Introduction
Many jurisdictions have enacted statutes which sanction netting and set-off in relation to financial markets. They have done so primarily to reduce systemic risk because of the very large amounts involved i.e. that a default by one institution may bring down others at the cost of the financial system and ultimately at the cost of the taxpayer1.
President Muhammadu Buhari on Friday, 7th August 2020 assented to the Companies and Allied Matters Bill, recently passed by the National Assembly of the Federal Republic of Nigeria2. The new Act which is the principal legislation that governs the business operations of companies and insolvency proceedings in Nigeria has generally sanctioned set-off and netting for the first time in the law by the positioning of Chapter 28 under the existing general insolvency framework in the new law3.
What is Set-off and Netting?
Set-off can simply be defined as a form of payment through the discharge of reciprocal obligations. In other words, a debtor can set off the crossclaim owed to him against the main claim which he owes his creditor. Thus, instead of paying money, he uses the claim owed to pay the claim he owes.
Netting on the other hand can be defined as a method of reducing credit and other risks of financial contracts by aggregating two or more obligations to achieve a reduced net obligation.
There are generally two categories of netting, namely settlement netting and close out netting4. Settlement netting is the set-off of reciprocal delivery obligations of the same asset which fall due for delivery on the same day. The objective of settlement netting is to reduce settlement risk. The settlement risk is reduced if obligations for the same asset falling due on the same day are netted so that the only obligation of the counterparty is to pay a net balance. Settlement netting is different from set-off because it applies to deliveries under executory contracts still to be performed, while set-off applies to debts owing for performance already made.
The second type of netting is the close-out netting. Close-out netting is the cancellation of the open executory contracts, the calculation of losses and gains either way and set off of those losses and gains. Its object is to reduce exposures on open or executory contracts still to be performed by both parties if one party becomes insolvent before the value date. The basic ingredients of close out netting is that it must be possible to terminate the unmatured executory contract with the counterparty; and it must be possible to set off resulting losses and gains over the whole series of mutual contracts. Close-out netting is different from set-off as set-off primarily applies to mutual debts, not open executory contracts and involves one step-set off. However, close out netting generally involves three steps, namely a) terminate the contract, b) calculate losses and gains and c) then set off5.
Imperative of Netting in Insolvency
When a company goes into insolvency, there are usually insufficient assets available to satisfy every claim by its various stakeholders6. There is usually a keen and desperate flurry of bilateral recourse to litigation, or other forms of attempt to enforce contractual mechanisms envisaged under the agreement between the parties upon breach or termination arising from the insolvency event.
General Insolvency Law formally seeks to curb and foreclose at onset of insolvency these private remedial options and replace same with a collective, efficient and orderly procedure with the private race to collect that ensues through majorly two mechanisms, namely a) the application of "equitable" rules (reflective of policy preferences of the particular insolvency jurisdiction) devised for distribution of assets realized vis a vis variety of claims and b) the enforcement of stay of private actions except with the leave of the court administering the formal collective procedure: this is not only to ensure that the company is not overrun with litigation but also that systemic collapse is averted and efficiency restored.
However, other special legislations can be enacted to amend these rules and tilt preference and priority to certain specific types of claims or contractual transactions- again to protect such special market or system and protect same from collapse.
Indeed, in virtually all jurisdictions, special rules which derogate from normal general rules of insolvency are made in relation to the financial industry and financial contracts (e.g. money and capital markets, the insurance industry, payment and settlement systems). Typically, in these industries, issues regarding settlement of transactions, set off and netting of positions arguably on a real time basis are constantly playing out for national and international contractual transactions7 on electronic platforms characterized by instantaneous change in legal positions.
In that regard, rules relating to netting and set off for payment systems are crucial to the effectiveness of a sound financial and capital market system in terms of speed of transactions, confidence and certainty created, risk & cost management and allocation of liability. Under the Basel II Accord for instance, the concept of close out netting was a risk reduction tool for transactions entered under a netting agreement. And under Basel III and with respect to Over The Counter (OTC) trades, an absence of a legal framework for netting means that financial institutions face the choice of either not conducting trades or shouldering the risk.
