rules are robustly protected, including in respect of contributions by a participant to a CCP's mutualised financial resources (default fund); and that such contributions will not be void or voidable in the event that the participant subsequently enters external administration.

1.73 This Bill will amend the legislative protections currently provided to netting markets such as CCPs to protect the CCP's exercise of its recovery powers, including the receipt of default fund contributions (and other obligations), by providing robust protection of the contractual rules governing the netting market.

1.74 These amendments will also provide robust protections to payments, and transfers of and dealings with, rights, obligations or property, in accordance with the rules that govern the operation of a netting market. This will protect default fund contributions and other payments or transfers of property by the party to meet an obligation under a market netting contract from being void under Australian insolvency law.

Summary of new law

Part 1 - Enforcing security in certain financial markets transactions

1.75 The expansion of the protections of Part 4 of the PSN Act to protect the enforcement of security in the context of margin requirements is required to ensure that, in circumstances where Australian law applies, entities are able to comply with the 2015 BCBS Margin Requirements (and the way in which those requirements are imposed by regulators domestically and internationally) and that such enforcement of security is not impeded by existing Australian law.

1.76 However, this extension of the protections is subject to the safeguards set out in the Bill and security may only be enforced if it complies with the criteria set out in the new provisions.

1.77 If subsections 14(1) or 14(2) of the PSN Act apply, then security given over financial property, in respect of obligations of a party to the contract, may be enforced in accordance with the terms of the security, provided the terms of the security are evidenced in writing (and subject to the safeguards set out in the Bill). However, in order for the enforcement of security over financial property, in respect of obligations of a party to a close-out netting contract, to prevail despite any other law in the manner set out in the Bill, a number of criteria must be satisfied, including that:

•

the obligations secured by the financial property, and discharged through the enforcement must be:

-

eligible obligations (as defined in the Bill) in relation to the close-out netting contract;

-

obligations under the contract of a party to the contract to pay interest on an eligible obligation; or

-

obligations of a party to the contract to pay costs and expenses incurred in connection with enforcing security given in respect of an eligible obligation;

•

before enforcement, the financial property must be transferred or otherwise dealt with so as to be in the possession or under the control of the secured person (i.e. the secured party) or another person (other than the grantor) on behalf of the secured person under the terms of an arrangement evidenced in writing. The requirement that the terms of the arrangement provide that the other person (i.e. the intermediary or custodian) has the possession or control of the financial property on behalf of the secured property does not cover the scenario commonly seen in project finance or syndicated facility transactions whereby a security trustee holds security over assets (and potentially holds the assets provided under that security) for the benefit of other interested parties in addition to a counterparty to the close-out netting contract (i.e. the counterparty being the secured person); and

•

the enforcement is carried out in a manner that complies with section 420A of the Corporations Act (if it applies) and any applicable general law duties that are not inconsistent with the terms of the security.

1.78 The Bill ensures that a party does not have the protections provided by the PSN Act if they knowingly purchased obligations under a close-out netting contract of an insolvent party from a third party.

Part 2 - Certainty for application of stays on close-out rights

1.79 The Bill promotes the capacity to effectively resolve distress of regulated bodies in the financial sector, and the stability of Australia's financial system, by addressing the inconsistency between the PSN Act and the Industry Acts in ways that broadly align Australian law to international standards, taking into account recent international developments.

1.80 The amendments in the Bill strike a balance between the dual objectives of protecting the legitimate interests of parties to netting contracts, while at the same time ensuring the Commonwealth can effectively address prudential concerns with a financial institution. The amendments will clarify that:

•

the protections given to approved RTGS systems, approved netting arrangements and market netting contracts under the PSN Act prevail over stays on close-out rights and the enforcement of security;

•

stays on close-out rights and enforcement of security set out in the Industry Acts prevail over the protections given in respect of close-out netting contracts under the PSN Act in the circumstances and for the duration set out in the Bill. However, the stays in the Industry Acts only relate to the particular action described in the relevant stay provision and do not prohibit a party closing out, or enforcing security, for any other reason (e.g. a counterparty may still terminate because the regulated body, e.g. an ADI, fails to make a payment or perform an obligation, irrespective of whether that failure to pay or perform was in compliance of a direction by the resolution authority);

•

in respect of certain derivatives-related arrangements, certain stays (e.g. the stay which arises on the appointment of a statutory manager or judicial manager) apply to restrict a party from exercising its close-out rights or enforcing security for a temporary period (generally, that time period ends at midnight by legal time in the Australian Capital Territory at the end of the first business day after the day on which the trigger event happens e.g. the appointment of the statutory manager which is a close-out right). This time period is described as the 'resolution period' in the PSN Act and has the meaning given in section 15A; and

•

a stay may continue to apply permanently if APRA declares it is satisfied of certain solvency- and licensing-related matters in respect of the regulated body in respect of which the stay applies. However, during the resolution period, APRA may declare instead that the stay ceases if it is satisfied that it will not make a declaration that the relevant stay continues.

1.81 Generally, the amendments are intended to:

•

reduce the risk of foreign counterparties declining to enter into such contracts with Regulated Entities in Australia, thereby reducing the risk that such Entities are unable to hedge their risks and maintain business dependent on those risks being hedged; and

•

reduce the risk of contagion in periods of financial distress by providing confidence to foreign counterparties that the Australian law is broadly consistent with accepted international benchmarks.

Close-out netting contracts

1.82 Close-out netting is a contractual mechanism that permits one party to the contract to terminate the contract if the other party becomes insolvent, to calculate the termination values of the obligations of the parties, and to net the termination values so calculated to arrive at a net amount payable by one party to the other. This mechanism reduces financial risk and provides legal certainty to parties to a bilateral contract in the case of insolvency of one party to the contract.

1.83 The Bill establishes a framework in respect to close-out netting contracts and the appointment of a statutory or judicial manager to one of the parties to the contract (the Regulated Entity). The specific mechanisms are described in the 'Detailed explanation of new law' below.

Approved RTGS systems, approved netting arrangements and market netting contracts

1.84 Due to the importance of approved RTGS systems, approved netting arrangements and netting markets to systemic stability and in light of recent international developments, the Bill clarifies that the protections provided in respect of approved RTGS systems, approved netting arrangements and netting markets have effect despite any other law (including the specified provisions and the specified stay provisions).

Voidable preferences

1.85 The Bill also extends the existing protection provided in section 14 of the PSN Act that the termination of obligations, the netting of obligations and any payment under the close-out netting contract to discharge a net obligation are not considered void or voidable in the external administration to certain things done by a party to a close-out netting contract or security while the party is in ADI statutory management or judicial management and a specified stay provision applies to the contract or security (as applicable). Such things are provided with legal certainty, and are unable to be 'clawed-back' under the operation of insolvency law, to facilitate an external administrator such as a statutory manager achieving the objectives of the external administration.

Business Transfer Act amendments

1.86 The Bill also provides that, if there is a partial transfer of the business under the Business Transfer Act of a transferring body which is a party to a close-out netting contract, market netting contract, approved netting arrangement or certain related security - and the partial transfer covers some (but not all) of the assets and liabilities the body has; under the contract or arrangement, with respect to another party to the contract or arrangement, or certain assets that are property over which security is given in respect of such a contract, that partial transfer is void to the extent of the assets or liabilities the transferring body has, just before the partial transfer, under the contract or arrangement, with respect to the counterparty and void to the extent of certain assets which were subject to the security. The Bill deals with the interaction between partial transfers and security given over financial property, in respect of an obligation of the transferring body under a close-out netting contract and security given over property, in respect of an obligation of the transferring body under a market netting contract.

Part 3 - Impact of non-terminal administrations on participation in approved RTGS systems and approved netting arrangements

1.87 The amendment to Part 2 of the PSN Act protects payments and transfers executed through an approved RTGS system before the participant goes into, or while it is in, non-terminal administration. A person goes into non-terminal administration if it goes into external administration and, if the person is a body corporate-the external administration is not a winding up under the Corporations Act or a corresponding process under a law of a foreign country (which includes the laws of a state of a foreign country) (and includes any winding up, liquidation or dissolution under that law) and, if the person is an individual-the external administration is not the result of the person becoming a bankrupt under the Bankruptcy Act 1966, or the person having a corresponding status under a law of a foreign country (which includes the laws of a state of a foreign country) (i.e. a non-terminal administration, as defined in the Bill).

1.88 The protection provided under section 6 of the PSN Act is extended by the Bill to provide that, if a participant in an approved RTGS system goes into non-terminal administration, any payment or settlement transaction which involves the payment of money or the transfer of an asset by the participant which is executed through the system at any time before the participant goes into, or while the participant is in the non-terminal administration has the same effect it would have had if the participant had not gone into that non-terminal administration. It is important to note that sections 6 and 6A, as with the other relevant sections of the PSN Act, apply separately in respect of each external administration.

1.89 However, this amendment does not affect the operation of section 6, as currently drafted, with respect to external administrations which are not non-terminal administrations. Such an external administration includes, in respect of a body corporate, a winding up under the Corporations Act (irrespective of whether the winding up is a winding up in insolvency, a winding up by the court on other grounds, a winding up by ASIC or a voluntary winding up) or a corresponding process under foreign law or, in respect of an individual, a person becoming a bankrupt under the Bankruptcy Act or having a corresponding status under foreign law.

1.90 The key objectives of the reforms to the protection provided under the PSN Act to approved RTGS systems^[23] and approved netting arrangements^[24] are:

•

that transactions completed by a member of an approved RTGS system who is subject to a non-terminal administration are not void by virtue of the zero hour rule, section 468 of the Corporations Act or any similar approach that would automatically make void all payments completed by the RTGS system member who is under external administration. This is particularly important in respect of statutory management and judicial management; and

•

ensure that a Regulated Entity which is subject to a resolution measure such as statutory management can effectively participate in an approved RTGS system and that counterparties to transactions through approved RTGS systems can transact through such a system with confidence.

1.91 The system administrator continues to have discretion over whether they suspend a participant in external administration.

1.92 In order for a Regulated Entity to be able to continue to access an approved netting arrangement during a resolution measure such as statutory management, the protections provided to approved netting arrangements under section 10 must extend to:

•

obligations incurred before the participant such as a Regulated Entity goes into, and while the participant is in, such a non-terminal external administration (such as a resolution measure like statutory management); and

•

net obligations if the obligations that are directly or indirectly netted are incurred before the participant such as a Regulated Entity, and while the participant is in, such a non-terminal external administration.

1.93 This is expected to facilitate the continued participation of the Regulated Entity in the approved netting arrangement where such participation may be fundamental to the entity's ongoing viability (e.g. due to the necessity of making payments through such an arrangement).

Part 4 - Cash market settlement activities in approved netting arrangements

1.94 Amendments are made to Part 3 of the PSN Act to provide that, for an approved netting arrangement that is governed by the rules of a licensed CS facility (as defined in section 761A of the Corporations Act), a payment, or a transfer of property, by a party under the arrangement to discharge a net obligation (such net obligation being a net obligation which arises under the approved netting arrangement) is not to be void or voidable in the event that a party to the arrangement is, or comes under, external administration.

Part 5 - Market netting contracts and payments and transfers under netting markets

1.95 The definition of market netting contract in the PSN Act is amended to include the rules governing the operation of a netting market if those rules have effect as a contract between a participant in the netting market and one or more other persons.

1.96 Part 5 of the PSN Act is amended to provide that any payment or a transfer of property (whether absolutely or by way of security) by the party to meet an obligation under the market netting contract is not to be void or voidable in the external administration of the party to the market netting contract.

Comparison of key features of new law and current law

Detailed explanation of new law

Part 1 - Enforcing security in certain financial markets transactions

Existing provisions of the PSN Act

1.97 Section 14 of the PSN Act sets out certain actions that may be done under the terms of close-out netting contracts. Close-out netting contracts are defined in section 5 of the PSN Act as a contract under which, if a particular event happens:

•

particular obligations of the parties terminate or may be terminated;

•

the termination values of the obligations are calculated or may be calculated; and

•

the termination values are netted, or may be netted, so that only a net cash amount (whether in Australian currency or some other currency) is payable.^[26]

1.98 The PSN Act in this manner provides certain protections to the contracts widely used in financial markets transactions such as currency (foreign exchange) derivatives, interest rate swaps and other interest rate derivatives, credit derivatives, equity derivatives, securities lending agreements, master repurchase agreements and other types of derivatives.

1.99 Existing subsection 14(1) allows obligations under a close-out netting contract to be terminated, termination values to be calculated and a net amount to become payable in accordance with the contract if Australian law governs the close-out netting contract and the contract is entered into in circumstances that are within Commonwealth constitutional reach. Subsection 14(2) allows the same thing to be done and provide other insolvency-related protections where a person who is, or has been, a party to a close-out netting contract goes into external administration and Australian law governs either the external administration or the contract, and makes it explicit that termination and netting can occur despite the external administration. These two subsections are not mutually exclusive. The existing subsections 14(3) and 14(5) provide that a person may not rely on the application of subsections 14(1) and 14(2) (subsection 14(1) only in the case of subsection 14(3)) if certain conditions set out in subsections 14(3) or 14(5) are present. Subsection 14(4) currently provides that subsections 14(1) and 14(2) have effect despite any other law (including the specified provisions, which are defined in section 5.

1.100 The ability to override other legislation makes these provisions in the PSN Act particularly powerful. The main policy rationale for the special powers provided under the PSN Act is that the entities and transactions that benefit from them are at the heart of the financial system and are important in protecting financial systemic stability.

1.101 While the protection provided by section 14 of the PSN Act is powerful, it is limited in all cases to actions that are allowed under the terms of the close-out netting contract. In the case of two parties transacting under a close-out netting contract, each transaction entered into between the parties occurs under the close-out netting contract. Accordingly, the scope of the actions permissible under section 14 of the PSN Act is significantly determined by the terms of the close-out netting contract. The reforms set out in the Bill to subsections 14(1) and 14(2) in relation to enforcing security do not limit the existing protections available under the PSN Act (including those in respect of close-out netting in paragraphs 14(1)(c) and 14(2)(c)) or otherwise adversely affect the existing protection of close-out netting contracts (including any related title transfer credit support arrangements) under the close-out netting protections of the PSN Act. Additionally, these reforms are facilitative and do not adversely affect the rights which a secured party may otherwise have under Australian law.

Amendments to subsection 14(1) of the PSN Act

1.102 Amendments are made to subsection 14(1) of the PSN Act that allow a person to whom security has been granted (this party is called the secured party or secured person interchangeably in this explanatory memorandum but is referred to in the Bill as the 'secured person') to enforce security in certain situations in accordance with the terms of the security where the person who has granted the security (this person is described as the grantor in this explanatory memorandum) defaults on its obligations (including where it has not entered external administration).

1.103 Such defaults would be likely to occur in situations where the counterparty is experiencing financial difficulties, and it is important for the secured party to be able to take immediate action without having to wait for a formal external administration to commence and without needing to comply with, or be affected by, other existing requirements under Australian law (e.g. perfection and priority rules under the PPSA). Due to the impending margin requirements and importance of being able to enforce security for certain Regulated Entity's capital requirements, it is important that entities subject to Australian law can provide, and enforce rights in, margin provided by way of security in the manner contemplated by the BCBS-IOSCO Margin Requirements.

1.104 However, it is also important to ensure that these powerful protections provided to secured persons in relation to close-out netting contracts are not abused and accordingly the protection of the enforcement of security is subject to a range of safeguards.

Enforcing security

1.105 This Bill reforms the PSN to ensure that entities subject to Australian law can give, and enforce rights in, margin provided by way of security in the manner contemplated by the BCBS-IOSCO Margin Requirements. The PSN Act is amended to provide that security given over financial property, in respect of obligations of a party to the contract, may be enforced in accordance with the terms of the security, provided the terms of the security are evidenced in writing (subject to the conditions set out in the new section 14A of the PSN Act). The reference to security contemplates the traditional forms of security, being the charge, mortgage, pledge and lien and analogous concepts under foreign law rather than non-traditional forms of 'security interest' (as contemplated by the PPSA) such as a conditional sale agreement (including an agreement to sell subject to retention of title). The obligations referred to in the new paragraph 14(1)(ca) are intended to apply broadly to encompass monetary and non-monetary obligations, including obligations to deliver commodities under commodity derivatives and securities under physically settled equity derivatives, and includes prospective and contingent obligations. The protections provided under this Bill provide a facilitative protective regime (subject to the safeguards set out in the Bill) and do not adversely affect existing Australian laws. For example, it is noted that under existing Australian law, security may be valid notwithstanding the fact that the security secures future obligations or fluctuating obligations, or that the security is granted over a fluctuating but identified and identifiable pool of property (provided it does so in accordance with the terms agreed between the parties), or that the grantor may provide financial property in excess of the secured obligations. Additionally, the Bill does not impose a requirement for the amount secured to be subject to a fixed amount or fixed maximum amount which does not otherwise exist under Australian law. [Schedule 1, Part 1, item 23, after paragraph 14(1)(c), paragraph (ca) of the PSN Act, and item 28 After paragraph 14(2)(f), paragraph 14(2)(fa) of the PSN Act]

1.106 One of the requirements under paragraphs 14(1)(ca) and 14(2)(fa) which must be satisfied in order for security to be enforced is that the 'the terms of the security are evidenced in writing'. This would be satisfied where a security arises through an act where the terms of an agreement in writing between the parties provide for the security to arise on the performance or occurrence of such an act. This wording is intended to be broad enough to ensure that security arrangements which require that a subsequent act occur, after the 'security' is signed, in order for security to arise or apply to particular financial property (e.g. where a transfer is required in order for the security to attach to the relevant property) satisfy the requirement for the terms of the security to be evidenced in writing where the terms of that arrangement are evidenced in writing. For example, it is common for parties to enter into an agreement providing that one can give the other security over assets by delivering possession or control, setting out the terms that will apply to that security when the assets are delivered into the possession or control of the relevant person. [Schedule 1, Part 1, item 23 After paragraph 14(1)(c), paragraph 14(1)(ca) of the PSN Act, and item 28 After paragraph 14(2)(f), paragraph 14(2)(fa) of the PSN Act]

1.107 It is important that the PSN Act protect the enforcement of security by a secured person over an account held by it in the name of the grantor. This is because granting security over accounts is common in financial market transactions and the account over which security is granted is often an account held by the secured party (for example, a corporate counterparty grants its counterparty, an ADI, security over its account with the ADI). A technical issue arises under Australian case law for this structure, because the 'account' is, legally, just an obligation of the bank to repay money to the counterparty and there is some doubt under Australian law as to whether the interest which an entity has over its own liability is technically 'security'.^[27] This has been resolved in the PPSA context by the explicit inclusion of subsection 12(3A). Accordingly, the Bill clarifies the meaning of 'give security' in a new section 5A of the PSN Act so that, if a person owes payment or performance of an obligation to another person (an 'account holder'), the account holder may give security over the account holder's right to require the payment or performance of the obligation and the persons to whom security may be given include the person who owes the payment or the performance of the obligation to the account holder. For example, in circumstances where a person holds an account with a bank, the person may give security to the bank over the person's right to require the bank to pay the person money from the account. [Schedule 1, Part 1, item 4 Section 5, 'give security' definition of the PSN Act and item 12, At the end of Part 1, Section 5A Security given over a person's right to require payment or performance of an obligation of the PSN Act]

1.108 Clarification is also made by establishing Divisions within Part 4, the first in respect of the effectiveness of close-out netting contracts (which should not be read to mean that, if the relevant parts of Division 1 of Part 4 of the PSN Act do not apply, the contract or security is not otherwise effective or enforceable in accordance with other laws) and the second in respect of the circumstances in which non direction stays may cease. [Schedule 1, Part 1, item 22, Before section 14, Division 1-Effectiveness of close out netting contracts of the PSN Act]

1.109 The reforms in the Bill are facilitative rather than mandatory or prescriptive. These reforms which protect the enforcement of security in accordance with the PSN Act (including the provisions of section 14A) should not be interpreted as limiting or otherwise restricting anything which would otherwise be available or protected at law (including any rights which a secured party would otherwise have by virtue of the PPSA, the exercise of those rights and any protection which applies to those rights or the exercise of those rights). If a particular outcome would occur under the PPSA (taking into account the priority regime of the Banking Act), the PSN Act should not result in a worse outcome arising for the secured party. The reforms also do not affect the existing protection of close-out netting contracts (including any associated title transfer credit support arrangements) available under paragraphs 14(1)(c) and 14(2)(c) of the PSN Act.

References to 'enforce' and 'enforcement'

1.110 The references to 'enforced', and 'enforcement' of, security in the PSN Act should be interpreted to include the exercise by the secured party of a right, power or remedy existing because of the security arising under an agreement or instrument relating to the security (including the close-out netting contract), under a written or unwritten law or in any other way.

1.111 Similarly, the references to 'enforced', 'enforcement' and 'discharged through enforcement' include:

•

the satisfaction (through payment of an amount, or through realisation of the secured financial property by way of sale or liquidation) of; or

•

setting off the value of the secured financial property (through appropriation, or the proceeds of the secured financial property obtained through selling or liquidating that property) against; or

•

applying that value in discharge of any of the following:

-

eligible obligations in relation to the contract; or

-

obligations under the contract of a party to the contract to pay interest on an eligible obligation; or

-

obligations of a party to the contract to pay costs and expenses incurred in connection with enforcing security given in respect of an eligible obligation.

1.112 However, the secured party is subject to any conditions or restrictions on enforcement to which the secured party agrees in the terms of the security.

No protection of creating security if not otherwise able to

1.113 The protection given to the enforcement of security under the PSN Act does not of itself allow for the creation of security by an entity where that entity does not otherwise have the power to create the security or the security could not otherwise have been created, or otherwise do away with any fundamental legal requirement regarding the creation of security (e.g. that there be a valid contract and that there be no fraud or other vitiating factors) except as expressly provided (e.g. in respect of charge-backs, described above, and vesting, described below).

