The Bilateral Netting of Qualified Financial Contracts Bill, 2020 was introduced in the Lok Sabha on 14 September 2020 and passed on 20 September 2020 by a voice vote. The Bill  provides for the enforceability of bilateral netting of qualified financial contracts. ‘Netting’ enables two counterparties in a bilateral financial contract to offset claims against each other to determine a single net payment obligation due from one counterparty to the other in the event of default. A Qualified Financial Contract (QFC) is a bilateral agreement or contract or transaction or a type of contract regulated by the relevant authority and notified by it as a qualified financial contract.. The relevant authority includes the RBI, SEBI, IRDAI, PFRDA and the International Financial Services Centres Authority (IFSCA).

Currently, India does not have a legal framework for bilateral netting. Banks are forced to measure credit exposure to a counterparty for over the counter (OTC) derivative contracts based on gross basis and not net basis. This  increases credit risk exposure and systemic risk in the financial market in the event of default of a counterparty, in addition to blocking of a significant amount of capital by banks. The law of bilateral  netting will enable efficient margining and capital saving for banks to provide price efficiency in offering hedging instruments to businesses in India, and catalyse the corporate bond market through developing the credit default swap market.

The Act overrides any other law for the time being in force or any instrument having effect by virtue of any such law. Its key features are as under:

1) Applicability: The Act applies to a qualified financial contract entered into on a bilateral basis between qualified financial market participants, either under a netting agreement or otherwise, where at least one of such participants will be an entity regulated by an authority specified in the First Schedule i.e. RBI, SEBI, IRDAI, PFRDA and the International Financial Services Centres Authority(IFSCA) .

“Netting” means determination of a net claim or obligations after setting off or adjusting all the claims or obligations based or arising from mutual dealings between the parties to qualified financial contracts and includes close-out netting as well.

“Close-out netting” means a process involving termination of obligations under a qualified financial contract with a party in default and subsequent combining of positive and negative replacement values into a single net payable or receivable;

“Netting agreement” means an agreement that provides for the netting of amounts due under two or more netting agreements and a collateral arrangement relating to or forming part of a netting agreement.

Collateral Arrangement” means any margin, collateral or security arrangement or other credit enhancement related to or forming part of a netting agreement or one or more qualified financial contracts to which a netting agreement applies, and includes, a pledge or any other form of security interest in collateral, whether possessory or non-possessory; a title transfer collateral arrangement; and  any guarantee, letter of credit or reimbursement obligation by or to a party to one or more qualified financial contracts, in respect of those qualified financial contracts; or a netting agreement

“Qualified financial market participant” includes:

• a banking institution, or a non-banking financial company, or such other financial institution which is subject to regulation or prudential supervision by the Reserve Bank of India;
• an individual, partnership firm, company, or any other person or body corporate whether incorporated in India or under the laws of any other country and includes any international or regional development bank or other international or regional organisation;
• an insurance or reinsurance company which is subject to regulation or prudential supervision by the Insurance Regulatory and Development Authority of India;
• a pension fund regulated by the Pension Fund Regulatory and Development Authority
• a financial institution regulated by the International Financial Services Centres Authority (IFSCA) and
• any other entity notified by the relevant authority .

2) Enforceability of Netting : The netting of QFCs is enforceable if the contract is entered into with a netting agreement or even without a netting agreement. The inclusion of non-qualified financial contracts in a netting agreement will not invalidate the enforceability of netting of QFCs under the agreement. A QFC shall not be void and shall be deemed never to have been void or unenforceable by reason of any law for the time being in force.

Close-out netting of a QFC is enforceable against an insolvent party and against a guarantor or other person providing collateral or security for a party and shall not be affected or limited by —

• the appointment of, or any application for the appointment of, an administration practitioner, or
• applicability of any provision of law relating to administration, or
• any other provision of law that may be applicable to an insolvent party.

Where a qualified financial market participant is subject to administration, close-out netting shall be applicable, notwithstanding any stay, injunction, avoidance, moratorium or similar proceedings or any other order of a court, tribunal or authority, or any order of adjudication or dissolution or winding up or resolution or insolvency, or any rule, regulation, scheme, direction, guideline, circular or order, made or issued under any law for the time being in force.

The amount payable or other claims to be made in accordance with the close-out netting shall be final, irrevocable and binding upon the parties to a QFC and upon the administration practitioner of the party in administration.

3) Close-out netting and its enforcement: Close-out netting refers to the termination of all obligations arising out of relevant QFCs.  It may be commenced by a notice given by one party to the other party upon the occurrence of an event of default or a termination event. However, where any one of the parties to a netting agreement is subject to administration, then no prior notice to or consent of the party in insolvency, winding up, liquidation, administration or resolution proceeding, or to the administration practitioner of such proceeding, is required.

The parties to a QFC must ensure that all obligations owed by one party to the other under the contract are replaced by a single net amount. The netting will have the effect of liquidating present and future obligations arising out of QFCs to which the netting agreement applies.  The net amount payable/receivable under the close-out netting will be determined: (i) in accordance with the netting agreement entered into by the parties, if one exists, or (ii) through agreement between the parties, or (iii) through arbitration.

The realisation, appropriation or liquidation of collateral under a collateral arrangement will take effect without any requirement of prior notice to, or consent from, any party, person or entity, without prejudice to the provisions of any law for the time being in force and unless otherwise agreed by the parties,

Close-out netting is applicable to all qualified financial market participants who are parties to a QFC notwithstanding anything to the contrary contained in any law specified in the Second Schedule or any other law pursuant to which any qualified financial market participant has been incorporated.  Accordingly, this provision  overrides the Reserve Bank of India Act, 1934;  The Insurance Act, 1938; Banking Regulation Act,1949, The State Bank of India Act, 1955, The Securities Contracts (Regulation) Act, 1956,  The Banking Companies (Acquisition and Transfer of Undertakings) Act, 1970 and 1980, The Regional Rural Bank Act, 1976, the Securities and Exchange Board of India Act,1992, The Foreign Exchange Management Act,1999, The Insurance Regulatory and Development Authority Act, 1999, The Payment and Settlement Systems Act, 2007, The Companies Act, 2013, the Pension Fund Regulatory and Development Authority and the Insolvency and Bankruptcy Code, 2016

5) Limitations on Powers of Administration Practitioner: The administration practitioner cannot render ineffective any transfer of cash, collateral or other interests made in connection with a netting agreement between the insolvent party and the non-insolvent party to a QFC. Nor can it render ineffective any payment or delivery obligation incurred by the insolvent party and owing to the non-insolvent party under or in connection with a netting agreement, on the grounds of it constituting a preference including a fraudulent preference or a transfer for undervalue, including during a suspect period by the insolvent party to the non-insolvent party.

To refer to the Bilateral Netting of Qualified Financial Contracts Bill, 2020, as introduced in the Lok Sabha, click here.