General insolvency rules raise the question of enforceability of contractual netting clauses in financial agreements8 pre and post commencement of insolvency procedure.
Set-off (essentially a form of net position payment of existing debts arising from fully performed contracts) and Netting (applicable essentially to the delivery or cancellation of obligations from financial contracts which are executory) is at the heart of the reduction of exposures particularly in derivative markets and their validity is one of the leading indicators of whether a jurisdiction is pro-debtor or pro-creditor, and by extension in the latter case, pro investment.
It is a key indicator because the amounts involved are usually large and there is an acute collision of policies as to who to protect on insolvency: should it be the debtor or even the normal creditor under general insolvency law, or the investor (creditor) as is usually the policy focus of the financial industry? If everybody could pay their debts, there would be no need for the protection of set-off. Thus, the jurisdiction has to jump one way or the other, and the way it jumps is highly revealing of the underlying approach.
Whereas there was a huge gap in our insolvency laws generally on this issue, Nigeria has now taken its stand for the first time on the validity of netting in insolvency as contained in chapter 28 of the Companies and Allied Matters Act 2020 (CAMA) and we shall consider the provisions in brief.
Netting under the general insolvency framework of CAMA 2020
Netting is discussed under four provisions in Chapter 28, namely Sections 718 (definition of applicable concepts), 719 (Powers of a Financial Regulatory Authority), 720 (Enforceability of a qualified financial contract vis a vis Gaming laws ) and 721(Enforceability of Netting agreement and restriction of exercise of avoidance powers by the IP).
Section 718 of CAMA has defined netting to mean the following:
- Termination, liquidation or acceleration of any payment or delivery obligation or entitlement under one or more qualified financial contracts entered into under a netting agreement;
- Calculation or estimation of a close-out value, market value, liquidation value or replacement value in respect of each obligation or entitlement or group of obligations or entitlements terminated, liquidated or accelerated under paragraph (a);
- Conversion of any values calculated or estimated under paragraph (b) into a single currency; and
- Determination of the net balance of the values calculated under paragraph (b), as converted under paragraph (c), whether by operation of set-off or otherwise;
Section 718 of CAMA further defines Netting Agreement as any-
- Agreement between two parties that provides for netting of present or future payment or delivery obligations or entitlements arising under or in connection with one or more qualified financial contracts entered into under the agreement by the parties to the agreement (a "master netting agreement");
- Master agreement between two parties that provides for netting of amounts due under two or more master netting agreements (a "master-master netting agreement); and
- Collateral arrangement related to or forming part of one or more of the foregoing.
While the precise vernacular or colloquialism of "settlement netting" or "close out netting" or even "set-off" was specifically not used in the Act, the definitions as contained in the provisions describes the basic principles of set off and netting. Section 718 also recognizes the concept of "collateral arrangement" and it defines it as any security arrangement or other credit enhancement relating to or forming part of a netting agreement or more qualified financial contracts including a security interest collateral arrangement or any guarantee, reimbursement obligation by or to a party in respect of a qualified contract.
It is noteworthy that the definitions of Netting and or Netting Agreement appeared to have been particularly predicated or tied to formal Master Agreement as opposed to any or all netting provisions in any form of financial contracts, leaving an initial impression of creation a general netting framework that may have been somewhat unnecessarily restrictive in terms of interpretation of the provisions of a financial agreement. In that regard, a position could have been taken that the law appears to have defined netting agreement by reference to ISDA Master Agreement which are the standard contracts used for OTC derivative transactions9. Such that the financial agreements that would qualify as being subject to special derogatory rules in insolvency would have been those agreements permitting netting of amounts owed under transactions governed by different agreements, usually one or more ISDA Master Agreements10.