Interaction with the PPSA and other laws

1.114 The reforms are not intended to create a comprehensive security regime. However, the protections provided in the Bill to the enforcement of security (which includes the application of proceeds of enforcement and the implicit resolution of any priority dispute) apply despite any other law. Accordingly, this Bill intentionally overrides, rather than adopting, the PPSA to the extent of any inconsistency. It was not considered appropriate to refer broadly to 'security interest' or otherwise incorporate concepts of the PPSA generally except in very limited circumstances. For example, the consequences that the PPSA concepts of 'control' or 'possession' would otherwise have under the PPSA in relation to enforcement and priority are subject to the protection of enforcement under the PSN Act. The protection given by the PSN Act to the enforcement of security applies despite any other law (including the additional requirements imposed by the PPSA in relation to the enforceability, validity and perfection of security interests, the PPSA's priority framework and any vesting which could otherwise occur under the PPSA or Corporations Act due to non-perfection or a delay in perfection). This is because the PPSA concepts are not entirely appropriate for use in this context and may not adequately deal with the complex financial structures contemplated by the Bill. The approach taken in this Bill is broadly consistent with the approach which has previously been taken on this issue in other parts of the PSN Act (e.g. section 16). Similarly, it is not considered appropriate to refer solely to the specific types of personal property described in the PPSA (e.g. 'intermediated security' or 'investment instrument'), as this could lead to uncertainty and unnecessary complexity, which is inconsistent with the intention of this reform facilitating enforcement of security in practical circumstances without unnecessary legal complexity. The PPSA requirements for perfection (e.g. registration under the Personal Property Securities Register (PPS Register), and the subsequent priority regime and vesting issues) do not apply in order for an enforcement of security to be protected under the PSN Act.

1.115 The amendments have the effect that, unless the PPSA is applicable in the context of 'excess' collateral or proceeds of collateral (i.e. collateral or proceeds where the enforcement against which would not satisfy the safeguards in section 14A), the PPSA (including the provisions which relate to the perfection, priority, vesting and enforcement of security interests) do not apply to restrict the enforcement of security which is otherwise protected under the PSN Act. For example, the secured party is not required to register any security interest that secured party has under the security on the PPS Register, comply with any of the requirements in the PPSA regarding perfection and priority in order to obtain the benefits of the protection provided under the PSN Act in respect of enforcing security. In consideration of any potential mischief which could be caused to other creditors, it is noted that, under the PPSA, as the PPSA currently applies, security interests under the PPSA may be perfected by means other than registration (e.g. perfection by possession or control)^[28] and such security interests may not be registered on the PPS Register. Therefore, searches of the PPS Register conducted by interested parties in respect of an entity may not show up all security interests granted by an entity in any case.

1.116 Similarly, unless it is applicable in the context of collateral or proceeds of collateral which are in excess of the amount used to discharge the eligible obligations (discussed below in the context of the reference to 'to the extent that' in subsection 14A(1)), the application of the secured property or proceeds of the secured property to discharge the obligations described in paragraph 14(1)(a) will not be subject to the preference regimes set out in the Industry Acts^[29] and priority regime in the Corporations Act and PPSA.

Financial property

1.117 In order for the enforcement of security to be protected under the amendments in the Bill, only the enforcement of security over financial property would be protected under the PSN Act. The term 'financial property' is defined in section 5 of the PSN Act to include a range of different property, whether the property (or the intermediary or the account) is in Australia or elsewhere. The definition is intended to broadly capture the property which is commonly provided as collateral in financial markets transactions and uses existing concepts familiar to Australian law such as:

•

'security' (within the meaning of section 92 of the Corporations Act but disregarding subsections 92(3) and (4) which alter the meaning of the term in relation to specific Chapters of the Corporations Act), which includes debentures, stocks or bonds issued or proposed to be issued by a government, shares in, and debentures of, a body, interests in a managed investment scheme, units of such shares but does not include certain derivatives or excluded securities);

•

a derivative. The amendments provide that term derivative, when used in the PSN Act, has the same meaning as in Chapter 7 of the Corporations Act; [Schedule 1, Part 1, item 1, Section 5, definition of 'derivative' of the PSN Act and item 4, Section 5, 'financial property' of the PSN Act]

•

a financial product (within the meaning of the Corporations Act) that is traded on a financial market (within the meaning of that Act) that is:

-

operated in accordance with an Australian market licence (within the meaning of that Act); or

-

exempt from the operation of Part 7.2 of that Act. This should be read as including a financial market to which any licensing requirements in Part 7.2 of the Corporations Act do not apply because the financial market is not operated in Australia. This definition is intended to capture any other financial products which may be traded on financial markets (including foreign financial markets) which do not otherwise fall into another category of 'financial property';

•

a negotiable instrument (within the meaning of the PPSA), which is defined in section 10 of the PPSA to include a range of debt instruments such as bills of exchange, cheques, promissory notes, certain letters of credit and certain other writings evidencing a right to payment of currency (subject to certain exclusions);

•

currency (whether of Australia or of any other country);

•

gold, silver or platinum;

•

property declared by regulations to be financial property for the purposes of the PSN Act. As financial markets, and market conventions, change rapidly, it is important that the definition of property in respect of which security may be enforced can be adapted and updated to evolve with the markets. Accordingly, a regulation power is provided to allow for regulations to declare property to be financial property for the purposes of the PSN Act;

•

if a person (an intermediary) maintains an account to which interests in property or rights to payment or delivery of property described above may be credited or debited - the rights of a person in whose name the intermediary maintains the account, to the extent that those rights relate to the interests in that property or the rights to payment or delivery of that property.^[30] The rights of the person in whose name the intermediary maintains the account are defined as 'intermediated financial property'. This is intended to capture a range of property, including:

-

accounts where a bank holds money as banker for a customer in an account such as a savings account, cheque account or other accounts in which the customer has a right to payment of the equivalent amount of currency;

-

securities accounts and other intermediated debt and equity securities, being an interest in debt or equity securities recorded in fungible book-entry form in an account maintained by an intermediary where such interest has been credited to the account. It is noted that the interest of the holder of the account is generally considered to be a right to a beneficial interest in whatever is held by the intermediary for the account holder; and

-

proceeds (including rights and property) of property that is financial property. [Schedule 1, Part 1, item 4, Section 5, 'financial property' and 'intermediated financial property' definitions of the PSN Act]

1.118 This is intended to provide a list of property which, generally, includes cash (including cash accounts), securities accounts, government and central bank securities, corporate bonds, covered bonds, equities and gold (including accounts of gold) and cover debt and equity securities irrespective of whether they are directly held bearer securities, directly held registered securities, directly held dematerialised securities or indirectly held securities (using the term securities in its generic sense). Precious metals, such as gold, silver and platinum, have been included as 'financial property' because it is understood they are commonly used as collateral by market participants. The location of the property, intermediary or account is not relevant to the definition. [Schedule 1, Part 1, item 4, Section 5, 'financial property' definition of the PSN Act]

1.119 To ensure that the definition can be adapted if the Government becomes aware of certain types of property against which security should not be able to be enforced, the Government may declare by regulations that certain property is not to be financial property for the purposes of the PSN Act.

Amendments to paragraph 14(1)(d) and consequential amendments

1.120 Amendments to paragraph 14(1)(d) are made which are intended to ensure that certain actions by a defaulting counterparty in violation of the terms of the close-out netting contract or security such as disposals of rights or assets cannot stop the secured person from enforcing security it holds. The purpose of extending paragraph 14(1)(d) to the enforcement of security is to ensure that the security can be enforced even if one of the parties to the contract has breached it, including by improperly assigning the rights that may be netted under the contract of financial property or improperly creating, or allowing to exist, an encumbrance or other rights in relation to those rights or financial property. The protection provided to the enforcement of security is intended to ensure that the secured person's rights to the financial property subject to the security are not subject to any other third party's interest (whether that third party be a secured person or a creditor which would otherwise be mandatorily preferred by operation of laws)^[31] or any priority regime (i.e. the security in respect of that amount should be first ranking despite any other law).

1.121 The effect of these provisions is that an acquisition of title to rights or property by a third person in breach of a close-out netting contract may potentially be voidable in the event of enforcement occurring.

1.122 It is clarified that paragraph 14(1)(d) applies to the matters contained in new paragraph 14(1)(ca). That is to say, it applies to the enforcement of the security given in writing over financial property in respect of obligations of a party to the contract. [Schedule 1, Part 1, item 24, paragraph 14(1)(d) of the PSN Act]

1.123 Amendments to subparagraphs 14(1)(d)(ii) and (iii) clarify that the enforcement of security remains valid despite any encumbrance or other interest granted over the rights that may be netted under the contract or the financial property over which security is given in respect of obligations of a party to the contract by the defaulting counterparty to a third party in violation of the terms of the close-out netting contract netting contract or in the security the enforcement of which is protected under paragraph 14(1)(ca). It is noted that this provision may give rise to a possible breach of paragraph 51(xxxi) of the Constitution which prohibits the acquisition of property other than on just terms. This issue arises because the property may have been transferred to an innocent third party prior to the commencement of this amendment, whose interests may subsequently suffer because of the operation of this amendment. The issue is being addressed through an application provision confining the effect of this amendment to cases where the interest is granted after the commencement of the amendment so that no acquisition on unjust terms occurs (see paragraph 1.292 in respect of Part 3 - Application, subitem (5)). [Schedule 1, Part 1, item 25, Subparagraph 14(1)(d)(ii) of the PSN Act, item 26, Subparagraph 14(1)(d)(iii) of the PSN Act and item 27, Paragraph 14(2)(d) of the PSN Act]

1.124 It is equally important to ensure that close-out netting, and the enforcement of security in accordance with the safeguards set out in sections 14 and 14A of the PSN Act, on an external administration (as protected under subsection 14(2)) is not affected by the interests of third parties which arise in contravention of a prohibition in the contract or the relevant security. The existing protections in subsection 14(2) were not subject to any deficiency due to the equivalent drafting as appears in 14(1)(d) not appearing in 14(2), however for consistency purposes equivalent explicit protections are set out in subsection 14(2). Additional drafting has been included in subsection 14(2) to ensure that the relevant paragraphs in that subsection explicitly benefits from equivalent protections to those currently provided in paragraph 14(1)(d) in respect of the protections in subsection 14(1). Due to the broadening of the protection to be provided under subsection 10(2) and the existing breadth of subsection 16(2), equivalent conforming changes have been made to subsections 10(2) and 16(2) so that the relevant paragraphs apply despite the occurrence of any of the things currently referred to in paragraphs 10(1)(b) or 16(1)(d) (as applicable)). [Schedule 1, Part 1, item 19 At the end of subsection 10(2) (before note 1), paragraph 10(2)(g) of the PSN Act, item 29 Paragraph 14(2)(g), paragraph 14(2)(h) of the PSN Act and item 34 At the end of subsection 16(2) (before the note), paragraph 16(2)(h) of the PSN Act]

Amendments to subsection 14(2) of the PSN Act

1.125 The amendments to subsection 14(2) of the PSN Act address issues arising when a party who is, or has been, a party to a close-out netting contract goes into external administration. The key issues relate to the enforcement of security given over financial property in respect of obligations of a party to the contract (provided the terms of the security are evidenced in writing) (including without limitation by way of liquidation, sale, appropriation or appointing a receiver) without obtaining the consent of the external administrator or the court, and ensuring that the external administrator cannot unwind that enforcement of security (including the discharge of any obligations of the party to the contract).

1.126 It is clarified that in a situation where such a party enters external administration the secured person can enforce security given over financial property in respect of obligations of a party to the contract in accordance with the terms of the security, provided the terms of the security are evidenced in writing (but subject to the criteria in section 14A, discussed below). As noted in paragraph 1.23 there are currently a range of issues which arise in the context of creating and enforcing rights as a secured party under Australian law which could prevent entities subject to Australian law from being able to provide, or enforce rights in, margin provided by way of security in the manner contemplated by the BCBS-IOSCO Margin Requirements. This amendment and the amendment to subsection 14(1) are designed to remove this ambiguity (including in respect of priority regimes that could have otherwise applied). It is noted that this amendment is worded in a flexible manner intended to encompass more complex types of security arrangements, for example in cases where the financial property is held by a person who is not the secured person or the grantor (e.g. a third party custodian) or where a receiver or other insolvency official enforces the security on behalf of the secured person. The same interpretation of terms described above in respect of the amendment to paragraph 14(1) applies in the context of this amendment. [Schedule 1, Part 1, item 28, after paragraph 14(2)(f), paragraph 14(2)(fa) of the PSN Act]

1.127 Division 2 of Part 5.7B of the Corporations Act provides that certain transactions entered into before the commencement of an external administration may be unwound. This includes unreasonable payments to directors, transactions that are of an uncommercial nature, payments to a creditor that provide an unfair preference to that creditor and others. There may be some ambiguity as to whether the enforcement of security may not fall under one of these headings, and could therefore be subject to being unwound or voided. Existing paragraph 14(2)(g) provides that the termination of obligations, the netting of obligations and any payment made by the party under the contract to discharge a net obligation are not to be void or voidable in the external administration of a party to a close-out netting contract. Any enforcement of security under paragraph (fa) is added to this list of transactions, thereby removing the ambiguity referred to above. It is noted that there is a definition in section 5 of the PSN Act which clarifies the scope of the term 'voidable' and states that, among others, it includes transactions to which Division 2 of Part 5.7B of the Corporations Act applies. [Schedule 1, Part 1, item 29, paragraph 14(2)(g) of the PSN Act]

1.128 One of the policy positions inherent in the Bill is that entities subject to Australian law should be able to give, and enforce rights in respect of, margin provided by way of security in connection with certain financial market transactions in a manner consistent with international requirements. This includes facilitating the enforcement of security without requiring a secured party to perfect its interest under the PPSA (e.g. through registration) or comply with certain timeframes for perfecting that interest, provided that the security satisfies certain safeguards set out in the Bill. This is similar to the policy rationale for the EU Financial Collateral Directive, as explained in the explanatory note to the Financial Collateral Arrangements Regulations, being that the 'Directive provides that the only formality which may be required for a financial collateral arrangement to be perfected and enforceable, is that the arrangement be evidenced in writing'.^[32]

1.129 However, the PPSA and Corporations Act provide for circumstances in which a security interest may vest in the grantor if certain conditions are not satisfied (e.g. sections 267 and 267A of the PPSA and section 588FL of the Corporations Act). Generally, if section 267 of the PPSA was to apply, then a security held by a secured person vests in the grantor immediately before the event mentioned in paragraph (1)(a) of that section occurs (e.g. immediately before the making of the relevant order or the appointment of the administrator etc.) (section 267(2)). Section 267A applies where the security interest attaches after the time mentioned in section 267(1)(b). In these circumstances, the security interest vests in the grantor when it attaches to the collateral. Similar issues arise under section 588FL of the Corporations Act.

1.130 In determining the interaction between the PSN Act and these other laws regarding vesting, it is noted that the PSN Act protections under subsection 14(2) are triggered as soon as a party to a close-out netting contract goes into external administration, and (by virtue of the old subsection 14(4) and new subsection 14(3)) apply despite any other law (and therefore overrides any other inconsistent law, including the PPSA, to the extent of any inconsistency). Therefore, if the event(s) that constitutes going into 'external administration' under the PSN Act is the same as, or occurs before or simultaneously with, the events mentioned in section 267(1)(a) of the PPSA (or the events described in the other vesting provisions), then it follows that the protections given under the PSN Act apply (such that the vesting has no effect) by virtue to those protections apply despite any other law. In other words, upon the going into external administration, section 14(4) (section 14(3), as amended by the Bill) would operate to counteract the operation of section 267 of the PPSA (and section 267A of the PPSA and section 588FL of the Corporations Act), so that those sections do not operate to vest (and backdate the vesting of) the security in the grantor. Therefore, section 267 of the PPSA could only potentially operate to vest security in the grantor if that section is triggered before section 14(2) is triggered.^[33] It is not expected that this could ever occur, at least in relation to individuals and Australian companies (and therefore secured parties in respect of these types of grantors will not have their security vest).

1.131 However, the hypothetical risk that section 267 could be triggered before the operation of subsection 14(2) in respect of foreign companies has necessitated clarification in the Bill to ensure that, in no circumstances, sections 267 and 267A of the PPSA and 588FL of the Corporations Act have effect such that a security vests where, but for the vesting, the enforcement of security would otherwise be protected under the PSN Act. This is because an important policy rationale for the PSN Act is to ensure that secured parties under these security-based credit support arrangements which comply with the safeguards of the PSN Act do not need to register their interest under the PPS Register in order to benefit from the protections of the PSN Act (however it is noted that the protections of the PSN Act do not apply to the discharge of 'excess' obligations which are not 'eligible obligations'). To achieve this, a new paragraph 14(2)(fb) of the PSN Act provides that, if:

•

under section 267 or 267A of the Personal Property Securities Act 2009 or section 588FL of the Corporations Act 2001, a security interest would, but for this paragraph (fb), vest in the grantor before the external administration begins; and

•

where the security interest did not vest under one of those sections before the external administration begins, the security interest would be enforceable under paragraph (fa),

the security interest does not vest under that section before the external administration begins. The reason this paragraph only refers to a vesting in the grantor 'before the external administration begins' is because the new subsection 14(3) (and old subsection 14(4)) already have the effect that the protections of the PSN Act prevail over any vesting which purportedly occurs on, or after, the commencement of the external administration which triggers subsection 14(2). Therefore, this new paragraph (fb) only needs to deal with a vesting which would otherwise occur before section 14(2) applies (i.e. where the vesting would occur before the external administration). [Schedule 1, Part 1, item 28 After paragraph 12(2)(f), paragraph 14(2)(fb) of the PSN Act]

1.132 Accordingly, in order for the protection given to the enforcement of security under the PSN Act to be effective in accordance with its terms despite any vesting, the PSN Act provides that the PSN Act prevails despite any other law (subject to certain specified stay provisions, as discussed in this memorandum) and specifically deals with the circumstance in which a vesting may occur before the protections of subsection 14(2) are enlivened. This result is emphasised by the inclusion of sections 267 and 267A of the PPSA and section 588FL of the Corporations Act in the specified provisions. The application of the PSN Act to the enforcement of security, and clarification that vesting will not impact on a secured person enforcing its security as provided for under the PSN Act, means that the secured person will be able to enforce its security (including applying the proceeds of enforcement) notwithstanding any priority issues which may have otherwise arisen under the PPSA but for the PSN Act protections. [Schedule 1, Part 1, item 8, Section 5 (paragraph (d) of the definition of specified provisions) , paragraph (d) of the definition of 'specified provisions' of the PSN Act, item 9 Section 5 (after paragraph (f) of the definition of specified provisions) of the PSN Act, paragraph (fb) of the definition of 'specified provisions' and item 28 After paragraph 14(2)(f), paragraph 14(2)(fb) of the PSN Act]

1.133 Consequential changes have been made to the definition of 'voidable' to expand the scope of the concept beyond payments to capture actions and things. [Schedule 1, Part 1, item 11 Section 5 (definition of voidable), 'voidable' definition of the PSN Act]

Criteria which must be satisfied for the enforcement of security to be protected under the PSN Act

1.134 The protections provided under paragraphs 14(1)(ca) and 14(2)(fa) of the PSN apply to the enforcement of security over financial property, in respect of obligations of a party to a close-out netting contract, only to the extent that certain safeguards are satisfied. These safeguards are described in the paragraphs below. The reference to 'to the extent that' in subsection 14A(1) should be interpreted to mean that the application of proceeds of an enforcement which go beyond the discharge of the obligations described in paragraph 14(1)(a), or the enforcement of security over non-financial property or financial property which has not been transferred or dealt with so as to be in the possession or under the control of the secured person or relevant third party, is subject to the general Australian law regarding priority, securities, insolvency and creditors' rights (including the priority regimes set out in the PPSA and the Corporations Act). However, the enforcement of security which has been given over both financial property and non-financial property or a security which has been given over both financial property which has been transferred or dealt with so as to be in the possession or under the control of the secured person or relevant third party and other property may still be protected under the PSN Act (despite any other law) to the extent the safeguards are satisfied. [Schedule 1, Part 1, item 31, after section 14, subsection 14A(1) of the PSN Act]

Eligible obligations

1.135 Paragraph 14A(1)(a) requires that the obligations secured by the financial property, and discharged through the enforcement, are:

•

eligible obligations in relation to the contract; or

•

obligations under the contract of a party to the contract to pay interest on an eligible obligation; or

•

obligations of a party to the contract to pay costs and expenses incurred in connection with enforcing security given in respect of an eligible obligation. [Schedule 1, Part 1, item 31, after section 14, paragraph 14A(1)(a) of the PSN Act]

1.136 The 'eligible obligation' term has the meaning given in section 14A.^[34] [Schedule 1, Part 1, item 1, section 5 of the PSN Act] An obligation is an eligible obligation in relation to a close out netting contract if the obligation is any of the following:

•

an obligation under the contract of a party to the contract that relates to a derivative or foreign exchange contract or is of another prescribed kind;

•

an obligation that results from the netting of 2 or more obligations that are created under the contract that:

-

must include at least one obligation which is an obligation under the contract of a party to the contract that relates to a derivative or foreign exchange contract or is of another prescribed kind; and

-

other than an obligation (or obligations) under the contract of a party to the contract that relates to a derivative (as defined in the Bill) or foreign exchange contract or is of another prescribed kind, may only include one or more incidental obligations that, taken together, do not form a material part of the obligation. [Schedule 1, Part 1, item 31, after section 14, subsection 14A(8) of the PSN Act]

1.137 The netting which is described in paragraph 14A(8)(b) is the close-out netting which occurs under the contract that is currently protected under the PSN Act for close-out netting contracts and not cross-affiliate cross-agreement set-off which may purportedly occur under other arrangements. If a close-out netting process involved the termination and valuing of only one unperformed obligation (which itself fell within paragraph (a) of the definition of 'eligible obligation') (and therefore obligation for a party to pay one amount), it is expected that this amount would also fall within paragraph (a) of the definition of 'eligible obligation'.

