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CONTENTS
Passage History
Purpose
Background
Main Provisions
Concluding Comments
Endnotes
Contact Officer & Copyright Details
Passage
History
Date Introduced: 1 April 1998
House: House of Representatives
Portfolio: Treasury
Commencement: This Act commences on the day
on which it receives the Royal Assent
Purpose
To create certainty in the Australian financial
payments system by deeming certain transactions valid which might
otherwise be declared void in the event of a party to the
transaction entering into external administration on the same day
as the transaction.
The Bill addresses the lacuna in the law
resulting from rapid advances in technology. Telecommunications and
computers now enable financial institutions to embrace the age of
electronic commerce as it becomes available to them.
The Bill specifically provides certainty for the
following transactions:
- Multilateral netting payments or transfers (multilateral
netting);
- Netting arrangements in connection with trading of derivatives
(close-out netting);
- Netting arrangements in connection with the rules of a stock
market or futures exchange or an associated clearing house (market
netting); and
- Transactions undertaken through the soon to be implemented
"Real Time Gross Settlement" system (RTGS).
Background
Netting
Mutual parties to a transaction may set-off
their debts and credits at the time of the transaction so that a
net balance can be determined at that point in time (bilateral
netting).
The main object is for each party to reduce its
exposure on open contracts if its counter-party becomes insolvent
before the date for performance(1).
The law allows the net amount (rather than the
gross amount) to become payable or provable in the event of
liquidation, provided a party claiming the benefit of a set-off is
without notice of the liquidation at the time of the
transaction.(2)
Multiparty netting
With the advance of technology, financial
institutions are now able to involve themselves in a web of
multiple and complex transactions with customers on a very large
scale. Accordingly, the participants have in place a system of
multiparty set-off (multiparty netting).
However, unlike bilateral netting arrangements,
uncertainty currently exists where multiparty netting transactions
occur on the day a participant enters into external
administration.
At common law, the zero hour rule
applies to transactions from the beginning of the day (midnight or
zero hour) on which the external administration is
declared. This Bill displaces the zero hour rule and brings
multiparty netting transactions into line with the certainty
created by the legislative regime of bilateral netting
transactions.
Close-out netting
This is used in financial markets transactions
such as currency (foreign exchange) and interest rate swaps. It is
a process which permits a party to a financial contract to
terminate the contract if the counter-party becomes insolvent
and;
- To calculate the termination value of the obligations of the
parties; and
- To set-off the termination value so calculated to arrive at a
net amount payable by one party to the other.
Market netting
This typically arises under the rules of a stock
exchange, futures exchange or a clearing house.
The rules commonly provide for the novation (an
agreement discharging a contract and entering into a new one) to a
clearing house of contracts entered into by exchange members, and
the setting-off obligations under those contracts in the event of
default by a member and for the purpose of settlement.
The Draft Report of the Companies and Securities
Advisory Committee (CASAC) Netting Sub-Committee of November 1996,
Netting in Financial Markets Transactions, states that
some experienced lawyers believe that there is no basis for
doubting that current close-out netting and market netting
arrangements are effective.(3) However, in the Final Report of June
1997, the Sub-Committee held the view that it would be very
desirable that the legal position be clarified beyond doubt. It
argues that if, for example, the law were to allow a liquidator of
an insolvent party to "cherry-pick" by disclaiming unfavourable
contracts and holding the other party to contracts which are
favourable, the outcome could be disastrous to the other party. If
there is any risk that this outcome could occur, the risk must be
taken into account as part of the credit risk process when a
financial institution considers whether to enter into financial
contracts. The result could be to inhibit contracting and
consequently deny counter-parties the benefits which can flow from
financial contracts such as financial derivatives, even if the
apprehended disaster never occurs.(4)
The Bill creates certainty in that current
close-out and market netting arrangements would be allowed to stand
notwithstanding the insolvency of a party to the netting
contract.
Real Time Gross Settlement Systems (RTGS)
The Reserve Bank and the Australian Payments
Clearing Association (APCA) have initiated this system. The basis
of RTGS is the development of a sound framework and related
infrastructure to settle high-value payments and to enhance
clearing and settlement systems between participants in the payment
system.