However, this isolated and narrow interpretation is excluded by various other provisions. First, Section 718 defines Financial Regulatory Authority to include different existing and future Financial Services sector regulators11. Second, these may from time to time and in their discretion in relation to the sector they regulate define or determine as qualified as a Netting agreement any eligible financial contracts12 not already defined or listed as qualified under Section 71813. Third, Section 721(8) dealing with enforceability of Netting Agreements makes it abundantly clear that an agreement would be qualified as a netting agreement notwithstanding lack of any such label or recognition under Section 718 so long as it falls under the definition of a qualified financial contract under Chapter 28.
Flowing from all the above, it would also seem apparent that a private financial contract which skilfully provides for set-off and netting clauses in good faith can defeat insolvency proceedings regulated by statute in Nigeria.
That being the case, the key question therefore is how the legislation treats express clauses that permit a solvent counter party to cancel the contract by reason of the commencement of insolvency proceedings against the other party?
By virtue of section 721 of the Act, the provisions of a netting agreement are said to be enforceable in accordance with their terms, including against an insolvent party, and, where applicable, against a guarantor and shall not be stayed or avoided by any action of the liquidator, any provision of law relating to bankruptcy, receivership or any other provision of law that may be applicable to the insolvent party subject to the conditions contained in the applicable netting agreement. In other words, the application/enforcement of provisions of the netting agreement can neither be avoided by an IP nor stayed as a result of an insolvency proceeding in Nigeria: although not expressly stated, we opine that this would extend to any insolvency proceeding anywhere outside Nigeria to the extent that Nigerian law would be the yardstick to guide our Nigerian Court in the event of a cross border insolvency proceeding or for the purpose of recognition or enforcement of related foreign proceedings or judgments.
Section 721 (2 & 3) further provides that after commencement of insolvency proceedings in relation to a party, the only obligation/right if any of either party is to make/receive payment or delivery under a netting agreement and it shall be equal to its net entitlement with respect to the other party as determined in the netting agreement. Furthermore, any power of the liquidator to assume or repudiate the contract would not prevent the termination or acceleration of all payment or delivery obligations in connection with a netting agreement to the net amount due in respect of the financial contract.
The exception to this general rule however is contained in section 721(6) which provides that the liquidator may not avoid the terms of a netting agreement unless there is clear and convincing evidence that the non-insolvent party incurred such obligation with actual intent to delay or defraud any entity to which the insolvent party was indebted or became indebted, on or after the date that such transfer was made or such obligation was incurred.
With regard to enforcing "collateral arrangements", section 721 (7) provides that reasonable notice to interested parties, persons, entities shall be required for the realisation or appropriation of collateral under a collateral agreement unless agreed by parties provided that it is without prejudice to any applicable provision of law requiring the realisation or appropriation of the collateral is conducted in a commercially reasonable manner.
Analysis of the impact of the new netting provisions created under CAMA general insolvency framework
As earlier stated, in the context of an interconnected world and the internet of things, international trade are conducted electronically all around the world through dematerialized platforms at instantaneous speed with seemingly no barriers, such that there is an exacerbated need for legal certainty in apportionment of rights, risks & liabilities and in using investments and insolvency rules to mitigate such risks and losses arising from termination of the financial contracts and insolvency of the counterparty.
International instruments such as the UNCITRAL Model Law on Cross Border Insolvency, the Geneva Securities Convention, the UNIDROIT Convention on substantive rules for intermediated securities are a few of these international laws dealing with the interact between Insolvency and Netting Rules14 and emphasizing this need for legal certainty and allocation of liabilities depending on time of commencement of insolvency proceedings.
Under Part II of the Legislative Guide to the Model Law on Cross Border Insolvency15 the issue of operations of right of set offs in the context of insolvency is dealt with.