1.138 The regulations may declare that an obligation is an eligible obligation in relation to a close out netting contract (under paragraph 14A(8)(a) and paragraph 14A(8)(c)). The regulations may also declare that an obligation is not an eligible obligation in relation to a close-out netting contract if circumstances arise in respect of which it is considered that it would be inappropriate to extend the coverage of the PSN Act protections (under subsection 14A(9)). Given the rapidly evolving nature of the financial markets and the need to both ensure the protections provided under the PSN Act are sufficiently broad and robust and ensure that any potential abuse or mischief is quickly dealt with, it will be possible to make regulations expanding or narrowing the coverage of the term eligible obligation should the definition prove to have inappropriate coverage. [Schedule 1, Part 1, item 31, after section 14, paragraphs 14A(8)(a) and 14A(8)(c) and subsection 14A(9) of the PSN Act]

1.139 The key consideration inherent in the term eligible obligation is whether an obligation under the contract of a party to the contract relates to a derivative or foreign exchange contract or is of another prescribed kind. The definition of derivative from Chapter 7 of the Corporations Act has been used here due to its flexibility and breadth, but paragraph (a) of the definition of 'eligible obligation' is also supplemented by a regulation power to declare certain things to be, or to not be, eligible obligations. As margin requirements are expected to be imposed in respect of all derivatives transactions that are not cleared by CCPs, it was considered important to use a definition of 'eligible obligation' which encompasses, in a facilitative manner, a wide range of financial market transactions, including credit derivatives, equity derivatives, foreign exchange derivatives, interest rate derivatives, weather derivatives, commodity derivatives and other types of derivative transactions. The regulation power is intended to ensure that certain transactions which are customarily viewed as derivatives in the financial markets are included in the functional definition of 'derivative' to be used in the PSN Act (and included in concepts such as 'eligible obligation'), such as physically settled commodity forwards and derivatives contracts relating to tangible property in the form of commodities, including grain forwards, which are documented under a derivatives master agreement such as an ISDA Master Agreement, are included in the definition of 'derivative' for the purposes of the PSN Act. The regulation power may also be used to exclude from the definition of 'eligible obligation' things which inadvertently fall within the Corporations Act definition of 'derivative' but which are not customarily considered to be derivatives in the financial markets or to which different policy considerations apply. Foreign exchange contract has the same meaning as in Chapter 7 of the Corporations Act. [Schedule 1, Part 1, item 1, Section 5, 'derivative' of the PSN Act and item 4, section 5, 'foreign exchange contract' of the PSN Act and item 31, after section 14, paragraph 14A(8)(a) of the PSN Act]

1.140 To fall within the eligible obligation term, an obligation may also relate to a foreign exchange contract. This is to deal with the issues which arise in relation to short-term foreign exchange derivatives under Corporations Regulation 7.1.04. [Schedule 1, Part 1, item 31, after section 14, paragraph 14A(8)(a) of the PSN Act]

1.141 Paragraph 14A(8)(b) provides for an obligation (that results from the netting of 2 or more obligations that are created under the contract) which complies with certain criteria to constitute an eligible obligation. The criteria are described in paragraph 1.136 above. This paragraph 14A(8)(b) contemplates a situation where a derivatives master agreement, such as an ISDA Master Agreement, provides that, if particular events happen (e.g. an event of default), the obligations in relation to the transactions entered into under the master agreement are terminated and a net amount becomes payable. In addition to payment and delivery obligations in relation to specific transactions which are terminated, the obligations which are terminated under a master agreement may also include a range of obligations which are not directly related to any particular transaction, such as obligations to make certain representations and undertakings (including to comply with laws), provide certain information including taxation documents, pay expenses and provide notices. The mere fact that these obligations are terminated under a master agreement does not result in a net obligation which results from the netting of two or more obligations under the contract ceasing to constitute an eligible obligation. Similarly, the mere fact that one or more incidental payment or delivery obligations which do not relate to a derivative or foreign exchange contract (or not prescribed in the regulations) are included in the net obligation does not necessarily result in the resulting net obligation ceasing to constitute an eligible obligation if those incidental obligations, taken together, do not form a material part of the net obligation. [Schedule 1, Part 1, item 31, after section 14, paragraph 14A(8)(b) of the PSN Act]

Possession or control

1.142 Another safeguard set out in subsection 14A(1) is that the protections provided under paragraphs 14(1)(ca) and 14(2)(fa) of the PSN Act apply to the enforcement of security over financial property, in respect of obligations of a party to a close-out netting contract, only to the extent that, before the enforcement, the financial property is transferred or otherwise dealt with so as to be in the possession or under the control of:

•

the secured person; or

•

another person (who is not the grantor) on behalf of the secured person, under the terms of an arrangement evidenced in writing. [Schedule 1, Part 1, item 31, after section 14, paragraph 14A(1)(b) of the PSN Act]

1.143 The broad phrase 'transferred or otherwise dealt with' provides flexibility to accommodate different types of exchange mechanisms and transfer arrangements that exist in the market and the difficulties in applying traditional transfer-based analysis to modern financial markets, in which property may be held through chains of intermediaries as records in book-entry accounts. However, the mere granting of a charge itself (e.g. a floating charge over all the present and after-acquired property of an entity) is not enough to satisfy the requirement for the financial property to have been 'transferred or otherwise dealt with'. [Schedule 1, Part 1, item 31, after section 14, paragraph 14A(1)(b) of the PSN Act]

1.144 Before enforcement, the financial property must be transferred or otherwise dealt with so as to be in the possession or under the control of the secured person or other third party on behalf of the secured person, under the terms of an arrangement evidenced in writing. The reference to another person which under the terms of the arrangement has that possession or control on behalf of the secured person is intended to cover situations where a third party such as a custodian or intermediary has possession or control of the relevant financial property and there is an arrangement the terms of which are evidenced in writing which provides that the third party has that possession or control of the financial property on behalf of the secured person. It is understood that these third party custody arrangements are already common in the market and that these types of arrangements may be used by parties in complying with margin requirements (particularly for initial margin). The reference to the terms of the arrangement is intended to be a functional description of the types of custody arrangements (also known as triparty agreement or account control agreements) which, in the ordinary course, provide that the intermediated cash or securities account(s) is held in the name of the grantor but subject to the secured person's security interest. [Schedule 1, Part 1, item 31, after section 14, paragraph 14A(1)(b) of the PSN Act]

1.145 In using concepts of possession or control, the approach taken in The Financial Collateral Arrangements (No.2) Regulations 2003 (Financial Collateral Arrangements Regulations) in the United Kingdom and the EU Financial Collateral Directive, and associated interpretation of English courts and commentary from the Financial Markets Law Committee noting issues in respect of that interpretation, has been informative. For example, in these amendments, the concept of 'possession' is intended to have a more general application beyond its technical legal meaning (which could confine the concept to financial property such as bearer securities in certificated form only). As contemplated in the EU Financial Collateral Directive, an underlying policy consideration for these amendments is to 'provide a balance between market efficiency and the safety of the parties to the arrangement and third parties, thereby avoiding inter alia the risk of fraud' (Recital 10 of the EU Financial Collateral Directive). These amendments address some of the issues identified in other jurisdictions in subsection 14A(5) (as described below).

1.146 The general concepts of possession or control are supplemented by deeming provisions in subsections 14A(2), (3), (4) and (5) to provide certainty as to the application of these concepts to specific examples of market practice.

1.147 For the purposes of determining 'possession' and 'control' under paragraph 14A(1)(b), financial property is taken not to be in the possession or control of a person mentioned in that paragraph if, under the security, the grantor is free to deal with the financial property in the ordinary course of business until the secured person's interest in the financial property becomes fixed and enforceable. This applies even if the secured person's interest in the financial property under a security under which the grantor was previously free to deal with the financial property in the ordinary course of business becomes fixed and enforceable before the enforcement of the security over that property mentioned in subsection 14A(1). This provision exists to ensure that a security which was historically considered to be a 'floating charge' over all present and after-acquired property (or all present and after-acquired property of a particular class) which remained on the balance sheet would not, without more, satisfy the possession or control test in paragraph 14A(1)(b). Even without subsections 14A(2) and (3), it was not expected that such a security would satisfy paragraph 14A(1)(b). The wording of subsection 14A(2) broadly reflects the 'ordinary course of business' concept set out in In re Yorkshire Woolcombers Association Limited; Houldsworth v Yorkshire Woolcombers Association Limited [1903] 2 Ch 284 in respect of floating charges. In the PSN Act, the reference to an interest in the financial property being 'fixed and enforceable' means that circumstances arise such that the floating charge attaches to specific property and the grantor ceases to be able to deal with the property and the secured person has a presently exercisable right to take enforcement action in respect of the secured property. Subsection 14A(3) has the effect that security under which the grantor was free to deal with the financial property in the ordinary course of business at some time on or after creation of the security is taken not to be in the possession or under the control of a person even if the interest in the financial property becomes fixed and enforceable before the enforcement of the security over financial property which is described in paragraph 14A(1)(b) of the PSN Act. This is similar to the approach taken in respect of section 561 of the now repealed Corporations Law, as section 9 of that Act provided that a 'floating charge' included 'a charge that conferred a floating security at the time of its creation but has since become a fixed or specific charge'. [Schedule 1, Part 1, item 31, after section 14, subsections 14A(2) and (3) of the PSN Act]

1.148 However, it is expected that subsections 14A(2) and (3) should not apply in respect of financial property subject to a security which would not have been historically considered to be a floating charge (e.g. a fixed charge including a charge under which the grantor is not free to deal with the financial property in the ordinary course of business, pledge, lien, legal or equitable mortgage).

1.149 The fact that the grantor has one or more (or all) of the rights described in subsection 14A(6) does not of itself mean that the secured person or relevant third party does not have possession or control under paragraph 14A(1)(b) or that the grantor is free to deal with the financial property in the ordinary course of business for the purposes of subsections 14A(2) and (3). This is considered to be the case as a matter of ordinary statutory construction of section 14A and is very significant for the practical application of section 14A. Many modern financial structures, under which a secured person (or third party) is considered to have possession or control of particular financial property, still allow for the grantor to have certain rights (e.g. substitution rights, rights to withdraw excess collateral, rights to receive notices and exercise certain rights in relation to the collateral, such as voting rights, etc) which could historically have complicated the analysis as to whether a security was a floating charge or a fixed charge. [Schedule 1, Part 1, item 31, after section 14, subsection 14A(6) of the PSN Act]

1.150 The existence of the rights described in subsection 14A(6) alone or together (even if they all appear in a security) does not, of itself, lead to a conclusion that the grantor is free to deal with the financial property in the ordinary course of business. The list of rights set out in subsection 14A(6) is also not an exhaustive list of the rights which a grantor may have without being considered to be free to deal with the financial property in the ordinary course of business (i.e. the grantor may have other rights and still not be considered to be free to deal with the financial property in the ordinary course of its business but this depends on the facts). However, if a security provides the grantor with the rights set out in subsection 14A(6) of the PSN Act and other rights that do provide that the grantor is free to deal with the financial property in the ordinary course of business, the mere existence of the rights in subsection 14A(6) alone does not prevent subsection 14A(2) from applying. [Schedule 1, Part 1, item 31, after section 14, subsections 14A(2) and 14A(3) of the PSN Act]

1.151 Subsections 14A(4), (5) and (6) are intended to address the way in which the possession and control analysis of paragraph 14A(1)(b) applies in respect of specific financial market structures. It is acknowledged that historical legal concepts of possession and control may need to, but do not currently (or adequately), deal with control structures used in modern financial market^[35] and therefore the Bill provides certainty as to specific circumstances in which the control test in paragraph 14A(1)(b) will, and will not, be satisfied. These deeming provisions are intended to be inclusive and are not intended to restrict in any way the general application of the concepts of possession or control to financial market structures. These deeming provisions are described below.

1.152 Without limiting the general application of paragraph 14A(1)(b) (for example, if the financial property is in the possession, or control, of the person under principles of general law), financial property is taken to be in the possession of a person for the purposes of paragraph 14A(1)(b) if:

•

in a case where there is an issuer of the financial property-the person is registered by, or on behalf of, the issuer as the registered owner of the financial property; or

•

in a case where the financial property is an intermediated financial property - the person is the person in whose name the intermediary maintains the account. [Schedule 1, Part 1, item 31, after section 14, subsection 14A(4) of the PSN Act]

1.153 The first limb of subsection 14A(4) is intended to cover the situations where the secured person or third party is registered by, or on behalf of, the issuer as the registered owner of the financial property, including where such registration happens on the Clearing House Electronic Sub register System (CHESS) sub register, maintained by ASX Settlement, or the issuer sponsored sub register, maintained by the issuer or a share registry on the issuer's behalf. The first limb does not exhaustively set out the circumstances in which financial property in respect of which there is an issuer may be possessed. For example, in respect of financial property such as bearer securities in certificated form only, possession would be satisfied by taking physical possession of the certificate. The second limb of this subsection is intended to apply in respect of 'intermediated financial property' (which is defined in the section 5 of the PSN Act to mean the rights mentioned in paragraph (h) of the definition of financial property) where the secured person or third party acting on the secured person's behalf is the person is the person in whose name the intermediary maintains the account. Due to the breadth of the concept of 'intermediary', this would include circumstances where, if the financial property is traded or settled through a clearing house or securities depository, the clearing house or securities depository, as the case may be, records the interest of the person in the financial property. [Schedule 1, Part 1, item 31, after section 14, subsection 14A(4) of the PSN Act and item 4, Section 5 of the PSN Act]

1.154 Subsection 14A(5) is intended to address the developing market practice whereby financial property is held in an account maintained by a third party custodian (or the secured party itself) in the name of the grantor (i.e. the counterparty, rather than the secured person) and security over the account is granted to the secured person. For the purposes of this amendment, the relevant financial property would be the rights of the grantor in the account (i.e. an 'intermediated financial property' for the purposes of the PSN Act). In these (and other similar) circumstances, financial property is taken to be under the control of a person (being the secured person) for the purposes of paragraph 14A(1)(b) if:

•

the financial property is intermediated financial property (as defined in section 5 of the PSN Act); and

•

the intermediary is not the grantor (but may be the secured person or any other person); and

•

there is an agreement in force between the intermediary and one or more other persons, one of which is the secured person or the grantor (such as an account control agreement or tripartite agreement between the grantor, secured person and custodian); and

•

the agreement has one or more of the following effects:

-

the person in whose name the intermediary maintains the account (i.e. the grantor) is not able to transfer or otherwise deal with the financial property;

-

the intermediary must not comply with instructions given by the grantor in relation to the financial property without seeking the consent of the secured person (or a person who has agreed to act on the instructions of the secured person);

-

the intermediary must comply, or must comply in one or more specified circumstances, with instructions (including instructions to debit the account) given by the secured person in relation to the intermediated financial property without seeking the consent of the grantor (or any person who has agreed to act on the instructions of the grantor). [Schedule 1, Part 1, item 31, after section 14, subsection 14A(5) of the PSN Act]

1.155 The agreement described in paragraphs 14A(5)(b) and (c) is described broadly in contemplation of a situation where the intermediary may be the same entity as the secured person.

1.156 Subsection 14A(6) provides for clarification as to the impact of certain rights that a grantor may have in respect of a security arrangement on paragraph 14A(1)(b) the analysis regarding possession and control (or, more accurately, lack of impact of those rights on the analysis). This paragraph is intended to address some of the uncertainties which have been raised in respect of the Financial Collateral Arrangements Regulations in the United Kingdom. For example, the fact that a grantor has, or retains, rights of one or more of the following kinds does not of itself stop paragraph 14A(1)(b) from being satisfied or give rise, of itself, to a conclusion that the grantor is free to deal with the financial property in the ordinary course of business. These rights include the right to receive and withdraw income in relation to the financial property, right to receive notices in relation to the financial property, right to vote in relation to the financial property, right to substitute other financial property that the parties agree is of equivalent value for the financial property, right to withdraw excess financial property or right to determine the value of the financial property. It is important to note that subsection 14A(6) does not exhaustively list the rights which a grantor may retain and, depending on the circumstances, paragraph 14A(1)(b) may still be satisfied (and subsection 14A(2) may not apply) if the grantor has other rights. It is common for substitution rights and rights to withdraw excess collateral to be exercisable without the consent of the secured person. It is unclear at this stage whether security arrangements with flexible substitution rights and rights to withdraw excess financial property will arise more often due to the implementation of margin requirements and therefore the Bill is intended to be facilitative in relation to substitution rights, rights to withdraw excess collateral and certain other rights. The reference to 'substitute other financial property that the parties agree is of equivalent value' in the reference to right to substitute financial property in subsection 14A(6) is intended to refer to a circumstance where financial property is substituted for other property of equivalent value in accordance with the agreement between the parties (equivalent value having reference to the terms of, or mechanism set out in, the security agreement). The reference to 'excess' in the reference to the right to withdraw excess financial property in subsection 14A(6) is intended to refer to a circumstances where the value, or estimated value, of the financial property exceeds the amount of financial property required to be posted from time to time under the security arrangement between the grantor and secured person.^[36] The key point is that the secured person must, directly or through the third party on its behalf, have possession or control over the amount it has agreed with the grantor that it will be entitled to hold until discharge of the secured obligations or enforcement of the security arrangement. It is up to the secured person to ensure that the agreed collateral requirement is sufficient to satisfy the BCBS-IOSCO Margin Requirements. [Schedule 1, Part 1, item 31, after section 14, subsection 14A(6) of the PSN Act]

1.157 Regulations may prescribe circumstances in which financial property is, or is not, transferred or dealt with so as to be in the possession or under the control of a person for the purposes of paragraph 14A(1)(b). Whilst paragraph 14A(1)(b) and the associated deeming provisions should provide a robust and flexible mechanism which strikes the balance described above, it may be appropriate to use regulations to specify additional situations which do, or do not, satisfy the requirements set out in paragraph 14A(1)(b). This is particularly important because the possession and control analysis is complex, and the protective regime set out in the PSN Act must respond efficiently to changes in collateral holding arrangements that may evolve in the ever-changing financial markets. [Schedule 1, Part 1, item 31, after section 14, subsection 14A(7) of the PSN Act]

Compliance with other duties

1.158 The final safeguard set out in subsection 14A(1) is that the enforcement must be carried out in a manner that complies with section 420A of the Corporations Act 2001 (if it applies) and any applicable general law duties that are not inconsistent with the terms of the security. [Schedule 1, Part 1, item 31, after section 14, paragraph 14A(1)(c) of the PSN Act]

1.159 In order for the enforcement of security to prevail over other laws in accordance with the protections set out in the PSN Act, the secured person must comply with the duties that are not inconsistent with the terms of the security to which it is otherwise subject. For example, the duties to which controllers^[37] are subject under Part 5.2 of the Corporations Act (e.g. section 420A regarding the controller's duty of care in exercising power of sale) may still apply.

1.160 Whilst the security may be enforced in accordance with the terms of the security, the protections provided to the enforcement of security under subsections 14(1) and 14(2) would not apply to the extent the terms of the security purported to allow a secured person to appropriate or sell financial property at zero, or nominal, value as the enforcement would not reflect any attempt to calculate, or value, the financial property in good faith or in a commercially reasonable manner.

Interaction with other laws

1.161 Clarification has been made in a reordered subsection 14(3) to provide that subsections 14(1) and 14(2) have effect in relation to a close-out netting contract:

•

subject to a specified stay provision (defined in section 5 of the PSN Act) that applies to the contract; and

•

despite any other law (including the specified provisions). The notes to the new subsection 14(3) clarify that section 5 of the PSN Act defines specified provisions and specified stay provision and also note that Division 2 of Part 4 of the PSN Act sets out the circumstances in which non direction stays may cease. [Schedule 1, Part 1, item 30, subsections 14(3), (4) and (5), subsection 14(3) of the PSN Act]

1.162 Where security is given over financial property, in respect of obligations of a party to a close out netting contract, then the new subsection (3) of PSN Act applies in relation to the security in the same way as it applies in relation to the contract. Accordingly, if security is given over financial property, in respect of obligations of a party to a close out netting contract, the protections in subsections 14(1) and 14(2) of the PSN Act have effect in relation to the security:

•

subject to a specified stay provision that applies to the security; and

•

despite any other law (including the specified provisions). [Schedule 1, Part 1, item 30, subsections 14(3), (4) and (5), paragraph 14(9)(a) of the PSN Act]

1.163 Division 2 of the PSN Act sets out the circumstances in which non direction stays may cease. The impact of the specified stay provisions, and circumstances in which non direction stays may cease, is described in Part 2 - Certainty for application of stays on close-out rights below.

1.164 In addition to the provisions already specified, the definition of specified provisions set out in section 5 of the PSN Act has been expanded to include:

•

subsections 11CD(2) and (3), section 11F and subsection 13A(3) of the Banking Act; and [Schedule 1, Part 1, item 7, section 5 (paragraphs (a) and (b) of the definition of specified provisions) of the PSN Act]

•

subsections 105(2) and (3) of the Insurance Act; and [Schedule 1, Part 1, item 7, section 5 (paragraphs (a) and (b) of the definition of specified provisions) of the PSN Act]

•

section 187 and subsections 230C(2) and (3) of the Life Insurance Act; and [Schedule 1, Part 1, item 7, section 5 (paragraphs (a) and (b) of the definition of specified provisions) of the PSN Act]

•

sections 440B, 468, 556 and 588FL and Divisions 2 of Part 5.7B of the Corporations Act; [Schedule 1, Part 1, item 8, section 5 (paragraph (d) of the definition of specified provisions) of the PSN Act]

•

subsections 101(3) and (4) of the PHI Act; and [Schedule 1, Part 1, item 9, section 5 (after paragraph (f) of the definition of specified provisions), paragraph (fa) of the PSN Act]

•

sections 267 and 267A of the PPSA. [Schedule 1, Part 1, item 9, section 5 (after paragraph (f) of the definition of specified provisions), paragraph (fb) of the PSN Act]

1.165 The specified provisions definition is an inclusive list of the provisions of other laws over which the PSN Act prevails and is inserted for transparency and ease of reference.

1.166 The references to subsections 11CD(2) and (3) of the Banking Act, subsections 105(2) and (3) of the Insurance Act, subsections 230C(2) and (3) of the Life Insurance Act and subsections 101(3) and (4) of the PHIA Act are included to clarify that the protections provided under the PSN Act to close-out netting and other matters prevail over the regime set out in those Acts for a party or parties to be relieved from obligations owed to the relevant entity. In any circumstances where an entity such as a Regulated Entity or a private health insurer registered under Division 3 of Part 2 of the PHI Act is prevented from fulfilling its obligations under the contract (e.g. because of a direction under Subdivision A of Part II of the Banking Act), the counterparty would be able to close-out transactions under the contract and enforce security in the manner protected by the PSN Act. This is described using an example in paragraph 1.204 below.

1.167 The references to sections 440B, 556 and 588FL of the Corporations Act and sections 267 and 267A of the PPSA are included to clarify that the PSN Act would prevail over these provisions and that Act, which may otherwise impose a stay on enforcement of security in certain circumstances (section 440B of the Corporations Act), which set out certain priority payments (section 556 of the Corporations Act) and which provide for circumstances in which security interests will vest (section 588FL of the Corporations Act and sections 267 and 267A of the PPSA). This accords with the general policy intention of these amendments (and the new paragraph 14(2)(fb)), which is the ensure that security may be enforced in the manner contemplated in the PSN Act notwithstanding existing impediments under Australian law, such as perfection and registration requirements and priority regimes. There are thus strong policy reasons associated with the preservation of financial system stability and the need to ensure that entities subject to Australian law can provide, and enforce rights in respect of, margin by way of security in connection with certain derivatives in the manner required by international standards in protecting the enforcement of security in the manner set out in the Bill.