Effectively, the processing of payments only
occurs if the paying institution has funds available in its
settlement account with the Reserve Bank. If such funds are
available, the following occurs simultaneously;
- The funds are debited to the paying customer's account,
- The funds are credited to the payee's account, and
- Corresponding entries are entered to their respective
institution's accounts with the Reserve Bank.
The result is that the settlement of the
transaction takes place immediately and irrevocable.
The Bill displaces the zero hour rule so that
the integrity of the RTGS system is upheld in the event of a paying
party entering into external administration on the day of the
transaction. This will prevent the "undoing" of the transaction and
in doing so, maintains its simultaneous and irrevocable nature.
Main
Provisions
Clause 5 provides for
definitions and in addition refers to particular legislation for
clarity.
Clause 6 upholds the integrity
of the RTGS payment system by deeming payments (made in
accordance with the system) to be made on the day after the paying
participant goes into external liquidation. This displaces the
common law zero hour rule.
Clause 7 obliges participant
parties to notify the RTGS system administrator of the external
administration as soon as practicable. This section is important.
Failure to comply carries a penalty of imprisonment for 5
years.
Clause 10 upholds the integrity
of approved multilateral netting arrangements. If a party to such
an arrangement goes into external administration the external
administrator can recover from the other an amount equal to the
amount of the net obligation.
Clause 14 upholds the
effectiveness of close-out netting contracts. If a party to such a
contract goes into external administration the obligations may be
terminated, termination values may be calculated and the net amount
shall become payable in accordance with the contract. The
provisions of this clause are qualified by the requirement that the
parties must act in good faith and without notice.
Clause 15 gives the Reserve
Bank the power to declare that Clause 14 shall not apply to a
close-out netting contract if it is satisfied that systemic
disruption in the financial system could result if it were
to apply. The extent of the discretion conferred on the Reserve
Bank is unclear.
Clause 16 upholds the
effectiveness of market netting contracts. If a party to such a
contract goes into external administration the obligations may be
terminated, termination values may be calculated and the net amount
shall become payable in accordance with the contract.
Concluding Comments
The Bill insulates Australian financial payments
and netting systems from the application of insolvency laws.
Participants in the system are guaranteed the
integrity of their transactions at the expense of creditors of a
failed participant. Creditors, of course, include day-to-day
depositors.
Although the Bill creates stability in the
Australian financial system to which it relates, it does so at the
expense of those creditors outside the system who would otherwise
have a legitimate right to stand in line with all others under the
current insolvency law regime.
The balance favours the system. The system
follows that of other OECD countries who have already addressed, or
are presently addressing, the legal uncertainties which
attach.(5)
In essence, the Bill answers the call of
technology. As technology and the age of electronic commerce
continue to move forward, the law consistently limps in the
background. The Bill addresses the legal uncertainty under which
the system is currently operating and places the onus upon the
participants to consider their respective credit risks.
One issue, which may become legally troublesome,
is the nature of the entities entering into transactions addressed
by this Bill. Consider the following:
- What particular entities have the capacity to contract under
the system? Should they be clearly defined so that participants can
be certain that any issues of ultra vires do not arise?
- Should there be special provisions in place to safeguard
against trust entities where trust deeds do not entitle the trustee
to enter into contracts under the system?
As a final point, the Bill will uphold the
integrity and stability of the Australian financial system. As a
result, a heavy onus must be placed upon the integrity and
stability of the technological infrastructure under which the
system operates. In 1998, the legal uncertainty of the zero
hour rule may well be dealt with by this Bill, but will its
technological cousin be dealt with as effectively by the
communications and computer systems yet to face the zero hour of
the year 2000?
Endnotes
- Butterworths Australian Legal Dictionary 1997 at .785.
- Australian Corporations Law section 553C.
- Page 3 at 5.2.
- Page 3 at 5.2.
- Includes the United Kingdom, Canada and New Zealand.
Ross Kilmurray
18 May 1998
Bills Digest Service
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ISSN 1328-8091
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