Recommendation 100 of the Legislative Guide states as follows-
Recommendation 100
Purpose of legislative provisions
The purpose of provisions on set-off is:
(a) To provide certainty with respect to the effect of the commencement
of insolvency proceedings upon the exercise of set-off rights;
(b) To specify the types of obligation that may be set off after commencement of insolvency proceedings; and
(c) To specify the effect of other provisions of the law (e.g. avoidance
provisions and the stay) on the exercise of rights of set-off.
Contents of legislative provisions
100. The insolvency law should protect a general right of set-off existing under law other than the insolvency law that arose prior to the commencement of insolvency proceedings, subject to the application of avoidance provisions.
(emphasis ours please)
The Guide explains it is highly desirable even under insolvency context that an insolvency legislation affords protection of rights of set off of mutual obligations arising out of pre commencement of insolvency transactions. In other words, financial transactions post commencement of insolvency which seek to assert priority and enforcement of netting rights would not be afforded any protection and would be subjected to ordinary general insolvency rules and ranking of claims.
It further states that in majority of jurisdictions set off rights are not affected by rules on stay usually associated with insolvency proceedings whilst in some post commencement, set offs are disallowed16.
Recommendations 101 to 107 of the Legislative Guide17 also advocates that such legislations should include provisions on netting and set off of financial transactions only to achieve certainty and stability and reduce the potential for systemic risk; market participants should be allowed to extend credit based on "net" positions. Again, it is believed that such provisions would check the propensity for the debtor friendly Insolvency Practitioner to cherry pick the performance of certain contracts.
In a similar fashion, in dealing with intermediated securities, the UNIDROIT Convention on Intermediated Securities18 has provided the general guiding insolvency principle under Article 21 of a paramount protection of the rights of account holders and interest takers from the insolvency administrator and creditors of an insolvent intermediary. Whilst Article 28 derogates to domestic general insolvency law rules (including particularly in terms of ranking of claims) which are not expressly stated in the Convention. However, this derogation does not apply where the financial transaction was done as a transaction at a preference or fraud on creditors. As we have seen, this is also captured by Section the proviso of Section 721(6) CAMA.
As can be seen in above overview of relevant international instruments, legal certainty of outcome is guaranteed by two major mechanisms: the instantaneous efficiency of electronic platforms used in international trade (leading to clear time frame allowing for proper apportionment of risk and liabilities), and the clear legal position of protection of setoff and netting rights for transactions which occurred pre commencement of insolvency and which are not a fraudulent preference on the debtor and other creditors. In both cases, it is safe to say that timing is critical. It is also safe to say that the relevant infrastructure for real time transactions is in place.
That being the case, the same cannot be affirmed absolutely in an emerging market such as the Nigerian economy. Whilst the general framework created under the new CAMA is very commendable and addresses many of the policy preferences and protection of financial contracts which are advocated by international instruments, it is opined that Chapter 28 does not sufficiently and specifically address the issue of timing for the derogation to general insolvency rules (how would risks and liabilities be allocated and how would general insolvency rules and netting rules be applied in circumstances where the transactions are not instantaneous and result into gaps and shortfalls). As such this would be an area that may require further clarification through amendment of the general law or enactment of special law on netting for financial contracts. This in our view is particularly important where the formal insolvency procedure in issue is business rescue rather liquidation focused.
As it stands, and particularly for formal procedures that are voluntary or business rescue oriented, it is expected that those drafting the clauses of financial contracts may take advantage of this gap and draft the netting and set off clauses in such a way as to suggest that same can be enforced at any stage of insolvency- administrations, insolvency arrangements, final liquidations etc and that such clauses must also be available against interveners, such as assignees or creditors as the valid take-over of the claim destroys the mutuality necessary for set-off/netting. This is not ideal for the certainty and the underlying principles of insolvency which are always a balancing act between various claims and policy standpoint. It is also unhelpful and unencouraging from a business rescue and reorganization standpoint and the flexibility required from the law to allow same and consensual arrangements to be made within a clear framework.
