The Bilateral Netting of Qualified Financial Contracts Act, 2020, came into force on 1 October 2020 vide notification by the Ministry of Finance with the object of promoting stability and competitiveness in the Indian financial market. Netting essentially means setting off claims or obligations by eligible participants under qualified financial contracts in case of mutual dealing between the parties, including close-out netting, which is relevant for insolvency.
The positive values in the financial statements are adjusted against the negative values to give the ‘net’ financial position of the participant. Netting Agreements include both the one entered into by the financial parties and the collateral agreement (security or collateral agreement, margin and other credit enhancement agreements such as pledge or guarantee) forming a part of the netting agreement entered into by the parties.
These can be entered into by the ‘qualified financial market participant’, which includes banking institutions, NBFCs, individuals, partnership firms, etc., where at least one of the parties is any of the five major regulators in India: the Reserve Bank of India, Securities and Exchange Board of India, Insurance Regulatory and Development Authority of India, Pension Fund Regulatory and Development Authority, and International Financial Services Centres Authority. The qualified financial contract is any contract defined by the ‘relevant authority’ under the Act.
This is advantageous for two areas of banking and commercial law: one is the Over the Counter (OTC) Derivatives and the other, the resolution of insolvent companies. Initially, the Reserve Bank of India did not permit netting on derivative contracts. Now, since the Act lays down sufficient guidance on the same, the subsequent guidance and notification for its regulation by the RBI would guide the netting mechanism in such transactions.
In cases of insolvency, the concept of close-out netting has been introduced, which is the most promising aspect of this legislation. The setting off of mutual debts is a common practice in developed foreign jurisdictions like the United States, Europe and the United Kingdom, so much so that they have incorporated it in their insolvency legislations such as the Insolvency Act, 1986 (UK), and otherwise also treat it as a part of common law. This stems from the fact that set-off becomes an instrument of substantial justice between the parties as it is treated as an automatic and mandatory process.
The most common kind of agreements are swap ones for cancelling out of claims, which have now become prevalent. The provisions relating to close-out netting specifically stated under this Act streamline the process for the same. Close-out netting essentially means that due to default or insolvency of one of the parties, the obligations under the contract are terminated and the net balance of receivable or payable is taken into account. The amount for this has to be decided in accordance with the netting agreement.
The effect of invocation of close-out netting is that first, the obligations are immediately terminated, liquidation of any of the parties takes place or there can be acceleration of any payment (future or present), and second, that net payable balance is determined, which is to be paid by one of the parties to the netting agreement. In case, under the terms of the netting agreement, parties fail to come to a conclusion with regard to the net amount, or if there was no netting agreement in place initially, the net amount can be determined by way of arbitration as well.
This becomes valuable not only for the corporate debtor or the creditors but also the personal and corporate guarantors of the corporate debtor. This is because currently their liability is co-extensive with the corporate debtor but they do not have the absolute right of subrogation even after payment of the debt on behalf of the corporate debtor. This Act also puts reasonable restrictions on the power of the administration practitioner (including the resolution professional, liquidator, or receiver) for preserving the value of the assets of the insolvent financial party. Therefore, this Act not only creates a better financial environment within India but also has a positive impact on the ease of doing business.
Kavya Lalchandani
Legal scholar based out of Delhi
(lalchandani.kavya @gmail.com)