1.168 As the protections provided under subsections 14(1) and (2) have effect despite any other law (subject to the reforms in respect of specified stay provisions discussed below), if another law purported to prevent enforcement of the security in accordance with its terms, it would be inconsistent and must yield. Similarly, if any other law purported to impose conditions that must be satisfied before the security can be enforced, that other law would also be inconsistent and must yield (subject to the reforms in respect of specified stay provisions discussed below).

1.169 However, another law which purported to regulate the manner in which the security is enforced (for example, section 420A of the Corporations Act, if it applied, as described above) would continue to apply provided that it only impacted the way in which the secured person need to enforce its security and did not in any way inhibit the actual enforcement of security.

Circumstances in which subsections 14(1) and 14(2) do not apply

1.170 The PSN Act enhances the legal certainty of close-out netting contracts. In particular, subsection 14(2) preserves the validity of close-out netting contracts on the external administration (see the footnote to paragraph 1.179 below for a description of this definition) of a party to that contract.

1.171 Subsection 14(3) of the PSN Act previously provided that a person may not rely on the application of subsection 14(2) of the PSN Act to a right or obligation under a close-out netting contract if the person acquired the right or obligation from another person with notice that that other person was at that time unable to pay their debts as and when they became due and payable.

1.172 The subsection is designed to prevent a party to a close-out netting contract from knowingly buying up the debts (rights or obligations) of an insolvent person with a view to netting them against that party's own obligations under the contract.^[38]

1.173 However, the unamended wording of subsection 14(3) of the PSN Act may not cover all situations of potential misuse by counterparties. For example, party A acquires from party B a right or obligation under a close-out netting contract with party C. In this case, if party C was unable to pay their debts as and when they became due and payable (that is, was insolvent), the wording of subsection 14(3) may not prevent party A acquiring those rights and obligations from party B, and obtaining the benefit of subsection 14(2), even if they had notice that party C was insolvent.

1.174 The existing subsection 14(3) of the PSN Act is replaced by subsection 14(4) of the PSN Act, as amended by the Bill. The amended subsection 14(3) (now re-numbered as subsection 14(4)) provides that a party to a close-out netting contract is prevented from netting, or enforcing security in reliance on subsections 14(1) or 14(2) in respect of, rights and obligations under a close out netting contract or to a security if the person acquired the right or obligation from another person with notice that that other person, or the other party to the contract, was at that time unable to pay their debts as and when they became due and payable. The term 'acquired' is intended to mean both obtained by grant or creation and by transfer. The Bill also clarifies that this subsection does not apply if the acquisition of rights and obligations was part of a transfer under the Business Transfer Act. [Schedule 1, Part 1, item 30, subsections 14(3), (4) and (5), subsection 14(4) of the PSN Act]

1.175 The Bill also extends the application of subsection 14(4) to security given over financial property in respect of obligations of a party of a close-out netting contract. If security is given over financial property, in respect of obligations of a party to a close out netting contract, then the new subsection 14(4) applies in relation to rights and obligations under the security in the same way as it applies in relation to rights and obligations under the contract. [Schedule 1, Part 1, item 30, subsections 14(3), (4) and (5), subsection 14(9) of the PSN Act]

1.176 The amended subsection 14(5) of the PSN Act, together with the insertion of new subsections 14(6) and 14(9) expands the scope of that subsection to contemplate the giving of the security. Under subsection 14(5), the protection otherwise provided under subsection 14(1) or 14(2) does not apply to an obligation owed by a party to a close-out netting contract to another person if the party goes into external administration, the party acquired the obligation otherwise than as a result of a compulsory transfer of business and subsection (6) is satisfied. The Bill clarifies that subsection 14(5) will not be triggered (i.e. rights and obligations may still be netted and security may be enforced in these circumstances) if the acquisition of rights and obligations was part of a transfer under the Business Transfer Act. Please refer to paragraphs 1.249 to 1.254 for an explanation of subsection 14(7). [Schedule 1, Part 1, item 30, Subsections 14(3), (4) and (5), subsection 14(5) of the PSN Act]

1.177 Subsection 14(6) is substantively similar to the existing paragraph 14(5)(c). Accordingly, subsection 14(5) will have the effect set out in that clause if the party goes into external administration, the acquisition of rights and obligations was not part of a transfer under the Business Transfer Act and any of the following are satisfied:

•

the other person did not act in good faith in entering into the transaction that created the terminated obligation;

•

when that transaction was entered into, the other person had reasonable grounds for suspecting that the party was insolvent at that time or would become insolvent because of, or because of matters including:

-

entering into the transaction; or

-

a person doing an act, or making an omission, for the purposes of giving effect to the transaction;

•

the other person neither provided valuable consideration under, nor changed their position in reliance on, the transaction. [Schedule 1, Part 1, item 30, subsections 14(3), (4) and (5), subsection 14(6) of the PSN Act]

1.178 Subsection 14(5) (and by extension subsection 14(6)) applies in relation to an obligation owed by a party to the security in the same way as it applies in relation to an obligation owed by a party to the contract. [Schedule 1, Part 1, item 30, subsections 14(3), (4) and (5), paragraph 14(9)(c) of the PSN Act]

Expanded definition of external administration

1.179 The PSN Act provides a range of fundamentally important protections to financial market transactions, payment and settlement systems and financial market infrastructure in circumstances where a party to a close-out netting contract, market netting contract or approved netting arrangement or a participant in an approved RTGS system goes into external administration.^[39]

1.180 In some circumstances (particularly where the relevant close-out netting contract or market netting contract is not governed by Australian law), a party or participant going into external administration is a prerequisite to the application of several of these vitally important protections. Without such an external administration, as the term is defined in the PSN Act, those protections may not be able to apply.

1.181 Despite the importance of the external administration to the term, it is unclear whether resolution measures such as statutory management and judicial management fall within the definition in all circumstances.

1.182 Accordingly, the definition of external administration in section 5 of the PSN Act will be expanded to provide that a person goes into external administration if, in addition to the existing circumstances:

•

an ADI statutory manager takes control of the person's business under the Banking Act; or

•

the person comes under judicial management under the Insurance Act; or

•

the person, or a part of the person's business, comes under judicial management under the Life Insurance Act. [Schedule 1, Part 1, item 2, section 5 (at the end of the definition of external administration) of the PSN Act]

1.183 Consequential amendments are also made to the definition of external administrator in section 5 to clarify that the external administrator for a person who goes into external administration is the person who takes control of the property, part of the property, the business, or part of the business, of the person under the administration. This change is necessary as an external administration may relate to the person's business or part of the business as well as the person's property or the part of the property. For example, under the Life Insurance Act, a life company, or part of the business of a life company, may be placed under judicial management. Another example is that a receiver may, in certain circumstances, be appointed to a particular asset of a person rather than the person itself or all of the assets of the person (in which case, the receiver would still be an 'external administrator' for the purposes of the PSN Act and the receivership would be an 'external administration' under paragraph (a) of the definition). [Schedule 1, Part 1, item 3, section 5 (definition of external administrator)]

Part 2 - Certainty for application of stays on close-out rights

1.184 The PSN Act was enacted to reinforce the effectiveness of netting contracts in Australia. Broadly, it provides that the action of netting in certain contracts is legally certain, and cannot later be unwound, as may be the case should insolvency law prevail. Further, it allows close-out and market netting to proceed upon the appointment of an external administrator, such as a liquidator, receiver or administrator.

Netting contracts

1.185 Close-out netting is a contractual mechanism that enables the termination of obligations (e.g. obligations under transactions), calculation of the termination values of the obligations and the netting of the termination values so that only a net cash amount is payable in the case of insolvency (or other defined event of default, such as the appointment of a liquidator, receiver or administrator.

1.186 If one party to a netting contract becomes insolvent or otherwise defaults on its obligations, or another event of default (as defined in the applicable contract) occurs, close-out netting provisions in the contract allow the non-defaulting party to terminate all outstanding transactions within the contract, value those terminated transaction values and aggregate these transactions values so that a single net sum will be owed by, or owed to, the non-defaulting party (that is, 'close-out' transactions relating to the contract).

1.187 Close-out netting is a common feature of derivative transactions, including currency (foreign exchange), interest rate swaps, securities lending transactions and repurchase agreements, and the master agreements frequently used to govern such transactions (such as the ISDA Master Agreement). In such cases, close-out netting mitigates credit risks associated with these derivatives.

Payment Systems and Netting Act

1.188 Section 5 of the PSN Act defines a close-out netting contract as a contract under which, if a particular event happens, particular obligations of the parties terminate or may be terminated, and the termination values of the obligations are calculated or may be calculated and the termination values are netted, or may be netted, so that only a net cash amount (whether in Australian currency or some other currency) is payable.

1.189 The PSN Act enhances the legal certainty of close-out netting contracts. In particular, subsection 14(2) preserves the validity of close-out netting contracts on the external administration of a party to that contract. To support subsection 14(2), subsection 14(4) (subsection 14(3), as amended by the Bill) provides that subsection 14(2) has effect despite any other law, including insolvency law.^[40]

1.190 The provisions of the PSN Act reflect the importance of the legal certainty of close-out netting arrangements. In the absence of certainty, domestic and foreign counterparties may be reluctant to enter into financial market transactions that are generally regarded as an essential part of sound financial management, such as interest rate and currency swaps and other arrangements which hedge exposures. Similarly, without this certainty, counterparties may face increased capital requirements in respect of exposures under such transactions which make such transactions commercially unviable.

Industry Acts

1.191 The Industry Acts empower APRA to appoint a statutory manager (in the case of an ADI) and the Federal Court to appoint a judicial manager (in the case of a general insurer or life company) in certain circumstances.^[41] In such cases, the statutory manager or judicial manager is charged with managing the Regulated Entity in the interests of depositors or policy holders and promoting financial system stability in Australia.

1.192 However, the appointment of a statutory manager or judicial manager may constitute an act of default under close-out netting contracts (such as the ISDA Master Agreement) or even a trigger for the enforcement of security (discussed later in this explanatory memorandum). As such, the appointment of a statutory manager or judicial manager would provide counterparties with a right to close-out transactions under a close-out netting contract on the basis that a statutory or judicial manager has been appointed to the other party.

1.193 To provide statutory managers and judicial managers with flexibility to meet their objectives, the Industry Acts restrict certain contractual rights triggered on the appointment of a statutory or judicial manager and certain other resolution activities (described below). In particular, subsection 15C(2) of the Banking Act provides that the fact that an ADI statutory manager is in control of the ADI's business does not allow the contract, or a party to the contract, to do any of the following:

•

deny any obligations under that contract;

•

accelerate any debt under that contract;

•

close-out any transaction relating to that contract.

1.194 This Bill amends subsection 15C(2) to provide that the fact that an ADI statutory manager is in control of the ADI's business does not allow the contract, or a party to the contract, to, in addition to the matters described above, enforce any security under that contract.

1.195 Similar provisions are set out in subsection 62V(2) of the Insurance Act, and subsection 165B(2) of the Life Insurance Act in respect of the appointment of a judicial manager. The Bill introduces a new definition of 'statutory/judicial management' to cover these resolution activities. Under section 5 of the PSN Act, a person is under statutory/judicial management if:

•

an ADI statutory manager has control of the person's business under the Banking Act; or

•

the person is under judicial management under the Insurance Act; or

•

the person, or a part of the person's business, is under judicial management under the Life Insurance Act. [Schedule 1, Part 1, item 10, Section 5, 'statutory/judicial management' definition of the PSN Act]

1.196 These provisions can assist a statutory or judicial manager in preserving currency and interest rate hedges if they are in the interests of depositors or policy holders or promote financial system stability. The automatic termination of large volumes of financial contracts upon the appointment of a statutory or judicial manager could result in market instability and frustrate the implementation of resolution measures.

1.197 In addition to the provisions which do not allow for the close-out of transactions under a contract due to the appointment of a statutory manager or judicial manager, certain other stays exist under the Industry Acts and PHI Act. For example, in addition to the stays on close-out rights which apply in respect of the appointment of a statutory manager or judicial manager, the following do not allow the contract, or a party to the contract, to close out transactions relating to that contract:

•

the fact that the relevant Regulated Entity, private health insurer or certain other body (e.g. an authorised NOHC as defined in the Banking Act) is subject to a direction by APRA under the relevant provisions of the Industry Acts (see subsection 11CD(1A) of the Banking Act, subsection 105(1A) of the Insurance Act, subsection 230C(1A) of the Life Insurance Act and subsection 101(2) of the PHI Act);

•

the fact that the relevant Regulated Entity is subject to a recapitalisation direction (see subsection 13N(2) of the Banking Act, subsection 103K(2) of the Insurance Act and subsection 230AJ(2) of the Life Insurance Act);

•

the fact that the statutory manager or judicial manager of a Regulated Entity does certain acts to facilitate recapitalisation (see subsection 14AC(2) of the Banking Act, subsection 62ZB(2) of the Insurance Act and subsection 168C(2) of the Life Insurance Act); and

•

the fact that an act is done for the purposes of Division 2 or 3 of Part 4 of the Business Transfer Act, or that a certificate of transfer comes into force under Division 3 of Part 4 of the Business Transfer Act, in connection with the relevant body (see subsection 36AA(2) of the Business Transfer Act).

1.198 The PSN Act is clarified to describe each of these provisions of the Industry Acts and PHI Act which stay close-out rights (along with subsection 15C(2) of the Banking Act, subsection 62V(2) of the Insurance Act, and subsection 165B(2) of the Life Insurance Act in relation to statutory management and judicial management) as a specified stay provision. [Schedule 1, Part 1, item 10, Section 5, 'specified stay provision' definition of the PSN Act]

1.199 The provisions of the Industry Acts and PHI Act which do not allow the contract, or a party to the contract, to close-out transactions relating to that contract due to the fact of the relevant entity being subject to a direction by APRA or a recapitalisation direction are defined in the PSN Act as each being a direction stay provision. These provisions are defined in both the definition specified stay provision and direction stay provision because the framework set out in the Bill provides for these stays to interact with the PSN Act in a different manner to non-direction related specified stay provisions (as described below). [Schedule 1, Part 1, item 1, Section 5, 'direction stay provision' definition of the PSN Act]

1.200 Generally speaking, as a matter of Australian law, the stays in the Industry Acts and PHI Act apply where the relevant regulated entity is party to a contract, whether the proper law of the contract is:

•

Australian law, including the law of a state or territory; or

•

law of a foreign country, including the law of part of a foreign country.

1.201 However, this does not necessarily mean that a foreign court would recognise Australian law as applying in these circumstances and may not give effect to the stays set out under the Industry Acts. This also necessitates the need for international cooperation regarding resolution regimes, and the Stay Protocol is one approach which has been adopted by a number of foreign regulators and international systemically important financial institutions to achieve this objective.

Close-out, and enforcement of security, for any other reason

1.202 However, these stays should not be read to cover any other event of default or ground for termination beyond the specific circumstances described in the provision (even if it occurs simultaneously with the event described in the relevant stay provision). No specified stay provision, including a direction stay provision, has any effect in respect of any other close-out event or trigger for the enforcement of security given in relation to the close-out netting contract happening in relation to the contract or security (e.g. a failure to comply with an obligation under the contract). The stays in the Industry Acts do not prevent a counterparty from closing-out transactions relating to a close-out netting contract or enforcing security on the basis of an action other than the appointment of a statutory or judicial manager or relevant fact referred to in the other specified stay provisions.^[42] For example, counterparties may close-out transactions relating to such an arrangement or contract or enforce security because the Regulated Entity or private health insurer is insolvent, or if a Regulated Entity or private health insurer under statutory or judicial management or subject to a direction from APRA (as applicable) fails to satisfy any substantive obligations under a close-out netting contract, market netting contract or security (including any payment and delivery obligations). These other events generally constitute separate events of default which could trigger the close-out or enforcement rights under the contract, arrangement or security which would be protected under the PSN Act notwithstanding the specified stay provisions.

1.203 Even if APRA specifically gives a direction that a Regulated Entity or private health insurer is not to make payments or deliveries or otherwise perform obligations under a close-out netting contract (or for the regulated entity not to make payments generally) or a direction has this effect (even inadvertently), the counterparty may rely on the protections of the PSN Act and exercise a close-out right it has to close-out transactions or enforce security on the basis of such non-performance when the relevant obligation is not performed (i.e. PSN Act prevails over the direction stay provision in those circumstances).

1.204 This is explained in the following example. APRA gives a direction on a Monday to an ADI under Subdivision A or B of Division 1BA of Part II of the Banking Act (e.g. section 11CA) or section 29 of the Banking Act which prevents the ADI from fulfilling an obligation under a close-out netting contract with another party (this party is the Terminating Party for this example) which it was otherwise required to perform on Thursday. Due to the operation of section 11CD(1A), the Terminating Party (or the contract itself):

•

is not able to terminate transactions relating to the close-out netting contract or enforce security on Monday in reliance on an event of default which is triggered solely by the mere giving of the direction by APRA;

•

may terminate transactions relating to the close-out netting contract or enforce security in reliance on an event of default which arises because the ADI has not fulfilled an obligation under a close-out netting contract or security on Thursday or any other event of default.

Framework for the interaction between PSN Act protections and stays

1.205 A potential inconsistency exists between the PSN Act and the specified stay provisions. The specified stay provisions provide that a party cannot close-out transactions relating to a contract (and will provide that a party cannot enforce security under a contract) due to happening of the event described in the specified stay provision, while the PSN Act, as amended, provides that parties to close-out netting contracts and market netting contracts can close-out transactions or enforce security on the appointment of an external administrator in the manner contemplated in the PSN Act.

1.206 This Bill resolves this potential inconsistency by amending the PSN Act to introduce a new framework to deal with the occurrence of the events described in the specified stay provisions.

1.207 The general principle of the reforms to the operation of the stays on close-out rights in close-out netting contracts, market netting contracts and security given in relation to obligations under the contract is that:

•

the protections given to important approved RTGS systems, approved netting arrangements and market netting contracts under the PSN Act prevail over stays on close-out rights set out in the specified stay provisions; and

•

a specified stay provision of an Industry Act which applies to a close-out netting contract or security will prevail over the protections given to close-out netting contracts and security under the PSN Act broadly in the manner set out in the Bill.

Close-out netting contracts

1.208 For close-out netting contracts, the new framework involves the following features:

•

close-out and enforcement of security generally prevented on grounds of a direction or recapitalisation direction for all types of close-out netting contracts. Counterparties generally cannot close-out transactions under a close-out netting contract or enforce security under the contract on the grounds that a Regulated Entity or private health insurer is subject to a direction or recapitalisation direction (regardless of the nature of obligations under the close-out netting contract or security);

•

for:

-

close-out netting contracts which do not contain an obligation related to a derivative or foreign exchange contract or of another prescribed kind; and

-

security given over financial property, in respect of an obligation of a party to a close-out netting contract to which a regulated body is a party, where the obligation is not an eligible obligation in relation to the contract nor an obligation of a prescribed kind,

close-out and enforcement of security generally prevented on grounds of the appointment of a statutory manager or judicial manager, the taking of recapitalisation act or certain transfer-related events (Resolution Events) where a specified stay provision (other than a direction stay provision) applies to a trigger event that happens in relation to the contract. Counterparties generally cannot close-out transactions under such a close-out netting contract or enforce such a security, on the grounds of the appointment of a statutory manager or judicial manager, the statutory manager or judicial manager taking action to facilitate recapitalisation or certain events occurring in relation to a compulsory transfer of business (these grounds are described in this explanatory memorandum as Resolution Events);

•

for:

-

close-out netting contracts which contain an eligible obligation or an obligation of another prescribed kind; and

-

security given over financial property, in respect of an obligation of a party to a close-out netting contract to which a regulated body is a party, where the obligation is an eligible obligation in relation to the contract, or an obligation of a prescribed kind,

close-out and enforcement of security prevented on grounds of Resolution Events for the resolution period where a specified stay provision (other than a direction stay provision) applies to a trigger event that happens in relation to the contract. For these close-out netting contracts and securities, counterparties are restricted from closing out transactions under the contract or enforcing security on the grounds of a Resolution Event for a temporary period (the 'resolution period', which has the meaning given by section 15A). [Schedule 1, Part 1, item 6, Section 5, 'resolution period' definition of the PSN Act]

•

The resolution period starts when the trigger event occurs (e.g. when the Resolution Event which is grounds for closing out transactions related to the contract occurs) and ends:

-

for the transfer stay under subsection 36AA(2) of the Business Transfer Act, just after the certificate of transfer comes into force or when APRA declares that the resolution period for the relevant event ends; and

-

for other stays, at midnight (by legal time in the Australian Capital Territory) at the end of the first business day after the trigger event (e.g. the Resolution Event which is a close-out right under the contract) unless a declaration by APRA that the stay ceases to apply takes effect at an earlier time;

•

However, close-out and enforcement of security are permitted during the resolution period if APRA makes a declaration determining the stay ceases to apply.

•

At the end of the relevant resolution period, counterparties are generally permitted to close-out transactions under close-out netting contracts, or enforce security under securities, which fall within subsections 15A(1) or 15A(2) on the grounds of the Resolution Event.

•

Close-out and enforcement of security may be prevented permanently beyond resolution period if resolution action is successful. A stay may continue to apply permanently if APRA declares it is satisfied of certain solvency- and licensing-related matters in respect of the Regulated Entity under section 15C.

1.209 However, as described above, the stays only relate to the particular action described in the specified stay provisions and the framework does not prohibit a party closing out under any close-out netting contract (whether or not it contains an eligible obligation) or enforcing security (whether or not it is given in relation to eligible obligations) for any other reason (e.g. a counterparty may still close-out transactions or enforce security because the Regulated Entity fails to make a payment or perform an obligation).