Conclusion
The new Nigerian CAMA has provided a major assistance and level of certainty to investments and trade through the enactment of general netting rules applicable in the event of insolvency to provide certainty and clear apportionment of rights, risks and liabilities to stakeholders, and to protect the financial and capital market sector from systemic risk and collapse. It can however be strengthened through a more thorough and special legislation to address these issues in more details, including but not limited to treatment and applicability of netting rules post commencement of insolvency.
The enactment of a special Netting legislation, aside from providing clarity and certainty in insolvency, enhances international competitiveness of the Nigerian Financial and Capital Market.
The current reform efforts in the new Investments & Securities Bill being championed by the Nigerian Securities & Exchange provides the perfect opportunity to strengthen and complement these general rules on Netting now outlined under CAMA.
Footnotes
1 Phillip R Wood-Law and Practice of International Finance-Set-off and Netting, Derivatives, Clearing systems 2nd Edition Sweet & Maxwell, London 2007. Some of these statutes in other jurisdictions include Anguilla's Netting Act 2006; Iceland's Financial Services and Markets Act 2003; Poland's Bankruptcy and Restructuring law 2003.
2 Vanguardngr.com-Senate commends Buhari for assenting to CAMA Bill on August 8, 2020. The law is yet to be gazetted and by extension, there is uncertainty regarding its commencement date, although it is expected that this would be done shortly.
3 This paper acknowledges that the Act is yet to be officially enforceable, same not having yet been published in the Government Official Gazette.
4 We note that there are other types of netting which includes netting by novation, multilateral netting etc and this article recognizes that the descriptions may be catered for under the Act.
5 See the decision in Commissioners for HM Revenue and Customs v Enron Europe Ltd (2006) EWHC 824.
6 shareholders, (foreign/local) investors, banks and other financiers, governments (tax revenue), employees, suppliers, contractors, and generally sundry trade creditors.
7 E.g. electronic banking, capital market transactions, money transfer services, credit and debit transfers, online consumer related transactions, other intermediated payment facilities or transactions, derivatives and other OTC transactions.
8 This include practices where no specific netting clause exist between the contractual parties.
9 Please see https://www.investopedia.com/terms/i/isda-master-agreement.asp
10 Please see https://uk.practicallaw.thomsonreuters.com/1-503-0869?transitionType=Default&contextData=(sc.Default)&firstPage=true
11 E.g. the Central Bank of Nigeria, Securities & Exchange Commission, National Insurance Commission, Pension Commission,
12 Section 719 CAMA 2020
13 These include various forms of swap agreements, spot, future & forward agreements, cap, collar or floor transactions, derivatives, securities contracts inclusive or margin loans, collateral arrangement, securities clearing and settlement transactions, etc
14 United Nations Commission on International Trade Law Model Law on Cross-Border Insolvency 1997 accessible at https://www.uncitral.org/pdf/english/texts/insolven/1997-Model-Law-Insol-2013-Guide-Enactment-e.pdf ; UNIDROIT Convention on Substantive Rules for Intermediated Securities also known as the Geneva Securities Convention of October 2009. The official commentary on the Convention was first published in 2012. It is accessible at https://www.unidroit.org/instruments/capital-markets/geneva-convention
15 Titled "treatment of assets on commencement of insolvency proceedings". Parts 2 and 3 of the Legislative Guide published in 2004 is accessible at https://uncitral.un.org/sites/uncitral.un.org/files/media-documents/uncitral/en/05-80722_ebook.pdf
16 It appears the latter position is what obtains in Nigeria in personal insolvency procedures.
17 These recommendations were also generally acknowledged positively by the Committee of experts that worked on the UNIDROIT Draft Principles on Close out Netting provisions which the UNIDROIT Governing Council at its 92nd session held from 8 to 10 May 2013 adopted same. Also, the EU has already adopted a substantially harmonized framework on netting provisions. Please Phillip Paech UNIDROIT Work on Draft Principles of close out netting provisions.
18 Adopted at Geneva, October 9, 2009 in a single original in the English and French languages, both texts being equally authentic.
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