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Irrelevant Ipso Facto Clauses, or, the Meaninglessness of the Fact Itself

March 22, 2012

On Tuesday, the FDIC published for comment proposed rules implementing Section 210(c)(16) of the Dodd-Frank Act.  The section permits the FDIC, as receiver for a financial company whose failure would pose a significant risk to the financial stability of the U.S. (a “covered financial company”), to enforce contracts of subsidiaries or affiliates of the covered financial company despite contract clauses that purport to terminate, accelerate, or provide for other remedies based on the insolvency, financial condition, or receivership of the covered financial company. The proposed rule makes clear that the effect of this enforcement authority is that no party may exercise any remedy under a contract simply as a result of the appointment of the receiver and the exercise of its orderly liquidation authorities as long as the receiver complies with certain statutory requirements.

In other words, ipso facto clauses are unenforceable against systemically important financial institutions (“SIFI”). 

Affected contracts. The proposed rule would apply to any covered financial company’s subsidiary or affiliate whose contractual obligations to a third party are “linked to” the covered financial company or are “supported by” the covered financial company. A contract is “linked to” a covered financial company if it contains a provision that provides a contractual right to “cause the termination, liquidation or acceleration of such contract based solely on the insolvency, financial condition, or receivership of the covered financial company.”

A contractual obligation “guaranteed or otherwise supported by” the covered financial company includes guarantees that may or may not be collateralized, netting arrangements and other examples of financial support of the obligations of the subsidiary or affiliate under the contract.

The effect on contracts. The proposed rule would establish that if the subsidiaries’ obligations under the linked contract are supported by the covered financial company through, for example, guarantees or the granting of collateral that supports the obligations, the FDIC as receiver must either (i) transfer such support (along with all related assets and liabilities) to a qualified transferee not later than 5:00 p.m. (Eastern Time) on the business day following the appointment of the receiver, or (ii) provide “adequate protection” to contract counterparties following notice given to the counterparties in accordance with the guidelines set forth in the proposed rule by the one-business-day deadline.

The proposal’s breadth. The proposed rule applies broadly to all contracts, and not solely to qualified financial contracts. For example, a real estate lease or a credit agreement, neither of which would typically be classified as a qualified financial contract, would be subject to enforcement under the proposed rule notwithstanding a specified financial condition clause that might, for instance, give a lessor the right to terminate a lease based upon a change in financial condition of the parent of the lessee. A swap agreement of a subsidiary or affiliate would be subject to the proposed rule in the same manner as if the agreement contained a specified financial condition clause.

What the proposal means. On the one hand, the FDIC’s proposal simply aligns the SIFI resolution provisions with the Bankruptcy Code while providing SIFI counterparties with collateral protection. The proposal does not, however, resolve such thorny issue as “flip clauses” which reprioritize payments.

Comments should be submitted within 60 days after the proposal’s publication in the Federal Register, which is expected during the week of March 26. View the proposal here.  (If you’re a Knowledge Mosaic user, set up a Dodd-Frank Tracker alert for all FDIC releases.)

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