Close-out and enforcement of security generally prevented on grounds of a direction or recapitalisation direction

1.210 As a general matter, the protections provided in respect of close-out netting contracts and security under subsections 14(1) and (2) have effect in relation to a close-out netting contract subject to a specified stay provision that applies to the contract. If security is given over financial property, in respect of obligations of a party to a close out netting contract, this applies in relation to the security in the same way as it applies in relation to the contract. [Schedule 1, Part 1, item 30, paragraphs 14(3)(a) and 14(9)(a) of the PSN Act]

1.211 Division 2 of Part 4 of the PSN Act, entitled 'Ceasing non direction stays for derivatives contracts' clarifies the circumstances in which non-direction stays^[43] may cease. However, the PSN Act (including Division 2 of Part 4) does not provide that direction stay provisions cease to have effect. Accordingly, counterparties generally cannot close-out transactions under a close-out netting contract (or, as a result of the Bill, enforce security under a contract) solely on the grounds that a Regulated Entity or private health insurer is subject to a direction or recapitalisation direction (regardless of the nature of obligations under the close-out netting contract or security). [Schedule 1, Part 1, item 30 Subsections 14(3), (4) and (5), Note 2 at the end of subsection 14(3) of the PSN Act and item 32, at the end of Part 4, Division 2 of the PSN Act]

Close-out netting contracts with no obligations related to derivatives or foreign exchange contracts or of another prescribed kind

1.212 Counterparties generally cannot close-out transactions under a close-out netting contract under which there are no eligible obligations (e.g. obligations that relate to a derivative or foreign exchange contract or are of another prescribed kind) nor obligations of another prescribed kind (for the purposes of section 15A) solely on the grounds of a Resolution Event.^[44] Similarly, where security given over financial property, in respect of an obligation of a party to a close-out netting contract to which a regulated body is a party, counterparties generally cannot enforce security if that obligation is not an eligible obligation in relation to the contract nor an obligation of a prescribed kind.

1.213 As described above, Division 2 of Part 4 of the PSN Act clarifies the circumstances in which non-direction stays may cease. The mechanism set out in Division 2 will apply to the stays relating to closing out transactions and enforcing security. The stay on enforcing security given in relation to obligations under the close-out netting contract ceases under Division 2 in a similar way to the stay on closing out transactions under the contract does. This supports the policy that security-based credit support arrangements in support of obligations pursuant to a close-out netting contract (including any pledge, charge, mortgage, lien or other analogous interest under foreign law) and other credit enhancements entered into in respect of the close-out netting contract should be treated in the same way as the close-out netting contract. However, the specified stay provisions (other than direction stay provisions) will only cease to apply in accordance with that Division if section 15A applies to this relevant close-out netting contract or security. The stays which apply for Resolution Events will not cease to apply in accordance with Division 2 for close-out netting contracts and security which do not satisfy the requirements in subsections 15A(1) or 15A(2) (as applicable). [Schedule 1, Part 1, item 32, at the end of Part 4, subsections 15A(1) and 15A(2) of the PSN Act]

Close-out netting contracts with obligations related to derivatives or foreign exchange contracts or of another prescribed kind

1.214 The framework in the Bill ensures that, in the event of a Resolution Event occurring in respect of a Regulated Entity, the appropriate balance is struck between ensuring that counterparties to contracts with the Regulated Entity can manage their risks but also giving APRA the best chance to determine the appropriate course of action to take in resolving the distressed Regulated Entity. A particular focus on international developments have been to ensure that any stay which is imposed on a counterparty's exercise of close-out rights in respect of financial market transactions such as arrangements governing derivatives and foreign exchange contracts or certain other kinds of obligations prescribed in regulations to the PSN Act is temporary.

1.215 Division 2 of Part 4 of the PSN Act is intended to clarify that the specified stay provisions of the Industry Acts apply in respect of financial market transactions such as derivatives-related arrangements in a manner broadly consistent with international best practice, as set out in the FSB's Key Attributes and the Stay Protocol.

1.216 Generally:

•

the counterparty to a close-out netting contract under which an obligation of a party to the contract is an eligible obligation in relation to the contract or an obligation of a kind prescribed by the regulations to the PSN Act (such that paragraph 15A(1)(a) is satisfied); or

•

secured person under a security given over financial property, in respect of an obligation of a party to a close-out netting contract to which a regulated body is a party, under which the obligation is an eligible obligation in relation to the contract or an obligation of a prescribed kind (such that paragraph 15A(2)(a) is satisfied),

is restricted from closing out transactions under the contract or enforcing security on the grounds of a Resolution Event for a temporary period in the manner set out in Division 2 of Part 4 of the PSN Act.

1.217 In order for a specified stay provision (other than a direction stay provision) to cease to apply to a close-out netting contract accordance with the mechanism set out in section 15A (and the remainder of Division 2), subsection 15A(1) requires, in relation to a close-out netting contract to which a regulated body is a party, that the following are satisfied:

•

an obligation under the contract of a party to the contract is an eligible obligation in relation to the contract or is of another prescribed kind; and

•

a specified stay provision (other than a direction stay provision) applies to a trigger event that happens in relation to the contract. [Schedule 1, Part 1, item 32, at the end of Part 4, subsection 15A(1) of the PSN Act]

1.218 In order for a specified stay provision (other than a direction stay provision) to cease to apply to a security given over financial property, in respect of an obligation of a party to a close-out netting contract to which a regulated body is a party in accordance with the mechanism set out in section 15A (and the remainder of Division 2), subsection 15A(2) requires, in relation to the security, that the following are satisfied:

•

the obligation is an eligible obligation in relation to the contract, or an obligation of a prescribed kind; and

•

a specified stay provision (other than a direction stay provision) applies to a trigger event that happens in relation to the contract. [Schedule 1, Part 1, item 32, at the end of Part 4, subsection 15A(2) of the PSN Act]

1.219 The term 'trigger event' for a close-out netting contract is defined in section 5 of the PSN Act to mean a particular event, such as a Resolution Event, which, if it happens, gives rise to close-out rights under the contract. In other words, a 'trigger event' happens in respect of a close-out netting contract if, on the happening of the event:

•

particular obligations of the parties terminate or may be terminated; and

•

the termination values of the obligations are calculated or may be calculated; and

•

the termination values are netted, or may be netted, so that only a net cash amount (whether in Australian currency or some other currency) is payable. The trigger event may also be relevant to enforcing the security in accordance with its terms. [Schedule 1, Part 1, item 10, section 5, 'trigger event' definition of the PSN Act]

1.220 The term 'regulated body' is defined in section 5 of the PSN Act to mean:

•

a body corporate that is an ADI for the purposes of the Banking Act; or

•

a general insurer within the meaning of the Insurance Act; or

•

a body corporate that is registered under section 21 of the Life Insurance Act; or

•

a private health insurer within the meaning of the PHI Act. [Schedule 1, Part 1, item 6, section 5, 'regulated body' definition of the PSN Act]

1.221 Under subsection 15A(3) in Division 2 of Part 4 of the PSN Act, a specified stay provision (other than a direction stay provision)^[45] ceases to apply to a close-out netting contract or a security:

•

at the time when a declaration by APRA that the non-direction stay ceases under section 15B in relation to the contract or security takes effect; or

•

at the end of the resolution period for the trigger event, if no declaration under section 15C in relation to the contract or security has been made by APRA during that period. [Schedule 1, Part 1, item 32, at the end of Part 4, subsection 15A(3) of the PSN Act]

1.222 In other words, once one of these things occurs, a counterparty may close-out transactions relating to a close-out netting contract or enforce security given in relation to obligations under the contract on the grounds of a Resolution Event.

1.223 Under subsection 15A(4), for a trigger event, the resolution period starts when the Resolution Event which gives rise to a close-out right under the contract happens (i.e. when the trigger event happens) and ends:

•

for a transfer-related stay (i.e. subsection 36AA(2) of the Business Transfer Act):

-

if APRA declares, in writing, that the resolution period ends under subsection 15A(5), at the time the declaration is made; or

-

if a certificate of transfer under the Business Transfer Act comes into force, just after the certificate of transfer comes into force; and

•

for other non-direction stays, at midnight (by legal time in the Australian Capital Territory) at the end of the first business day after the day on which the trigger event happens. This is intended to be consistent with international requirements^[46] and the approach taken in other jurisdictions, and is considered to provide certainty as to the time at which counterparties to contracts with the Regulated Entity subject to the Resolution Event may close-out transactions relating to the contracts and enforce security given in relation to obligations under the contract.^[47] This resolution period cannot be amended by regulations. [Schedule 1, Part 1, item 32, at the end of Part 4, subsection 15A(4) of the PSN Act]

1.224 The note to subsection 15A(4) clarifies that the transfer-related stay applies indefinitely if a certificate of transfer does not come into force and APRA does not declare that the resolution period ends. This is because there does not appear to be any compelling policy reason why a party should be able to close-out transactions or enforce security solely because of preparatory actions taken in respect of a transfer when no transfer occurs (noting that a counterparty would be able to terminate and enforce security in accordance with the terms of the contract and security if there were any other substantive events of default such as insolvency or a failure to pay). [Schedule 1, Part 1, item 32, at the end of Part 4, note at the end of subsection 15A(4) of the PSN Act]

End of transfer-related resolution period on APRA's declaration

1.225 APRA has a power to allow counterparties to close-out transactions under a close-out netting contract or enforce security given in relation to obligations under the contract on the basis of the occurrence of an act done in relation to a compulsory transfer of business for the purposes of Division 2 or 3 of Part 4 of the Business Transfer Act which triggers close-out rights under the contract or rights to enforce security if APRA is satisfied that it will not issue a certificate of transfer under that Act. This would protect counterparties from their close-out rights and rights as secured party being stayed, potentially indefinitely for certain preparatory actions related to an aborted transfer, if APRA considers that it will not issue the certificate of transfer. If the conditions set out in subsection 15A(5) are satisfied, APRA may declare, in writing that the resolution period for that trigger event ends. [Schedule 1, Part 1, item 32, at the end of Part 4, subsection 15A(5) of the PSN Act]

1.226 The Bill provides that a declaration to shorten the resolution period is not a legislative instrument. The provision is included to assist readers and is merely declaratory of the law, as the instrument is not a legislative instrument within the meaning of section 5 of the Legislation Act 2003. [Schedule 1, Part 1, item 32, at the end of Part 4, subsection 15A(6) of the PSN Act]

APRA may declare that non direction stays cease before the end of the resolution period

1.227 APRA also has the power to allow counterparties to close-out transactions and enforce security before the end of the resolution period for a trigger event where it is clear that this will protect counterparties from the operation of a full resolution period. APRA has this declaratory power where APRA is satisfied that it will not make a declaration under section 15C in relation to a party before the end of the resolution period for the trigger event. It is expected that this will be particularly relevant where APRA does not expect that the Regulated Entity subject to the Resolution Event will satisfy the solvency- and licensing-related conditions set out in section 15C (e.g. if APRA does not expect the Regulated Entity will be solvent or the Regulated Entity's level of capital will comply with the minimum capital requirements that apply to it by the end of the resolution period).

1.228 APRA may, before the end of the resolution period for the trigger event, declare that the specified stay provision is to cease to apply to all close out netting contracts of the party and all securities given over financial property, in respect of obligations of the party under all close out netting contracts of the party if:

•

a trigger event to which a specified stay provision (other than a direction stay provision) applies happens in relation to a close out netting contract or security to which a regulated body is a party; and

•

APRA is satisfied that APRA will not make a declaration under section 15C in relation to a party before the end of the resolution period for the trigger event. [Schedule 1, Part 1, item 32, at the end of Part 4, section 15B of the PSN Act]

1.229 A declaration that the relevant non-direction stay ceases must be made before the end of the resolution period for the trigger event, and takes effect either at the time when the declaration is made or, if the declaration specifies a time before the end of the resolution period for when the specified stay provision is to cease to apply, at the specified time. Once the declaration takes effect, counterparties will not be prevented from closing out transactions relating to the close-out netting contracts to which the Regulated Entity is a party or enforcing security given in relation to obligations under the contrac ts. The declaration cannot be varied or revoked. [Schedule 1, Part 1, item 32, at the end of Part 4, subsections 15B(2), (3) and (4) of the PSN Act]

1.230 The Bill provides that such a declaration, if made in writing, is not a legislative instrument. The provision is included to assist readers and is merely declaratory of the law, as the instrument is not a legislative instrument within the meaning of section 5 of the Legislation Act 2003. [Schedule 1, Part 1, item 32, at the end of Part 4, subsection 15B(5) of the PSN Act]

Extending the prevention of close-out

1.231 The final feature of the framework is the capacity to prevent the close-out of transactions relating to close-out netting contracts or enforcement of security given over financial property, in respect of an obligation of a party to a close-out netting contract to which a regulated body is a party on the grounds of a Resolution Event beyond the resolution period where certain conditions have been met. This feature provides APRA with the ability, should it wish, to continue to prevent close-out should this course of action be considered to be in the interests of depositors or policy holders, or beneficial for the protection of financial stability.

1.232 To protect the legitimate interests of counterparties to close-out netting contracts and associated security, the Bill provides that a specified stay provision may only continue (and be declared to continue) if the following specified circumstances exist:

•

a trigger event to which a specified stay provision (other than a direction stay provision) applies happens in relation to a close out netting contract to which a regulated body is a party;

•

APRA is satisfied that all the matters set out in subsection 15C(3) will be satisfied in relation to the party in respect of which the declaration may be made:

-

if a certificate of transfer will come into force under the Business Transfer Act, just after that coming into force; or

-

in all other cases, at the time the declaration will be made;

•

the party in respect of which the declaration may be made is not in external administration (as defined in the PSN Act) (other than statutory management or judicial management); and

•

APRA has not already made a declaration under section 15B that the specified stay provision ceases to apply. This is to provide certainty, so that APRA cannot make a declaration extending the application of the relevant stay if it has previously made a declaration that the stay ceases to apply. [Schedule 1, Part 1, item 32, at the end of Part 4, subsections 15C(1) and (2) of the PSN Act]

1.233 If these conditions are satisfied, APRA may, before the end of the resolution period for the trigger event, declare that the specified stay provision is to continue to apply to:

•

if a certificate of transfer for a total transfer will come into force under the Business Transfer Act, all close-out netting contracts to which the receiving body (within the meaning of the Business Transfer Act) will become a party and all securities given over financial property, in respect of obligations under those close-out netting contracts;

•

if a certificate of transfer for a partial transfer will come into force under the Business Transfer Act, either or both of the following:

-

all close-out netting contracts to which the transferring body (within the meaning of the Business Transfer Act) is a party, and all securities given over financial property in respect of obligations under those contracts;

-

all close-out netting contracts to which the receiving body (within the meaning of the Business Transfer Act) will become a party, and all securities given over financial property in respect of obligations under those contracts; or

•

in all other cases, all close-out netting contracts to which the regulated body is a party and all securities given over financial property, in respect of obligations under those close-out netting contracts. [Schedule 1, Part 1, item 32, at the end of Part 4, subsection 15C(2) of the PSN Act]

Solvency- and licensing-related conditions

1.234 One of the specified circumstances which must be satisfied in order for a specified stay provision to continue to apply is that APRA must be satisfied that all the matters set out in subsection 15C(3) will be satisfied in relation to the regulated body in respect of which the declaration may be made at the time the declaration will be made (or just after the coming into force of a certificate of transfer, if applicable).

1.235 The conditions of which APRA must be satisfied are as follows:

•

that the party is able to meet all its liabilities under:

-

close out netting contracts to which it is a party; and

-

securities given over financial property in respect of obligations of the party under those contracts;

as and when they become due and payable (including all payment and delivery obligations); and

•

that the party is solvent (within the meaning of the Corporations Act); and

•

that the party has each material authorisation (however described) necessary for its regulated business. The term authorisations should be interpreted to include any licenses (e.g. an Australian financial services licence) and other authorisations upon which the regulated body relies to carry out its regulated business. The term 'regulated business' of a regulated body is defined in section 5 of the PSN Act to mean:

-

if the regulated body is an ADI, the body's banking business (within the meaning of the Banking Act); or

-

if the regulated body is a general insurer, the body's insurance business (within the meaning of the Insurance Act); or

-

if the regulated body is a life company-the body's life insurance business (within the meaning of the Life Insurance Act); [Schedule 1, Part 1, item 6, Section 5, 'regulated business' definition of the PSN Act] and

•

that either of the following is satisfied:

-

the party's level of capital complies with the minimum capital requirements that apply to it under the Banking Act, the Insurance Act or the Life Insurance Act (as the case requires) and the applicable prudential standards made under the relevant Act; or

-

arrangements are in place to ensure that the regulated body performs all its obligations under close out netting contracts to which it is a party and securities given over financial property in respect of obligations of the party under those contracts as and when they are due to be performed. Those arrangements must remain in place until at least the earliest day on which the party's level of capital complies with the applicable minimum capital requirements or the statutory management or judicial management comes to an end. [Schedule 1, Part 1, item 32, at the end of Part 4, subsections 15C(3), (4) and (5) of the PSN Act]

1.236 These requirements are intended to reflect international developments such as the Stay Protocol as closely as possible, particularly the requirements set out in the elements of paragraph (e) of the definition of 'Protocol-eligible Regime' in the Stay Protocol which relates to any 'Close-out Stay' (as that term is defined in the Stay Protocol), whilst also reflecting concepts recognised in Australian law.

1.237 Subsection 15C(5) of the PSN Act is focussed on the outcome of the arrangements, not the mere fact that assurances or arrangements are in place. In relation to the 'arrangements' described in subsection 15C(5), in order to any arrangements to satisfy subsection 15C(5), there must be a high degree of certainty that those arrangements will ensure performance. The focus on subsection 15C(5) is on the outcome of the arrangements rather than the mere fact that a guarantee has been given or other arrangement has been put in place. For example, it is not expected that a guarantee from a commercial guarantor of insufficient creditworthiness would satisfy the requirement. This requirement may be satisfied, for example, if the Commonwealth were to provide a guarantee which covered all the regulated body's obligations (including payment and delivery obligations) under close out netting contracts to which it is a party as and when they are due to be performed and which remained in place until at least the earliest day on which the circumstances set out in paragraph 15C(5)(b) occurred. However, this Bill does not provide the Government with the power to provide any guarantee. Nor does the Bill commit the Government to provide such a guarantee in any situations in which a Resolution Event occurs. The Bill merely provides that one criterion would be satisfied if a guarantee given by the Commonwealth was in place which satisfied the description of the arrangements in subsection 15C(5).^[48]

1.238 A declaration made under section 15C cannot be varied or revoked. [Schedule 1, Part 1, item 32, at the end of Part 4, subsection 15C(6) of the PSN Act]

1.239 The Bill provides that such a declaration, if made in writing, is not a legislative instrument. The provision is included to assist readers and is merely declaratory of the law, as the instrument is not a legislative instrument within the meaning of section 5 of the Legislation Act 2003. [Schedule 1, Part 1, item 32, at the end of Part 4, subsection 15C(7) of the PSN Act]

Regulation making powers regarding declarations

1.240 As outlined above, the Bill empowers APRA to make declarations in certain circumstances. A regulation making power is included with respect to the declarations in sections 15B and 15C. Then regulation making power is in substantially the same form for each of these declarations.

1.241 The Bill provides that the regulations may do any of the following:

•

prescribe requirements relating to how declarations made by APRA are to be made (including requirements relating to the content or form of declarations);

•

prescribe requirements relating to the notification or publication of declarations;

•

include provisions that apply to determining, either generally or for a particular purpose, the time when declarations are taken to be made. [Schedule 1, Part 1, item 32, at the end of Part 4, subsections 15B(6) and 15C(8) of the PSN Act]

1.242 By providing for the use of regulations, it will be possible, if required, to specify factors that increase certainty as to the declaration regime. For example, as stated in the note to subsections 15B(6) and 15C(8), regulations may (for example) provide that a declaration is taken not to have been made until certain requirements of regulations have been complied with.

Approved RTGS systems, approved netting arrangements and market netting contracts

1.243 The Bill also addresses the potential inconsistency between the Industry Acts and the PSN Act concerning market netting contracts. The Bill also clarifies that the protections providing to approved netting arrangements apply despite any other law (including the specified provisions and the specified stay provisions).

1.244 Approved RTGS systems are payment or settlement systems approved by the RBA under section 9 of the PSN Act. Approved netting arrangements typically arise in respect of multilateral netting in certain approved payment systems and securities settlement systems. Market netting typically arises under the rules of a stock exchange, futures exchange or CCP. The payment systems, settlement systems, exchanges and CCPs protected as approved RTGS systems, approved netting arrangements and netting markets under the PSN Act are fundamental to systemic stability in Australia. There are strong financial system stability reasons for ensuring that the operator of such a system, arrangement or market can enforce the arrangement or rules governing the operation of the market in accordance with their terms. Legal certainty is of the utmost importance in relation to these systems, arrangements and markets, and any uncertainty could cause significant systemic disruption. Accordingly, it has been considered that the protections provided to approved RTGS systems, approved netting arrangements and market netting contracts under the PSN Act should generally prevail over the specified stay provisions.

1.245 Accordingly, a new subsection 6(2) of the PSN Act is inserted by the Bill to provide that the protections which apply in respect of approved RTGS systems in section 6 have effect despite any other law (including the specified provisions and the specified stay provisions). A similar provision is inserted by the Bill in section 6A(2) in respect of the new protections which apply in respect of approved RTGS systems in respect of non-terminal administrations to ensure that those protections have effect despite any other law (including the specified provisions and the specified stay provisions). [Schedule 1, Part 1, item 15, subsection 6(2) of the PSN Act and item 16, after section 6, subsection 6A(2) of the PSN Act]

1.246 Similarly, a new subsection 10(3) of the PSN Act is inserted by the Bill to provide that the protections which apply in respect of approved netting arrangements in subsections 10(1) and 10(2) have effect despite any other law (including the specified provisions and the specified stay provisions). [Schedule 1, Part 1, item 21, subsection 10(3) of the PSN Act]

1.247 Similarly, a new subsection 16(3) is inserted by the Bill to provide that the protections which apply in respect of netting markets and market netting contracts in subsections 16(1) and 16(2) have effect despite any other law (including the specified provisions and the specified stay provisions). [Schedule 1, Part 1, item 35, subsection 16(3) of the PSN Act]

1.248 Reference is made in the note to each of subsections 6(2), 6A(2), 10(3) and 16(3) that section 5 of the PSN Act defines specified provisions and specified stay provision. [Schedule 1, Part 1, item 21, subsection 10(3) and item 35, subsection 16(3) of the PSN Act]

Additional protections from things being void or voidable

1.249 Under insolvency law, liquidators may 'claw-back' payments made to particular creditors in certain circumstances. For example, sections 588FE and 588FF of the Corporations Act allow a court to make orders setting aside voidable transactions, including unfair preference in certain circumstances.

