Contractual Stays Tips and Traps

The Financial Institutions (Resolution) (Contractual Recognition of Suspension of Termination Rights – Banking Sector) Rules (the “Stay Rules”), which came into operation on 27 August 2021, require in-scope banking sector entities to include a provision (“contractual stay language”) in their non-Hong Kong law governed in-scope financial contracts for the contractual parties to agree that they will be bound by the power of the Hong Kong Monetary Authority (as resolution authority for the banking sector) to temporarily suspend the termination right of a counterparty to the contract.  In-scope covered entities are given some time to implement the Stay Rules – 24 months (i.e. by 26 August 2023) or 30 months (i.e. by 26 February 2024) depending on the counterparties to the covered contracts.

With these dates quickly approaching, we set out below some practical points for compliance.  Our client alert contains a comprehensive overview of the requirements in the Stay Rules. 

• Q1. I am a Hong Kong-incorporated authorized institution (AI) so should be in-scope.  What are the key points I should be aware of when I am scoping out the entities in my group for compliance?

Note that in addition to Hong Kong-incorporated AIs (“HK AIs”), the Stay Rules also catch these types of entities as covered entities: (i) Hong Kong-incorporated holding company of a HK AI and (ii) group companies of a HK AI, if the obligations of the group company under the relevant financial contract are guaranteed or otherwise supported by a HK AI or a Hong Kong-incorporated holding company of a HK AI.  In addition to non-Hong Kong law governed financial contracts entered into by the HK AI or its Hong Kong-incorporated holding company, make sure you also look out for those financial contracts entered into by a group company but guaranteed or supported by the HK AI or its holding company.

We have encountered numerous questions on what “support” means and whether funding by the head office means that support is given to a group company.  For the purpose of the Stay Rules, “support” refers to support that is provided in respect of an obligation of the group company under the financial contract, as opposed to general support provided to the group company on an entity level that is not relevant to the group company’s obligation under the contract.  In addition to obvious cases such as derivatives credit support documentation, guarantees or security agreements, this may also catch indemnities or contractual obligations to provide financial assistance.  On the other hand, if the head office funding is not referable to the particular financial contract but is just how the group operates from a funding perspective, then it probably falls outside the scope of the Stay Rules as being “general support”.

• Q2. What are the key points to note when I am scoping out the in-scope financial contracts for compliance? 

The HKMA has deliberately set a very wide definition for covered contracts.  Securities contracts, commodities contracts, derivatives contracts, FX contracts and master or other agreements relating to them all falls under the definition of covered contracts.

The inclusion of “master or other agreements” relating to another type of covered contracts (such as securities contracts) may mean that certain contracts which prima facie are out-of-scope are in fact in-scope.  For example, custodian agreements relating to securities may be in-scope as a result of the wide definition set for covered contracts.

Note that a contract will only be in scope if it contains termination rights exercisable by the counterparty.  The term “termination rights” is wider than its literal sense and also includes rights to set-off and net.  As one can appreciate, set-off rights are quite often included in financial contracts so do bear that in mind in the contract scoping process.

• Q3. My group is not a HK AI group but our client base includes a number of HK AI groups and hence we frequently enter into financial contracts with them.  What are the key points to note for me?

Even though non-HK AI groups are out-of-scope of the Stay Rules, your client counterparty may be in-scope and they may require you to co-operate with them in including the contractual stay language in in-scope financial contracts.  As can be seen in Question 2, the range of in-scope contracts may be very wide in practice.  Consider if industry solutions (see Q4 below) can assist with implementation.

With respect to custodians, if they have HK AI groups in their client base, they should consider how the Stay Rules may impact their business.  In particular, in the context of security arrangements where the custodians are holding securities for clients, typical documentation (such as account control agreements) may require the inclusion of the contractual stay language.  In addition to documentation requirements, custodians should also consider how a stay exercisable by the HKMA may affect the operation of the contractual provisions (e.g. in the event of an enforcement before, during or after the stay). 

• Q4. What are the industry solutions that can assist in implementation?

Industry bodies such as the International Capital Market Association (ICMA) and the Asia Pacific Loan Market Association (APLMA) have published template contractual stay language to assist the bond market and the loan market in implementing the Stay Rules.  The International Swaps and Derivatives Association (ISDA) has also published the Jurisdictional Module for Hong Kong for use with the ISDA Resolution Stay Jurisdictional Modular Protocol (the “ISDA JMP”).

While the ISDA JMP is helpful for parties to ISDA derivatives documentation and other industry standard documentation for securities financing transactions (such as repos and stock loans) to comply with the Stay Rules, parties should understand how protocol adherence works (particular in cases where the contract is guaranteed) and be aware of what adherence means to their financial contracts.  Importantly, for covered entities that have entered into the PRC law governed NAFMII Derivatives Master Agreement published by the National Association of Financial Market Institutional Investors (NAFMII), even if the parties to such agreement have adhered to the ISDA JMP and the relevant Jurisdictional Module, an additional (PRC law governed) supplement may be required to be filed with NAFMII in order to satisfy local formality requirements.

• Q5. What are the opinions expected by the HKMA?

The HKMA requires covered entities to provide legal opinions to the effect that the contractual stay language included in an in-scope financial contract is legally enforceable.  The matters to be covered in the legal opinions are in fact quite broad.  The HKMA has said that the matters to be covered will depend on the circumstances of the case and may include:

1.  the compliance of the contractual stay language with the definition of “suspension of termination rights provision” in the Stay Rules;

2.  the absence of conflict between the contractual stay language and (i) the constitutional documents of any party to the covered contract and (ii) applicable laws; and

3.  the contractual stay language being legal, valid, binding and enforceable in accordance with its terms before the courts in the parties’ chosen jurisdiction for dispute resolution.

Some of these matters are Hong Kong law matters, while some are local law or governing law matters.  

While the HKMA is willing to adopt a flexible approach in its requests for legal opinions and will leave it to the covered entity to conduct its own assessment on the legal enforceability of the contractual stay language, covered entities should formulate a plan or strategy on how the legal opinion requirements may be satisfied.  The HKMA has said that in certain circumstances, it may consider it sufficient that a legal opinion previously issued in respect of one covered contract applies equally to another covered contract.  However, adopting this approach may be tricky when it comes to opinions on capacity (point ii above) as these issues are specific to each counterparty and getting counsel to produce one opinion for each counterparty (and reviewing the relevant constitutional documents) may not be practicable.  

Linklaters has extensive experience in advising financial institutions and their counterparties on the compliance with various recovery and resolution regimes across the globe. Linklaters Hong Kong has advised extensively on the requirements and compliance with the Hong Kong Financial Institutions (Resolution) Ordinance including the development of bilateral amendment solutions on contractual recognition requirements (such as the NAFMII Agreement and adherence to the ISDA JMP).  We would be delighted to assist you with the implementation of the Stay Rules.