1.250 Section 588FG of the Corporations Act provides a defence to a person who becomes a party to a transaction if that person became a party in good faith and at the time when the person became such a party the person had no reasonable grounds for suspecting that the company was insolvent at that time or would become insolvent because of, or because of matters including, entering into the transaction or a person doing an act, or making an omission, for the purpose of giving effect to the transaction.

1.251 In certain circumstances, the framework created by this Bill could give rise to transactions that may be voidable under insolvency law. For example:

•

if a counterparty to a close-out netting contract was prevented from closing-out transactions under the contract with a Regulated Entity because of the application of a specified stay provision; and

•

the Regulated Entity later becomes insolvent; and

•

a court considers that the counterparty had reasonable grounds for suspecting that the Regulated Entity was insolvent or would become insolvent because of the matters described above; and

•

payments received from the Regulated Entity under the transactions under the close-out netting contract that were prevented from being closed-out due to the operation of a specified stay provision may be liable to be set aside as an unfair preference (and as such become voidable).

1.252 Such an interpretation would require counterparties to meet their gross obligations outlined in this Bill, but merely hold a right to prove in the liquidation for the gross debts owed to them by the failed Regulated Entity.

1.253 The Bill prevents such a situation arising by providing, under subsection 14(7) of the PSN Act, that none of the following things done by a party to a close out netting contract or security, while it is in ADI statutory management or judicial management (as applicable) and a specified stay provision applies to the contract or security (as applicable), is to be void or voidable in an external administration (including under section 588FE of the Corporations Act):

•

making a payment, or transferring property, to another person to meet an obligation under the contract;

•

creating rights or obligations in another person under the contract;

•

giving any security to another person in relation to the contract;

•

entering into one or more close-out netting contracts, or transactions under one or more close-out netting contracts, with another person;

•

doing anything of the things mentioned above under a new close out netting contract (also described above). [Schedule 1, Part 1, item 30, subsections 14(3), (4) and (5), subsection 14(7) of the PSN Act]

1.254 Subsection 14(7) is intended to extend the existing protection provided in section 14 of the PSN Act that the termination of obligations, the netting of obligations and any payment under the close-out netting contract to discharge a net obligation are not considered void or voidable in the external administration (e.g. in existing paragraph 14(2)(g)) to certain things done by a party to a close-out netting contract while the party is in statutory/judicial management (as defined in the Bill) and a specified stay provision applies to the contract. A counterparty or secured person dealing with a Regulated Entity which is subject to statutory management or judicial management may have reasonable grounds for suspecting that the party was insolvent at the relevant time or would become insolvent because of certain matters. Despite this, the specified stay provisions may continue to apply to prevent a party from closing out transactions under the close-out netting contract it has with the Regulated Entity and effectively require the counterparty to continue to make payments and deliveries in accordance with the terms of the close-out netting contract. As discussed above, this could give rise to transactions that may be voidable under insolvency law. As the counterparty is still required to make payments and deliveries, and cannot manage the claw-back risk by closing out transactions, even though it may have reasonable grounds for suspecting the Regulated Entity is insolvent, it was not considered appropriate to include a similar provision in relation to subsection 14(7) as is currently set out in subsection 14(6)(b) in relation to subsections 14(1) and 14(2). However, the new protections in subsection 14(7) do not apply to a thing mentioned in that subsection done by a party to a close-out netting contract in relation to another person if the thing did not result from the operation of section 22, 35 or 36R of the Business Transfer Act and either of the following is satisfied:

•

the other person did not act in good faith in entering into the transaction;

•

the other person neither provided valuable consideration under, nor changed their position in reliance on, the transaction. [Schedule 1, Part 1, item 30, subsections 14(3), (4) and (5), subsection 14(8) of the PSN Act]

1.255 These carve-outs to the protection set out in subsection 14(8) will require the counterparty to the Regulated Entity to act in good faith and to have either provided valuable consideration under, or changed its position in reliance on, the transaction. [Schedule 1, Part 1, item 30, subsections 14(3), (4) and (5), subsection 14(8) of the PSN Act]

1.256 Subsection 14(7) applies to things done by a party to the security in relation to the security, or a right or obligation under the security, in the same way as it applies in relation to things done by a party to the contract in relation to the contract, or a right or obligation under the contract. [Schedule 1, Part 1, item 30, subsections 14(3), (4) and (5), paragraph 14(9)(d) of the PSN Act]

Enforcing security

1.257 In order to ensure that the enforcement of security is stayed under the Industry Acts in the same way as close-out netting rights are stayed, certain provisions of the Industry Acts which impose stays on close-out rights have been amended to provide that that the fact or happening of the event described in the relevant legislative provision does not allow the contract, or a party to the contract, to enforce any security under that contract. The reference to 'security' in these amendments is a reference to traditional forms of security. [Schedule 1, Part 2, item 36, after paragraph 11CD(1A)(c), paragraph 11CD(1A)(d) of the Banking Act, item 38, at the end of subsections 13N(2) and 14AC(2) of the Banking Act, item 41, at the end of subsection 36AA(2) of the Business Transfer Act, item 43, at the end of subsections 62V(2), 62ZB(2) and 103K(2) of the Insurance Act, item 44, after paragraph 105(1A)(c) of the Insurance Act, item 45, at the end of subsections 165B(2), 168C(2) and 230AJ(2) of the Life Insurance Act, item 46, after paragraph 230C(1A)(c) of the Life Insurance Act and item 47, at the end of subsection 101(2) of the PHI Act]

1.258 Certain supplemental changes have been made to the provisions of the Banking Act to explicitly recognise that the existing protection of certain contractual rights given under the Banking Act in relation to an asset that secures liabilities to holders of covered bonds, or their representatives, in circumstances where payments under the covered bonds to the holders or representatives are not made. Clarification is provided that subsections 11CD(1A) and 15C(2) have effect subject to section 31B of the Banking Act (which provides for the existing protections in relation to covered bonds). [Schedule 1, Part 2, item 37, subsection 11CD(1A) of the Banking Act and item 39, at the end of subsection 15C(2) of the Banking Act]

Business Transfer Act amendments

1.259 Transferring the business of an entity in financial distress to a healthy institution can be a less disruptive and costly means of resolving problems in financial institutions than wind-up.

1.260 Currently, Part 4 of the Business Transfer Act contains compulsory transfer of business powers. These powers may be used to transfer business from a distressed financial institution to a healthy one that is willing to receive (purchase) the business. The transfer may be of all the assets and liabilities of the institution (a total transfer) or of only some of the assets and liabilities of the institution (a partial transfer).

1.261 To support Part 4 of the Business Transfer Act, section 36AA of that Act currently limits the effect that certain acts taken in respect of a compulsory transfer has on contracts to which a body corporate that is, or is proposed to become, a transferring body is or was party. In particular, subsection 36AA(2) provides that the fact that an act is done for the purposes of Division 2 or 3, or that a certificate of transfer comes into force under Division 3, in connection with the body does not allow the contract, or any other party to the contract, to do any of the following:

•

deny any obligations under that contract;

•

accelerate any debt under that contract;

•

close-out any transaction relating to that contract.

1.262 There is some concern that the Business Transfer Act does not currently include provisions ensuring that APRA would not engage in 'cherry picking' when undertaking a compulsory transfer of business.

1.263 As such, the Bill provides that if:

•

a certificate of transfer comes into force in respect of a partial transfer; and

•

just before the partial transfer, the transferring body is a party to:

-

a close out netting contract; or

-

a security given over financial property, in respect of an obligation of the transferring body under a close-out netting contract; or

-

a market netting contract; or

-

a security given over property, in respect of an obligation of the transferring body under a market netting contract; or

-

an approved netting arrangement; and

•

the partial transfer covers some (but not all) of the following assets and liabilities:

-

the assets and liabilities the body has, under the close-out netting contract, market netting contract or approved netting arrangement, with respect to another party to the contract or arrangement (the counterparty);

-

those assets that are property over which security is given in respect of an obligation of the transferring body under the close-out netting contract or the market netting contract,

then the partial transfer is void:

-

to the extent of the assets or liabilities the transferring body has, just before the partial transfer, under the close-out netting contract, market netting contract or approved netting arrangement, with respect to the counterparty; and

-

if security is given over financial property in respect of an obligation of the transferring body under a close-out netting contract - to the extent that the assets are financial property in the possession or under the control of the counterparty or another person (who is not the transferring party) on behalf of the counterparty, under the terms of an arrangement evidenced in writing; and

-

if security is given over property in respect of an obligation of the transferring body under a market netting contract - to the extent that the assets are that property.

1.264 Accordingly, those assets and liabilities are not transferred to the transferee and instead remain with the transferring body. If security is given over financial property in respect of an obligation of the transferring body under a close-out netting contract or if security is given over property in respect of an obligation of the transferring body under a market netting contract, then those secured assets should be treated in a similar way as the other assets and liabilities under the close-out netting contract or market netting contract (as applicable). This would have the effect of voiding any partial transfer that sought to separate the obligations underlying a particular close-out netting contract or market netting contract from its associated collateral to the extent of that purported separation. However, it should be noted that, in Part 4 of the PSN Act, the enforcement of security is only protected to the extent that the secured property is financial property that has been transferred or otherwise dealt with so as to be in the possession or under control of the secured person or third party acting on the secured person's behalf. This concept has been adopted for use in paragraph 36AB(2)(b) of the Business Transfer Act as a limit to the extent to which a partial transfer will be void in relation to property which is subject to a security given in respect of an obligation under a close-out netting contract. This would have the effect that the partial transfer would not be void in relation to assets which are not financial property in the possession or under the control of the secured party or relevant third party even if those assets are subject to a security given in relation to the close-out netting contract. This is to avoid the risk that the ability to conduct a partial transfer could be impeded by a security granted over a wide range of a regulated entity's assets and under which a range of obligations, including obligations under close-out netting contracts, are secured. For example, a security over all the grantor's present and after acquired property given in respect of obligations under a close-out netting contract would not generally restrict APRA from making a compulsory partial transfer transferring certain assets subject to that security, or make such a partial transfer void, where those assets are not financial property in the possession or control of the secured party or its nominee. [Schedule 1, Part 2, item 42, after section 36AA, section 36AB of the Business Transfer Act]

1.265 The Bill also clarifies that the PSN Act affects what the assets and liabilities of a party to a close out netting contract, market netting contract or approved netting arrangement are taken to include. For example, paragraphs 10(1)(c), 14(1)(e) and 16(1)(e), in relation to approved netting arrangements, close-out netting contracts and market netting contracts respectively, generally provide that, for the purposes of any law, the assets of a party to the arrangement or contract are taken to include any net obligation owed to the party under the arrangement or contract and not to include obligations terminated under the arrangement or contract. [Schedule 1, Part 2, item 42, after section 36AA, note after subsection 36AB(1) of the Business Transfer Act]

1.266 These amendments are consistent with the FSB's recommendation that the resolution authority (APRA) would only be permitted to transfer all transactions under a particular close-out netting contracts, market netting contract or approved netting arrangement with a particular counterparty to a new entity, and would not be permitted to differentiate between individual rights, obligations or transactions with the same counterparty and subject to the same contract.^[49]

1.267 To support these amendments, the definitions of 'approved netting arrangement', 'close-out netting contract' and 'market netting contract' are inserted into subsection 4(1) of the Business Transfer Act. The terms are defined in each case as having the same meaning as in the PSN Act. The amendment ensures that the terms have consistent meaning between the PSN Act and the Business Transfer Act. [Schedule 1, Part 2, item 40, subsection 4(1) of the Business Transfer Act]

1.268 To support these amendments, the Bill also amends the way in which sections 6, 10, 14 and 16 of the PSN Act interact with the Business Transfer Act (specifically subsection 36AA(2)) as described above.

1.269 None of the powers granted to APRA under this Bill allow it to engage in 'cherry picking' within the same contract^[50] with the same counterparty. APRA does not have the ability to force counterparties to continue to honour certain obligations under a close-out netting contract, whilst at the same time disclaiming other obligations under that same close-out netting contract or otherwise alter, modify or vary the obligations.

Part 3 - Impact of non-terminal administrations on participation in approved RTGS systems and approved netting arrangements

1.270 It is fundamentally important to the stability of the Australian financial system that the payment and settlement systems approved by the RBA as approved RTGS systems have robust protection in all market conditions. Cash transfers and securities settlements made in approved RTGS systems, and made prior to the exclusion of the failed institution from the approved RTGS system, should not be rendered void by the zero hour rule as a disposition made after the commencement of the winding up.^[51]

1.271 As a consequence of the development of rehabilitative regimes, particularly for systemically important financial institutions, there is now a contemplation that a financial institution which is a participant in an approved RTGS system or approved netting arrangement may become subject to the control of an external administrator (in the form of a statutory manager or judicial manager) but that it would be in the interests of Australian (and potentially international) systemic stability and in the interests of depositors and policy holders that the institution subject to the non-terminal administration (e.g. the institution subject to statutory management or judicial management) continue to transact in the key payment and settlement systems, exchanges and clearing houses. For this to occur, the system must benefit from robust protections throughout the duration of that non-terminal administration (as the protections need to extend beyond the first day of the external administration, which was previously the day on which the operator of the system, administrator of market would have expected to exclude the institution). If there were to be any uncertainty as to the protections during the course of the non-terminal administration, this uncertainty could, among other things, result in the systemic failure of other participants in the system and a loss of confidence in the financial system generally.^[52]

1.272 Accordingly, a new concept of 'non-terminal administration' has been included in section 5 of the PSN Act. A person goes into non terminal administration if the person goes into external administration and, if the person is a body corporate-the external administration is not a winding up under the Corporations Act (whether that winding up is a winding up by the court, a voluntary winding up or a winding up by ASIC) or corresponding process under a corresponding law of a foreign country (including part of the foreign country) (such as a winding up, liquidation, dissolution or equivalent under that law) and, if the person is an individual-the external administration is not the result of the person becoming a bankrupt under the Bankruptcy Act, or the person having a corresponding status under a law of a foreign country. The definition of 'non-terminal administration' takes into account that foreign proceedings which result in the termination of a body's existence, or dissolution of an entity, are often described in terms of 'liquidation' or 'dissolution' rather than 'winding up' and will apply where the laws of a state within a federated country govern the winding up, liquidation or dissolution. [Schedule 1, Part 1, item 6, Section 5, 'non-terminal administration' definition of the PSN Act]

Approved RTGS systems

1.273 A new section 6A of the PSN Act is inserted by the Bill to clarify that, if the 3 conditions described below are satisfied, section 6A will deem a payment or transfer made by a participant through an approved RTGS system to have had the same effect it would have had if the participant had not gone into non terminal administration. The three conditions are as follows and are similar to those which apply under the existing section 6. [Schedule 1, Part 1, item 16, After section 6, section 6A Non terminal administration not to affect transactions of the PSN Act]

1.274 First, it will apply where a participant in an approved RTGS system goes into non-terminal administration (paragraph 6A(1)(a)).

1.275 Second, there is a transaction involving the payment of money, or the transfer of an asset, by the participant (paragraph 6A(1)(c)). As is the case in respect of section 6 (as explained in paragraphs 18 to 26 of the Explanatory Memorandum to the Payment Systems and Netting Bill 1998), the protection will therefore apply to both cash transfers and the transfer of ownership of an asset. It will apply to both linked cash transfers and to both legs of security settlements (i.e. the cash transfer and the exchange of ownership).

1.276 Third, the payment or settlement transaction is executed through the system at any time before the participant goes into, or while the participant is in, non-terminal administration (paragraph 6A(1)(b)).

1.277 Clarification is made that the existing protection given in respect of approved RTGS systems under section 6 of the PSN Act apply in accordance with the existing terms of that section in circumstances where a participant in an approved RTGS system goes into external administration (other than non-terminal administration). [Schedule 1, Part 1, item 14, paragraph 6(1)(a) of the PSN Act]

1.278 Supplemental changes have been made to clarify the heading of the existing section 6 of the PSN Act. [Schedule 1, Part 1, item 13, section 6 (heading) of the PSN Act]

Approved netting arrangements

1.279 The protections provided in the Bill in respect of approved netting arrangements apply in circumstances where a party to an approved netting arrangement goes into non-terminal administration and allow a party (including the operator of the approved netting arrangement) to do anything permitted or required by the arrangement in order to net:

•

obligations incurred before the participant goes into, or while the participant is in, non-terminal administration; and

•

net obligations if the obligations that are directly or indirectly netted are incurred before the participant goes into, or while the participant is in, non-terminal administration. [Schedule 1, Part 1, item 18, after paragraph 10(2)(a), paragraph 10(2)(aa) of the PSN Act]

1.280 This change applies in respect of all approved netting arrangements.

1.281 Clarification is made that the existing protection given under paragraph 10(2)(a) applies where the party to an approved netting arrangement goes into external administration and that external administration is not a non-terminal administration. [Schedule 1, Part 1, item 17, paragraph 10(2)(a) of the PSN Act]

1.282 The mechanism for claiming that transactions which are netted through an approved netting arrangement are voidable under section 10(4) would still enable obligations netted under the arrangement during an external administration which are unfair preferences to be unwound.^[53]

Part 4 - Cash market settlement activities in approved netting arrangements

1.283 In order to validate the settlement of net obligations by a participant on or after the date on which it enters external administration which occur under an approved netting arrangement contained in the rules of, or contracts which relate to, a licensed CS facility (as defined in section 761A of the Corporations Act), it is important for section 10(2) of the PSN Act to expressly cover any transfer of assets as well as any payment made to discharge a net obligation. This is because settlement occurs on a delivery (i.e. of assets) versus payment basis, and both the delivery and the payment need to be protected. The intention is to provide a more comprehensive protection from insolvency laws in respect of these settlements. This intention is evinced by specifying in subsection 10(2)(f) of the PSN that, for an arrangement that is governed by the rules of a licensed CS facility as defined in section 761A of the Corporations Act, a payment, or a transfer of property, by a party under the arrangement to discharge a net obligation under the arrangement is not to be void or voidable in the external administration. [Schedule 1, Part 1, item 19, after paragraph 10(2)(e) (before note 1), paragraph 10(2)(f) of the PSN Act]

1.284 This protection will only apply in respect of an approved netting arrangement contained in the rules of, or contracts which relate to, a licensed CS facility (as defined in section 761A of the Corporations Act), rather than in respect of any approved netting arrangement. This is because systems (e.g. payment systems) other than securities settlement systems have been approved as approved netting arrangements and the protection of settlements which involve the transfer of assets is not considered necessary or appropriate for those other types of arrangements.

1.285 Clarification is made to note 1 to subsection 10(2) of the PSN Act that paragraphs 10(2)(a) and (aa) only authorise the party to take any action to arrive at a net obligation; they do not authorise the party to settle the net obligation by payment or transfer of property. This should not be read in any way as impacting on the protection provided in other paragraphs of subsection 10(2). [Schedule 1, Part 1, item 20, Subsection 10(2) (note 1) of the PSN Act]

Part 5 - Market netting contracts

1.286 Recent international developments such as CPMI and IOSCO's Recovery of financial market infrastructures paper have demonstrated the importance of systemically important FMIs having comprehensive and effective recovery plans and 'a set of recovery tools that is comprehensive and effective in allowing the FMI to, where relevant, allocate any uncovered losses and cover liquidity shortfalls'.^[54] Importantly, in order to be effective, the recovery tools must be 'reliable, timely and have a sound legal basis' and there 'should be a high degree of certainty that the FMI will be able to implement each tool in all relevant circumstances, including in times of stress'.^[55] Some of the recovery tools, such as replenishment, may be implemented in circumstances where there are no transactions on foot between the CCP and any participants.

1.287 As it is important to systemic stability and imperative to minimise any possible contagion effects, the protections set out in Part 5 of the PSN Act to market netting contracts and netting markets must robustly apply in all circumstances including where the only arrangement as between the operator of the netting market (i.e. the CCP) and a participant is the rules governing the operation of the netting market where those rules have effect as a contract between a participant in the netting market and one or more other persons (e.g. each other participant). One example of this is that section 822B of the Corporations Act sets out that the operating rules of a licensed CS facility have effect as a contract under seal between certain persons. The specific agreements made under the contract are not relevant for these purposes.

1.288 To achieve this robust protection, the definition of 'market netting contract' in section 5 of the PSN Act is clarified to provide that, in addition to the existing limbs of the definition, the definition also includes the rules governing the operation of a netting market, if those rules have effect as a contract between a participant in the netting market and one or more other persons. [Schedule 1, Part 1, item 5, section 5 (after paragraph (a) of the definition of market netting contract), 'market netting contract' definition of the PSN Act]

1.289 The recovery tools in a comprehensive recovery plan include tools to replenish any financial resources that may be employed in a stress event. This tool includes collecting resources from participants by means of cash calls or other mechanisms by which the CCP calls for contributions to replenish or otherwise supplement its default fund. The default fund represents pre-funded mutualised financial resources used to meet losses incurred by the CCP on default of a participant.

1.290 In order for the rules which govern the operation of the netting market such as a CCP, including the recovery rules, to be implemented in an expedient, robust and legally certain manner in all market conditions, including in times of financial distress, subparagraph 16(2)(g)(iii) of the PSN Act has been amended to ensure that any payment, or transfer of property (whether absolutely or by way of security), by a party to meet an obligation under the contract is not void or voidable in an external administration. Such an obligation may, but does not have to be, an obligation to contribute to, or otherwise replenish, the netting market's default fund. An external administrator may not bring legal proceedings to recover amounts, or property, received by the operator of a netting market as a payment, or a transfer of property, by the party in external administration to meet an obligation under the contract. [Schedule 1, Part 1, item 33, subparagraph 16(2)(g)(iii) of the PSN Act]

1.291 Generally, the protection set out in section 16(2)(g) which prevents certain things being void or voidable in an external administration applies irrespective of whether the participant was in external administration or not at the time that the thing happened (e.g. at the time the payment, or transfer of property, was done).

Application

Approved netting arrangements, close-out netting contracts and market netting contracts

1.292 Clarification is provided that in general the amendments in the Bill apply to existing and future close-out netting contract, approved netting arrangements, market netting contracts and external administrations, enforcements of security regardless of when the security was given. An exception is made for the amendments to paragraphs 14(1)(d) and 14(2)(d) of the PSN Act in items 24 to 27 of the Bill and the insertion of paragraph 14(2)(h) and 16(2)(h) of the PSN Act in items 29 and 34 of the Bill, which only affect disposals of rights or property, or the creation or operation of encumbrances or interests occurring after the amendments take effect (notwithstanding that the unamended paragraphs may have some application in this case). This amendment is intended to avoid possible breaches of paragraph 51(xxxi) of the Constitution with respect to the acquisition of property on other than just terms (see paragraph 1.292 for further explanation). [Schedule 1, item 48, application of amendments of the Bill]

1.293 The amendments made by Part 1 of Schedule 1 of this Bill apply in relation to approved netting arrangements, market netting contracts and close out netting contracts entered into after the start time, or that are in existence immediately before the commencement of this Schedule.

1.294 Except in relation to the amendments made by item 30 of this Bill (in respect of the repeal of subsections 14(3), (4) and (5) and substitution of new subsections 14(3), (4), (5), (6), (7), (8) and (9)), the amendments made by Part 1 of Schedule 1 of this Bill do not apply in relation to an external administration that commenced before the commencement of this Schedule.

1.295 The amendments made by Part 1 of Schedule 1 of this Bill apply in relation to trigger events that occur for a close out netting contract after the commencement of this Schedule.

1.296 The following do not apply to disposals of rights or property, or the creation or operation of encumbrances or interests, before the commencement of the Schedule of the Bill:

•

the amendments made by items 24 to 27;

•

paragraph 10(2)(g), as inserted by item 19;

•

paragraph 14(2)(h), as inserted by item 29;

•

paragraph 16(2)(h), as inserted by item 34. [Schedule 1, item 48, application of amendments, subitem (5) of the Bill]

1.297 The reason for this is discussed above.

1.298 The amendments made by item 30 of the Bill in respect of the repeal of subsections 14(3), (4) and (5) and substitution of new subsections 14(3), (4), (5), (6), (7), (8) and (9) deal with a range of issues including an additional protection from certain things being void or voidable in an external administration, the interaction between the PSN Act and other laws and the circumstances in which the protections in section 14 will not apply. In addition to the other application provisions applicable to these subsections, these amendments apply in relation to a person being in external administration, whether the external administration commences before or after the commencement of this Schedule.

1.299 The amendment made by item 42 involves the insertion of section 36AB which provides, generally, that, if certain circumstances exist, a partial transfer is void to the extent of certain assets or liabilities the transferring body has, just before the partial transfer, under the contract, arrangement or security, with respect to the counterparty. This amendment applies to a partial transfer if the certificate of transfer comes into force after the commencement of this Schedule.

1.300 The amendments made by Parts 1 and 2 of this Bill apply in relation to the enforcement of a security after the commencement of this Schedule, even if the security was given before the commencement of this Schedule. This is to ensure that these important reforms apply to as broad a range of security arrangements as possible to facilitate the compliance by entities subject to Australian law with international and commercial requirements.

Chapter 2 - Regulation impact statement

Executive Summary

2.1 From September 2016, regulators in many key jurisdictions will phase in new 'margining' requirements for trading in over-the-counter (OTC) derivatives (bilateral contracts which derive their value from shifts in the value of entities in the underlying market). Without legislative change, entities subject to Australian law may not be able to fully comply with margining requirements that are imposed on them, or their counterparties, as a result of participating in international markets. This could significantly restrict the ability of Australian entities to participate in certain financial markets or trade with particular counterparties.

2.2 The new margining requirements are a core component of international efforts to address problems highlighted in the 2007-2008 global financial crisis (GFC). Widespread defaults on sub-prime mortgages, and the consequent devaluation of mortgage-backed securities are generally considered to be primary factors leading to the onset of the GFC. The resulting problems were exacerbated by widespread failure to meet commitments arising from unsecured OTC derivatives contracts.

2.3 As a result, in 2009, the Group of Twenty (G20) nations agreed to reform OTC derivatives markets, contracts and practices in an effort to reduce the risks exposed by the GFC. This agenda recognised the legitimate and ongoing role of derivatives in hedging business and investment risk, but sought to limit opaque and excessive speculation in OTC derivatives, and the potential for this activity to undermine the resilience of the financial system. The reforms are also intended to enhance transparency in OTC derivatives markets and improve market efficiency, integrity and risk management.

2.4 Margining is the process of exchanging collateral to protect against counterparty credit risk in financial contracts and is a key component of risk reduction strategies. It is intended to reduce the kind of contagion and spill-over effects experienced in the GFC, by ensuring that collateral is available to offset losses caused by the default of a derivative counterparty. The collateral exchanged can be by way of direct transfer of, or granting security over, certain assets.

2.5 International margin requirements for OTC derivatives will be phased in from 1 September 2016, after which entities operating in Australia will need to be able to provide, and enforce rights in respect of, margin provided by way of security. If they are unable to do so, they will face rising costs and other barriers to participation in global OTC derivatives markets. To give a sense of the scale of these markets: the notional amount of outstanding OTC derivative contracts (as at June 2015) is US$553 trillion, globally; and the average daily turnover for Australian OTC foreign exchange derivatives (a subsection of the OTC derivatives market) was $125 billion in April 2015.

2.6 For various reasons, current Australian law contains provisions that impede certain institutions from providing margin in a manner consistent with existing or planned regulatory requirements (especially providing margin by way of security).

2.7 The Financial System Legislation Amendment (Resilience and Collateral Protection) Bill 2016 will allow Australian financial institutions to meet margin requirements in accordance with internationally agreed principles. It will also provide legal certainty in relation to termination rights (often referred to as close-out rights), and the operation of real time gross settlement systems, approved netting arrangements and netting markets in all market conditions.

2.8 These measures complement a suite of other reforms led by the Basel Committee on Banking Supervision, and implemented in Australia, to make financial institutions and systems more reliable and better able to withstand major shocks.

2.9 This Bill delivers on the Government's response to the Financial System Inquiry (Improving Australia's Financial System) (FSI) in October 2015, which undertook to 'develop legislative amendments to clarify domestic regulation to support globally coordinated policy efforts and facilitate the ongoing participation of Australian entities in international capital markets'.

2.10 The Government consulted the public on the draft Bill and associated Regulation from 21 December 2015 - 5 February 2016. The response was strongly supportive. The Government received ten submissions, primarily from industry representatives, all of whom emphasised the importance of the proposed reform to their business and the health of the financial sector. Australian financial regulators have been involved throughout the process, and support the proposed amendments.

2.11 This final stage regulation impact statement builds on the early stage statement (prepared prior to consultation), first pass final stage statement, and stakeholder feedback on the proposed changes.

Introduction

2.12 The global financial crisis (GFC) demonstrated the need for more resilient financial institutions, and financial market reform - particularly in relation to trade in over-the-counter (OTC) derivatives.^[56]

2.13 Trading in OTC derivatives (bilateral contracts which derive their value from shifts in the value of entities in the underlying market) exacerbated the consequences of the GFC.

2.14 As a result, in 2009, the Group of Twenty (G20) nations agreed to reform OTC derivatives markets, contracts and practices in an effort to reduce the risks exposed by the GFC. This agenda recognised the legitimate and ongoing role of derivatives in hedging business and investment risk, but sought to limit opaque and excessive speculation in OTC derivatives, and the potential for this activity to undermine the resilience of the financial system.

2.15 Specifically, the G20 leaders agreed to improve transparency by requiring transaction information on all OTC derivatives to be reported to trade repositories; improve market efficiency and risk management by requiring all standardised OTC derivatives to be cleared through central counterparties; and enhance market efficiency and integrity, by requiring the execution of all standardised OTC derivatives on exchanges or electronic trading platforms, where appropriate.'^[57]

2.16 Australia has made good progress to implement these reforms. The Corporations Legislation Amendment (Derivative Transactions) Act 2012 (Cth) covers: (a) the reporting of all OTC derivatives to trade repositories; (b) the clearing of all standardised OTC derivatives through central counterparties; and (c) the execution of all standardised OTC derivatives on exchanges or electronic trading platforms, where appropriate. Mandating central clearing^[58] is the next step in the implementation of the global OTC derivatives reforms in Australia. On these elements, Australia is meeting the G20-mandated timelines.

2.17 In 2011, G20 leaders added the imposition of margin requirements for non-centrally cleared derivatives to the reform agenda (i.e. OTC derivatives that are not cleared by a central counterparty, such as ASX Clear (Futures) Pty Limited).

2.18 Margining is the process of exchanging collateral to protect against counterparty credit risk for financial contracts, such as non-centrally cleared derivatives.^[59] Margin requirements are intended to reduce systemic risk and promote central clearing. It is anticipated that margin requirements would reduce the contagion and spill-over effects experienced in the GFC, by ensuring that collateral is available to offset losses caused by the default of a derivative counterparty.

2.19 In September 2013, the Basel Committee on Banking Supervision (BCBS) and the International Organization of Securities Commissions (IOSCO) published a final framework for margin requirements for non-centrally cleared OTC derivatives, to ensure that provision for losses on transactions is made when trading these products.

2.20 In March 2015, global regulators agreed that phasing in of global margin requirements for OTC derivatives would begin in September 2016. At this stage, various regulators in the United States have approved final rules, European authorities have published consultation papers on draft regulatory technical standards on margining and the Japan Financial Services Agency (JFSA) have released proposed draft amendments to implement margin requirements.

2.21 However, without legislative change, entities operating under Australian law may not be able to fully comply with margining requirements that are imposed on them, or their counterparties, due to domestic or foreign regulation, or market practice.

2.22 This could significantly restrict the ability of Australian entities to participate in certain financial markets or trade with particular counterparties. This is the problem addressed by this regulation impact statement (RIS).

2.23 The RIS compares the cost of maintaining the status quo with removing impediments in Australian law to comply with margin requirements for certain OTC derivatives contracts. These are the only feasible options in response to this policy problem, no other options have been seriously considered or proposed, as anything less than legislative amendment could not provide the kind of certainty needed to remove impediments outlined in this RIS, and ensure that entities subject to Australian law can participate effectively in global markets.

Question 1: What is the problem the government is trying to solve?

2.24 International margin requirements for OTC derivatives will be phased in, commencing from 1 September 2016, with full implementation by September 2020. From the September commencement, Australian entities operating in key global OTC derivatives markets will increasingly need to be able to provide, and enforce rights in respect of, margin provided by way of security, or face rising costs and other barriers to participation in these markets.

2.25 Under current Australian law entities may not be able to give and enforce margin in accordance with the new international practice.

2.26 More detailed background on global OTC reforms is included in the Appendix.

Problem definition - impact of foreign regulation

2.27 Market assessments, published by Australian regulators in July 2013,^[60] April 2014^[61] and November 2015,^[62] show that the Australian OTC derivatives market is dominated by the big banks, including the major Australian banks as well as the local operations of global financial institutions. These global banks are or will soon become subject to margining mandates imposed by their home regulators, especially in the US and the EU, as will some of the major Australian banks who are also subject to regulation in the US or EU.^[63] In turn, Australian banks directly, or indirectly by virtue of entering transactions with these global banks, will be captured by the US and the EU regulations, and will have to meet legal requirements for margining.

2.28 At this stage, various regulators in the United States have approved final rules (December 2015); European authorities have published consultation papers on draft regulatory technical standards on margining; and Japanese regulators have released proposed draft amendments to implement margin requirements. For the Australian banks, the US and the EU regulatory regimes are the most relevant as a significant majority of their wholesale funding is sourced from these jurisdictions.

2.29 Complying with the regulatory framework of another jurisdiction imposes significant legal and compliance costs (e.g. Australian banks operating in the US and the EU). Costs may be multiplied if these regulatory frameworks are inconsistent, imposing duplicative or even conflicting requirements.

2.30 Globally, regulators are addressing this problem through an approach known as substituted compliance, under which regulators grant relief from their own regulatory requirements if a foreign entity is subject to equivalent requirements in their home jurisdiction.^[64] An Australian bank concluding an OTC derivative transaction in the US would be exempt from complying with the relevant US regulations if the US Commodity Futures Trading Commission (CFTC) had made a formal determination granting substituted compliance to Australian-regulated entities, following an equivalence assessment by the CFTC of the Australian regulatory framework.

Problem definition - impediments to compliance in Australian law

2.31 Current laws obstruct an Australian participant from voluntarily, or mandatorily, exchanging margin with counterparties under the BCBS/IOSCO principles. This is problematic for an Australian participant that might want to voluntarily provide margin in compliance with the BCBS/IOSCO principles with its counterparties for capital reasons or, in the future, because the counterparty is required to provide margin.

2.32 The existing impediments under current law have come to the fore because the internationally agreed principles for margin requirements require that initial margin needs to be exchanged on a gross basis. This is likely to result in initial margin (at least) being transferred by way of security rather than by way of absolute transfer (as it is currently transferred in the Australian market). There may be compelling reasons why market participants choose to provide both initial margin and variation margin by way of security rather than by way of absolute transfer (for example, because of benefits to the collateral provider on the secured party's insolvency).

2.33 Some of the other issues which arise in the context of creating and enforcing rights as a secured party (i.e. enforcing rights in respect of margin provided by way of security) under current Australian law include:

•

the assets of an Australian Authorised Deposit-Taking Institution (ADI) in Australia are subject to a priority regime which would prefer other creditors (e.g. holders of protected accounts) ahead of a secured party;

•

the assets of a foreign ADI in Australia are subject to a priority regime which would prefer liabilities of the foreign ADI in Australia ahead of a secured party;

•

the assets of a general insurer regulated under the Insurance Act in Australia are subject to a priority regime which would prefer other creditors ahead of a secured party;

•

a secured party is restricted from enforcing its security interest over an Australian company's property during the company's administration and an administrator is given certain rights in respect of dealing with property subject to circulating security interests;

•

certain stays may apply in respect of an entity due to the recognition of a foreign insolvency proceeding under the Cross Border Insolvency Act 2008 (Cth);

•

client money and client property rules may affect the way in which a secured party must hold, and enforce rights against, collateral provided to it;

•

the Personal Property Securities Act 2009 (Cth) (PPSA) imposes additional requirements governing the enforceability, validity and perfection of security interests;

•

the PPSA and Corporations Act 2001 (Cth) (Corporations Act) set out priority rules which may result in a secured party losing priority in respect of secured assets and those Acts set out circumstances in which property secured by a security interest may vest in the grantor;

•

other security interests may arise in respect of the property of a grantor by operation of law;

•

security agreements may need to be stamped to be admissible in court proceedings; and

•

the PPSA sets out rules governing the enforcement of security interests (including procedural requirements and duties).

2.34 Global and US regulations are also impacting on Australian superannuation funds and life companies, which are restricted from accessing certain sections of the US OTC derivative markets. Australian regulations prevent these entities from complying with US regulation by giving security over their assets for the purposes of margining, and these entities are consequently unable to meet US clearing broker requirements. Being restricted from the US OTC derivatives market limits these entities' access to market liquidity, reducing their ability to manage and hedge risks, increasing trading costs.

Problem definition - impacts of not being able to comply with international regimes

2.35 Consultation with industry and financial regulators has revealed consensus about the need to have a facilitative regulatory regime in place by the time international margining requirements come into effect, or face serious economic consequences.

2.36 Without a facilitative regulatory regime, Australian institutions' capacity to trade with major counterparties will be progressively curtailed from 1 September 2016. As a consequence, banks would not be able to hedge their risks offshore, or get access to important liquidity pools.

2.37 Jurisdictions are set to adopt various thresholds for phasing in of the new margining requirements. Initially, entities with notional derivatives worth US$3 trillion+ (for the US), EUR3 trillion+ (for the European Union), and AUD$4.5 trillion (for Australia), will need to comply immediately after 1 September 2016. As margin requirements are phased in, the threshold will become smaller and smaller, capturing a larger range of entities.

2.38 Major Australian banks will likely be the first Australian entities affected by international requirements. Whether they are required to comply depends on the notional size of their derivatives position, but if even one bank were required to comply in the first phase of international margin requirements, the implications would be significant for that business, and their counterparties, and potentially the broader Australian economy.

2.39 Quite apart from the technical threshold requirements to comply, a range of financial institutions will likely want to comply before they are formally required to, for commercial reasons. This is because uncollateralised trades will soon become more expensive than trades where margin is given.

2.40 Even a short delay in creating a facilitative regulatory regime is likely to involve significant cost to the Australian finance sector. To give a sense of the scale of OTC derivative trade: The notional amount of outstanding OTC derivative contracts is ~US$553 trillion globally. The Australian Financial Markets Association (AFMA) recently estimated that there is an annual turnover of AUD$80 trillion in notional OTC derivatives in Australian financial markets.

Question 2: Why is Government action needed?

2.41 Australian financial market participants, superannuation funds, life companies, the Australian Financial Markets Association (AFMA), the Financial Services Council (FSC) and the International Swaps and Derivatives Association (ISDA) have all raised concerns that, in the absence of Government action to remove legal impediments to margining, Australian entities may face barriers in international markets where margining requirements established by the BCBS are becoming increasingly prevalent.

2.42 Under the 2015 BCBS Margin Requirements, initial margin^[65] collected in respect of non-centrally cleared derivatives must be 'immediately available to the collecting party in the event of the counterparty's default'. Margining requirements are commonly met by means of granting to the secured party, security over certain assets of the counterparty. In the Australian context, stakeholders have raised a concern that the requirement for such margin to be 'immediately available' (and that such margin may need to be provided in a way which satisfies other potential foreign legislative changes) requires legislative change to allow security over certain personal property to be enforced on the counterparty's default without such enforcement being subject to other legacy legal impediments which may otherwise apply as a matter of Australian law.

2.43 Put simply, without legislative change, entities to which Australian law applies may not be able to fully comply with margining requirements that are imposed on them, or their counterparties, due to domestic or foreign regulation or market practice. This could significantly restrict the ability of Australian entities to participate in certain financial markets or trade with particular counterparties. There could be significant consequences for Australian financial markets if, for example, Australian banks were restricted from trading with a US or European bank because any security granted by the Australian banks couldn't be enforced in the manner required by regulation or strictly observed market practice.

2.44 Other developed countries (including, for example, the United Kingdom and other members of the European Union) have enacted similar legislation to clarify their securities laws to provide for 'rapid and non-formalistic enforcement procedures in order to safeguard financial stability and limit contagion effects' in case of a default of a party to certain financial markets contracts. By doing so, they both reduce possible risks for parties to certain contracts in respect of which margin is provided and remove impediments to the international competitiveness of their local financial institutions.

2.45 Legislation will facilitate Australia maintaining its position as a regional financial centre with a strong regulatory and legislative framework. The fact that legislation protecting the enforcement of security in similar financial markets contracts has been thought appropriate elsewhere (including in the European Union), coupled with a concern that the absence of appropriate protections in Australia could affect the international competitiveness of Australian financial institutions, supports this reform. Stakeholders have indicated that an expansion of the existing legislative protections in the Payment Systems and Netting Act 1998 (Cth) (the PSN Act) to protect the enforcement of security in the context of margin requirements is required to ensure that, in circumstances where Australian law applies, entities are able to comply with the 2015 BCBS Margin Requirements' requirement for margin to be 'immediately available' (and other requirements which may potentially be imposed by foreign regulators).

2.46 The proposal is to amend the PSN Act to facilitate the enforcement of security given in writing over specified types of financial property, in respect of certain obligations of a party to the contract. This protection will be subject to a number of safeguards to ensure that the protection only applies in appropriate circumstances.

2.47 This would:

•

enable Australian entities to give, and enforce rights in respect of, margin provided by way of security in connection with certain financial market transactions in a manner consistent with international requirements; and

•

contribute to the integration and cost-efficiency of the financial markets and the stability of the financial system, and limit contagion effects in case of a default of a party to a close-out netting contract under which collateral is provided.

2.48 An additional problem arises in relation to margining, and the participation in certain important derivatives markets (particularly the US market), by trustees of regulated superannuation entities and life insurance companies. Currently, trustees of regulated superannuation funds are restricted under Australian law from giving a charge over an asset of the fund, subject to certain exceptions. Life companies are subject to similar, significant, restrictions on granting security. The existing 'derivatives contracts' exception to these restrictions in each of the Superannuation Industry (Supervision) Regulations 1994 (Cth) (Superannuation Industry (Supervision) Regulations) and the Life Insurance Regulations 1995 (Cth) (Life Insurance Regulations) is not currently broad enough to cover granting security in the context of cleared OTC derivatives and uncleared OTC derivatives.

2.49 The G20 derivative reforms and US reforms (particularly due to the Commodity Exchange Act) have directly and indirectly affected trustees of regulated superannuation funds and life companies, whose counterparties are subject to a range of requirements relating to derivatives. For example, due to asset segregation requirements, US law currently requires that Futures Commission Merchants (FCMs) request margin by way of security from their clients in respect of OTC derivatives they clear on behalf of their client. Trustees of regulated superannuation funds and life companies cannot currently grant such a security interest to the FCM due to restrictions imposed by the Superannuation Industry (Supervision) Regulations or the Life Insurance Regulations (as applicable). As a result of not being able to grant such security, trustees of regulated superannuation funds and life companies cannot participate in certain important derivatives markets. Adverse consequences of this include:

•

reduced access of these entities to liquid markets due to these entities' inability to trade with US FCMs; and

•

increased OTC derivative trading costs from reduced competition in these entities' dealer panels due to their inability to trade on a cleared basis with numerous counterparties.

2.50 This legislative package will achieve the policy outcome that trustees of superannuation entities regulated by the Superannuation Industry (Supervision) Act and life companies regulated by the Life Insurance Act will be able to grant security interests in certain circumstances to facilitate the participation of these Australian entities in international derivatives markets. Facilitating the access of trustees of superannuation entities and life companies to cleared OTC markets accords with Australia's commitments in respect of the G20 derivatives reforms.

2.51 Specifically, the proposal is to amend the Superannuation Industry (Supervision) Regulations and the Life Insurance Regulations to enable trustees of superannuation entities regulated by the Superannuation Industry (Supervision) Act and life companies regulated by the Life Insurance Act to grant security interests in respect of cleared OTC derivatives and uncleared OTC derivatives, subject to certain safeguards.

2.52 Other reforms will address existing inconsistencies between the Banking Act 1959 (Cth) (Banking Act), Life Insurance Act 1995 (Cth)(Life Insurance Act), Insurance Act 1973 (Cth) (Insurance Act), the Financial Sector (Business Transfer and Group Restructure) Act 1999 (Cth)(the Business Transfer Act) and the PSN Act relating to the effect of certain stays imposed under the Banking Act, Life Insurance Act, Insurance Act, and the Business Transfer Act on the exercise of certain termination rights (including due to statutory or judicial management) -which would otherwise be exercisable under close-out netting contracts, approved netting arrangements and market netting contract and the impact of those stays on enforcing security. These reforms are important to ensure parties to netting contracts have legal certainty over their contractual rights (including in circumstances when there is a compulsory transfer of business).

2.53 Any potential inconsistency in the legislative framework is undesirable. It creates uncertainty as to the ability of a party to an approved netting arrangement, close-out netting contract or market netting contract to legally exercise a contractual right to close-out transactions (or, in terms of the PSN Act, obligations) under a contract with a regulated entity in respect of which a statutory manager or judicial manager has been appointed. This uncertainty has the potential to impede the efficiency of financial markets in Australia by making it more difficult for Australian entities to enter into financial market transactions (including hedging arrangements) as well as impeding the ability of the Commonwealth to effectively manage distress in regulated financial institutions. However, this will be balanced with the need for a stay to apply in respect of certain termination rights which may be granted under contracts to which a regulated entity is party to enable the resolution authority (e.g. APRA) to adequately resolve the institution so that obligations continue to be met (whether in the existing bank or through a transfer of business).

2.54 Additionally, to resolve legal uncertainties which have been identified in respect of the protections provided to financial market infrastructures which are crucial to the operation of Australian financial markets, the proposal will ensure legal certainty for:

•

the settlement activities under an approved netting arrangement that is governed by the rules of a licensed CS facility as defined in section 761A of the Corporations Act (e.g. ASX Settlement, Australia's cash equity settlement system), such approved netting arrangement being an important component of Australian financial market infrastructure; and

•

the payments, or transfers of, dealings with, or the exercise or performance of, rights, obligations or property, in accordance with the market netting contract (such term amended to explicitly include the rules governing the operating of a netting market, if those rules have effect as a contract between a participant in the netting market and one or more other persons, e.g. the ASX Group's central counterparties, ASX Clear and ASX Clear (Futures)).

2.55 By removing impediments to Australian entities complying with margining requirements, resolving inconsistencies which currently exist in Australian law and providing legal certainty to certain operations of key financial market infrastructure, this proposal responds to the Financial System Inquiry's (FSI) observation that more needs to be done to remove impediments to cross-border competition and other barriers to the free flow of capital across borders^[66]; and the Government's response to the FSI, which undertook to develop legislative amendments to clarify domestic regulation to support globally coordinated policy efforts and facilitate the ongoing participation of Australian entities in international capital markets. ^[67]

Question 3: What policy options is the Government considering?

2.56 There are only two feasible options to address the problem this RIS identifies. These are to maintain the status quo, or to legislate to remove impediments to compliance with international resilience reforms. No other options have been seriously considered or proposed, as anything less than legislative amendment could not provide the kind of certainty needed to remove impediments outlined in this RIS, and ensure that entities subject to Australian law can participate effectively in global markets.

Option 1: Maintain the status quo

2.57 Under Option 1, no changes will be made to the legislative arrangements to support international competitiveness of Australian firms as well as their access to international OTC derivatives markets.

Option 2: Remove impediments to compliance with international resilience reforms

2.58 Under Option 2, the Government will develop legislative amendments to ensure that Australian law does not impede entities from complying with foreign OTC margining related regulations or practices. APRA is considering separately how best to implement the global recommendations for its regulated entities with regard to margining and is likely to proceed with its implementation through existing or new prudential standards and practice guides. Any proposals would follow the usual regulation impact assessment process.

2.59 The proposed amendments include:

•

amendments to the PSN Act to enable entities subject to Australian law to give, and enforce rights in respect of, margin provided by way of security in connection with certain financial market transactions in a manner consistent with international requirements;

•

amendments to resolve conflicts between the Banking Act, other Acts and the PSN Act with respect to stays on close-out rights;

•

amendments to the Superannuation Industry (Supervision) Regulations and the Life Insurance Regulations to enable trustees of superannuation entities and life companies to grant security interests in respect of cleared OTC derivatives and uncleared OTC derivatives;

•

amendments to remove other technical barriers to the provision of margin; and

•

amendments to promote certainty for the operation of key financial market infrastructure (e.g. certain operations of Australian settlement systems and licensed clearing and settlement facilities, such as ASX Settlement, ASX Clear and ASX Clear (Futures)) under the PSN Act.

Question 4: What is the likely net benefit of each option?

Option 1: Maintain the status quo

2.60 Under this option, Australian businesses would be unable to, or find it much more costly to, engage in global markets once the margining reforms are implemented by our major trading partners (the EU and the US). That is, Australian businesses would effectively face barriers to entry to global capital markets.

2.61 The implications for Australian businesses of being impeded or excluded from accessing foreign markets as a result of legal barriers in Australian law are difficult to quantify but will be considerable. For example, much higher costs of the wholesale funding for the Australian banks may result in loss of their international competitiveness (to remain competitive, banks need access to deeper pools of market liquidity and better market pricing).

2.62 Superannuation funds and life companies use derivatives to hedge and manage risks within their funds. The inability to access sections of the US-cleared OTC derivatives market will make it more costly and complicated for fund managers to hedge these risks.

2.63 Australia will also be hampered in seeking recognition of Australia's legislative arrangements which may mean that when Australian businesses are able to make arrangements to meet foreign obligations they will have to comply with inconsistent and often conflicting global rules. This could include accepting foreign models for margining which may be to the commercial disadvantage of Australia and Australian businesses. This would not result in any additional domestic regulatory costs or savings for industry but would be extremely costly for industry through extraterritorial application of foreign rules.

2.64 Given the size of the Australian OTC derivatives market and using both Deloitte's assumptions about the cost of post-margining trading^[68] and Australian firms' preliminary estimates of costs associated with their limited access to international OTC markets, we estimate the total costs of Option 1 to be around $88 million^[69] per year upon commencement of the international requirements.

2.65 There are significant risks, and costs to Australian businesses, associated with maintaining the status quo (Option 1). For example, a risk associated with keeping the status quo is that entities subject to Australian law would not be able to comply with the margin requirements to be imposed internationally and in Australia (noting the recent release of APRA's draft prudential standards on margining and risk mitigation).

2.66 APRA will not be able to effectively implement its margin requirements without this reform. This would be inconsistent with Australia's commitment to implement to G20 OTC derivatives reforms and the Australian Government's response to the Financial System Inquiry (which was to develop legislative amendments to clarify domestic regulation to support globally coordinated policy efforts and facilitate the ongoing participation of Australian entities in international capital markets).

Option 2: Remove impediments to compliance with international resilience reforms

2.67 The reforms proposed in Option 2 would ensure that Australian law provides a framework which enables Australian entities to give, and enforce rights in respect of, margin provided by way of security.

2.68 This Option, being generally facilitative in nature, will not of itself impose significant regulatory burdens on the entities which may receive the benefit of the reforms. This reform does not of itself impose any margin requirements. These reforms mitigate some of the legal risks, and costs and complexity, associated with any future margin requirements imposed by APRA and reduces the legal risks for entities which are subject to Australian law and foreign margin requirements.

2.69 Without this reform, entities subject to Australian law may be restricted from participating in important international financial markets and prevented from managing their risk, and allocating their capital, in the most efficient manner. To the extent Australian financial institutions were restricted from trading with important counterparties or in important capital markets, significant costs would arise.

2.70 The compliance costs associated with foreign OTC margining-related regulations, as well as the consequential barriers to access to international capital markets for Australian firms, would be lower if the legal impediments to posting margin were removed from Australian law. We estimate that removal of these impediments (Option 2) would bring the total associated costs of margining down to $84.2 million per year - a saving of $3.9 million per annum compared to Option 1.

2.71 The $3.9 million difference between the two options is a conservative estimate of the regulatory costs that industry will bear, if a facilitative legal regime is not in place by 1 September 2016. The $3.9 million per annum includes costs associated with: the creation of complex legal, administrative, and operational structures that attempt to comply with foreign requirements; negotiation to enter into transactions with counterparties that operate under different prudential standards; meeting reporting or notification obligations; and extensive work to understand how to the new international requirements may affect their business operations.

2.72 It is also highly likely that, in the absence of Government action, the foreign compliance costs and associated barriers to access to international capital markets for Australian firms will increase significantly over time as other jurisdictions move towards full implementation of their margining regulations.

2.73 These costs are directly associated with efforts to comply with international regulatory requirements. They do not, however, account for other, significant impacts on Australian business. Feedback from leading industry representatives emphasised the potential opportunity cost (i.e. incapacity to get the best prices, or trade with the full range of counterparties); and increased business risk due to an inability to properly hedge their specific risks.

2.74 Superannuation funds and life companies have noted that removing impediments in their sectors would immediately lower their costs by being able to access the US OTC derivatives market, which has a greater number of counterparties and increased liquidity. These entities would also able to access a wider range of cheaper derivatives to manage and hedge risks within their funds.

2.75 Failure to comply early will have follow on effects for domestic counterparties and the broader economy.

Risks

2.76 Because these reforms provide clarification regarding the rights of certain parties in relation to secured funds (or 'priorities'), the key risks that have been addressed relate to the potential for other creditors, depositors and/or policyholders to be adversely affected. This could arise, for example, if a party to an OTC derivative became insolvent and the other party exercised its rights to close-out, effectively obtaining priority for its debt over that of other creditors.

2.77 This risk has been carefully mitigated by working closely with the Council of Financial Regulators on the safeguards which must be satisfied in order for the new protections to apply and consulting widely with industry. The safeguards are outlined below.

•

The margin must be transferred to be in the possession or under the control of the secured party or their representative, which effectively means that the grantor has to internalise (to some degree) the costs of trading in derivatives.

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The law will only protect the enforcement of rights against limited types of property provided as margin, being cash and certain financial instruments.

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The only obligations that can be discharged are related to derivatives; and the protections afforded to enforcement do not extend to other kinds of financial dealings.

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Enforcement of security against property that can be dealt with in the ordinary course of a person's business will not be protected. This means that, for example, banks cannot give a floating charge over all of their assets.

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In enforcing its rights, the secured party must still comply with general law duties, in accordance with the terms of the security (this means, for example, the secured party would be unable to sell the margin for less than established market rates).

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The terms of the security given need to be evidenced in writing, to ensure the terms are clearly agreed in advance of entry into external administration.

•

Many security agreements also require parties to act in good faith, in a commercially reasonable manner.

Table 2.1 : Option 2 Regulatory Burden and Cost Offset Estimate

Question 5: Who will you consult and how will you consult them?

2.78 Since the release of the final report of the FSI in December 2014, the Government, through Treasury, has been actively consulting with industry associations on the cost of margining requirements and the need to remove legal impediments in Australian legislation. To date, the consultations have involved:

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panel discussion on a margining framework, model, and implementation timeline organised by ISDA;

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monthly participation in non-cleared derivatives margining liaison meetings organised by AFMA and the FSC; and

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public consultation on the legislative reform package intended to achieve Option 2 (including on exposure draft of the proposed Bill and Regulation to implement Option 2).

2.79 In addition, Treasury regularly consults with Australian Prudential Regulation Authority (APRA), Australian Securities and Investments Commission (ASIC) and the Reserve Bank of Australia (RBA) at fortnightly meetings of the OTC Derivatives Working Group on industry's readiness for margining requirements and progress to date on its implementation.

2.80 The Government, through Treasury, has developed an exposure draft for public consultation prior to introduction). This public consultation closed on 5 February 2016.

2.81 Overall, submissions indicated strong support for the reforms and their objectives (i.e. strong support for Option 2). The suggested amendments submitted by stakeholders on the draft legislation focused on specific technical issues, such as the definition of particular terms.

2.82 There was significant support for the amendments (which are broadly described in this RIS) to be made in relation to the enforcement of security-based collateral arrangements, and the enhanced protections and legal certainty provided by these changes. However, several stakeholders suggested broadening the types of obligations covered by the new protections. Whilst the Bill to be introduced to Parliament will clarify the obligations to be covered by the new protections, the reforms in the Bill will not go as far as requested by some submissions as this would increase potential unintended consequences and does not accord with the policy intention set out in this RIS.

2.83 Some stakeholders expressed the view that the reforms regarding the application of stays on close-out rights do not sufficiently align Australia's regime with international practice. It was recommended that Australia's regime should reflect and comply with the approach set out in internationally agreed documents. Further consideration has been given to this issue in the Bill to be introduced to Parliament, and the Bill to be introduced balances the need to align with international practice with the need to maintain Australia's strong and resilient financial system regulatory framework.

2.84 Given the strong industry support for making these changes (which was evidenced in the submissions received during the consultation process), these reforms are expected to be introduced in the Autumn sittings of parliament on the expectation that the legislation will be settled in time.

2.85 Changes to the Superannuation Industry (Supervision) Regulations and Life Insurance Regulations will not require legislation and would be implemented separately to, but in a similar timeframe to, the passage of the legislation. Superannuation funds and life companies have expressed a desire that the proposed Superannuation Industry (Supervision) Regulations and Life Insurance Regulations changes be expedited in light of the current difficulties faced by these superannuation funds and life companies.

Question 6: What is the best option from those you have considered?

2.86 Option 2 is the preferred option. This is consistent with the approach indicated by ASIC, APRA and RBA in the Council of Financial Regulators' Report on the Australian OTC Derivatives Market, November 2015 (CFR Report).^[70] The Council of Financial Regulators surveyed and met with a range of APRA-regulated entities in respect of margin requirements and risk mitigation standards for non-centrally cleared derivatives, including to gauge their preparedness to comply with these requirements and standards. The reforms in Option 2 will make Australian law consistent with requirements to be introduced in the Australian domestic prudential regulatory regime, as well as in international regulatory regimes.

2.87 It is expected that entities subject to Australian law, and by extension the efficient operation of Australian entities in global financial markets, would suffer significant adverse consequences if the status quo (Option 1) was maintained (for the reasons set out in this RIS). Retaining idiosyncratic legislative impediments in this respect in Australia would also be inconsistent with the promotion of Australia as a regional financial centre.

Question 7: How will you implement and evaluate your chosen option?

2.88 Option 2 will be implemented by amending the PSN Act and associated provisions in other Acts to:

•

enable entities subject to Australian law to give, and enforce rights in respect of, margin provided by way of security in connection with certain financial market transactions in a manner consistent with international requirements;

•

clarify domestic legislation to support globally coordinated policy efforts and provide certainty about the operation of Australian law in relation to the exercise of termination rights (also known as close-out rights) under certain financial market transactions; and

•

enhance financial system stability by ensuring legal certainty for the operation of approved Real Time Gross Settlement (RTGS) systems, approved netting arrangements and netting markets (more specifically, market netting contracts) in all market conditions.

2.89 This Bill will be substantially in the form of the exposure draft of the Bill which was publicly consulted on, subject to some amendments to reflect the issues raised during consultation.

2.90 Option 2 will also be implemented by amending the Superannuation Industry (Supervision) and the Life Insurance Regulations to enable trustees of superannuation entities and life companies to grant security interests in respect of cleared OTC derivatives and uncleared OTC derivatives. The amending regulation will be substantially in the form of the exposure draft of the Financial System Legislation Amendment (Resilience and Collateral Protection) Regulation 2016 (the Regulation) which was publicly consulted on, subject to some amendments to reflect the issues raised during consultation.

2.91 The Government will seek to introduce the Bill and Regulation early 2016, and the Bill and Regulation will commence in the manner set out in the Bill and Regulation respectively. The implementation of this Option 2 conforms with the Government's policy position as set out in its response to the FSI.

2.92 The Government, through Treasury, will evaluate the way in which Option 2 has been implemented by:

•

ensuring that the Bill and Regulation are finalised in time to be tabled in Parliament in the Autumn sittings and passed early 2016;

•

continuing to actively consult with industry associations such as AFMA and ISDA on the practical effect the removal of impediments is having on the implementation of margining arrangements by market participants and effectiveness of the reforms set out in the Bill and Regulation in facilitating that implementation;

•

continuing to attend monthly non-cleared derivatives margining liaison meetings organised by AFMA; and

•

regularly consulting with APRA, ASIC and the RBA, both formally and informally, including at fortnightly meetings of the OTC Derivatives Working Group on industry's implementation of margining requirements and the efficacy of the reforms set out in Option 2; and

•

reviewing the next report on the Australian OTC derivatives market published by the Council of Financial Regulators to ensure the reforms set out in Option 2 are having the desired effect.

Question 8: Status of regulatory impact statement at each key decision point?

2.93 An Early Assessment regulation impact statement was prepared, and approved by Office of Best Practice Regulation (OBPR), before the exposure drafts of the reforms were released for publication. The first pass regulation impact statement was submitted following consultation.

APPENDIX

Background - global OTC derivatives reforms

2.94 The OTC derivatives market is one of the largest global financial markets. OTC derivatives are used by a wide range of market participants to hedge numerous types of financial and other risks, as well as for speculative purposes. The GFC highlighted structural deficiencies in the OTC derivatives market and the related risks these markets posed for wider financial markets and the real economy.

2.95 To manage these risks, the G20 leaders agreed at the 2009 Pittsburgh Summit to a number of reforms designed to improve transparency and default risk management in OTC derivatives markets.

2.96 A legislative framework for implementing these G20 commitments was established in Australia in December 2012. The framework allows the Treasurer to make determinations in relation to trade reporting, central clearing and platform trading of OTC derivatives. In making a determination the Treasurer is required to consult with the regulators: ASIC, RBA and APRA. The regulators provide advice to the Minister about Australia's OTC derivatives markets and recommended regulatory action in the form of periodic reports on the Australian OTC derivatives market.

Background - margining

2.97 In 2011, the G20 agreed to add margin requirements on non-centrally-cleared derivatives to its reform program and called upon the BCBS and the IOSCO to develop consistent global standards for these margin requirements.

2.98 In October 2011, the BCBS and the IOSCO formed the Working Group on Margining Requirements (WGMR) to develop a proposal on margin requirements for non-centrally-cleared derivatives for consultation by mid-2012.

2.99 After a number of consultations, responses and a quantitative impact statement, the BCBS and the IOSCO published a final framework for margin requirements for non-centrally cleared OTC derivatives in September 2013. In March 2015, the WGMR subsequently revised this final framework and agreed that phasing in of the global margin requirements for OTC derivatives would begin in September 2016. This global implementation timeframe makes it now pressing that Australian legal issues which impede Australian firms from complying with the requirements being put in place by our trading partners (whether that compliance is required as a matter of foreign law or commercial imperative) are identified and resolved, in order to ensure Australian firms remain internationally competitive and retain access to, and the ability to effectively participate in, global capital markets.

2.100 Margining requirements aim to ensure that collateral is available to offset losses caused by the default of a derivatives counterparty when dealing in non-centrally cleared OTC derivatives. Whereas bank capital rules require that banks set aside their own capital to cover the risk of losses, the margining rules require that banks hold collateral from their counterparty to cover the risk of loss which may arise on that counterparty's default.

2.101 In the event of a counterparty default, the margin protects the surviving party by absorbing losses using the collateral provided by the defaulting entity. By contrast, capital adds loss absorbency to the system, but the costs accrue to the surviving counterparty, because the bank is using its own capital to meet losses, which can create systemic risk.

2.102 The BCBS and the IOSCO have identified two objectives, in formalising the requirement for margining.

•

Increased financial system resilience. Only standardised derivatives are suitable for central clearing. A substantial fraction of derivatives are not standardised and cannot be centrally cleared. These non-centrally cleared derivatives can potentially be destabilising to the financial system as they are highly pro-cyclical and may lead to the build-up of uncollateralised exposures.

•

Promotion of central clearing. In many jurisdictions, central clearing will be mandatory for most standardised derivatives. But clearing imposes costs, in part because central counterparties require margin to be posted. Margin requirements on non-centrally cleared derivatives, by reflecting the generally higher risk associated with these derivatives, will promote central clearing, making the G20's original 2009 reform program more effective. This could, in turn, contribute to the reduction of systemic risk.

2.103 There are also risks and costs from margining, as follows.

•

Adverse liquidity impact resulting from derivatives counterparties' need to provide liquid high-quality collateral to meet these requirements, including potential changes to market functioning as a result of an increased aggregate demand for such collateral.

•

Regulatory arbitrage. The effectiveness of margining requirements could be undermined if the requirements are not consistent internationally. Activity could move to locations with lower margin requirements as the financial institutions operating in the low-margin locations could gain a competitive advantage (that is, it could result in an uneven playing field).

•

Costs and complexity. Margining will make it more expensive for businesses to use derivatives products and require more of their time to manage risks. Complexity is a particular risk for corporations not active in financial markets which rely on derivatives to manage risks in funding or global income.,

•

Legal risks. The imposition of margining requirements domestically and internationally also means that rules around collateral protection, netting and bankruptcy remoteness need to be unambiguous, and wherever possible, consistent amongst trading partners. The proposals which this RIS considers, particularly Option 2, are intended to address this legal risk.

Chapter 3 - Statement of Compatibility with Human Rights

Prepared in accordance with Part 3 of the Human Rights (Parliamentary Scrutiny) Act 2011

Financial System Legislation Amendment (Resilience and Collateral Protection) Bill 2016

3.1 This Bill is compatible with the human rights and freedoms recognised or declared in the international instruments listed in section 3 of the Human Rights (Parliamentary Scrutiny) Act 2011.

Overview of the Bill

3.2 The Financial System Legislation Amendment (Resilience and Collateral Protection) Bill 2016 (the Bill) amends the Payment Systems and Netting Act 1998 and associated provisions in other Acts so that financial institutions in Australia can comply with internationally-agreed margining requirements when dealing in OTC derivatives. More specifically, it ensures that they can give, and enforce rights in respect of, margin provided by way of security.

3.3 The Bill also provides legal certainty about the operation of Australian law in relation to termination rights (also known as close out rights) under certain financial market transactions; and approved Real Time Gross Settlement (RTGS) systems, approved netting arrangements and netting markets (more specifically, market netting contracts) in all market conditions.

3.4 The Bill also makes consequential amendments to the Banking Act; Business Transfer Act; Insurance Act; Life Insurance Act; and PHI Act.

Human rights implications

3.5 This Bill does not engage any of the applicable rights or freedoms.

Conclusion

3.6 This Bill is compatible with human rights as it does not raise any human rights issues.

Index

Schedule 1: Amendments