Derivatives, repurchases, and securities lending transactions are often used by sophisticated financial institutions and large corporate entities in Bulgaria to manage their portfolios of investments, hedge against financial risks, or get short-term credit. Such products are predominantly offered on an OTC basis by foreign banks, with mainly the largest local banks having the know-how and resources to do the same.
A key legal matter in structuring such transactions is whether the major risk-reducing mechanism for non-defaulting counterparties – close-out netting arrangements – is enforceable in case of insolvency or restructuring of the Bulgarian counterparties under such deals. Close-out netting arrangements are contractual stipulations whereby, following insolvency or a restructuring event with respect to one of the counterparties, all due obligations of the parties may be set-off while future obligations/non-executed transactions may be terminated and replaced by their estimated values as if there had been no termination using complex formulae (estimated current exposures). Leaving aside the financial and mathematical aspects, the crucial question that needs to be addressed from a legal perspective is whether such mechanisms would be effective in the first place. In other words, it needs to be established whether the contractual arrangements for set-off, termination, and replacing terminated deals with the estimated current exposures - as elements of the close-out netting will not be affected by the mandatory moratoriums and other statutory restrictions for counterparties in distress/insolvency.
Bulgaria has piecemeal protection for close-out netting arrangements in restructuring or insolvency proceedings. It is limited to domestic laws transposing relevant EU directives (e.g., on financial collateral or restructuring/winding-up of banks and MiFID investment firms). Outside the scope of such laws, parties need to consider automatic termination clauses whereby close-out netting is agreed to take effect before the date of relevant moratoriums restricting the effectiveness of contractual arrangements. For example, contractual set-off (as an element of the close-out netting) is permitted under Bulgarian laws of contract but is overridden by mandatory insolvency restrictions, so it should be agreed to occur before the time when such restrictions are triggered.
Such automatic termination clauses, apart from being complex, result in a termination of the counterparty’s transactions at a time that the non-defaulting party has no control over, and thus may be unfavorable for the latter. Thus, if an automatic termination occurs when underlying rates/indices of a derivative are unfavorable for the non-defaulting party, it may have to pay a net sum to the defaulting party.
Following a two-year project supported by the EBRD and the EU Commission, the Bulgarian Ministry of Finance prepared a comprehensive netting legislation draft that was approved by the Bulgarian Government and was submitted to the Parliament in February 2024 (Expected Reform Law). The Expected Reform Law will supplement the currently applicable law transposing the EU Financial Collateral Directive (FCD) in Bulgaria so the close-out netting arrangements eligible for protection will broadly follow the FCD’s scope and relevant technical definitions. A list of eligible counterparties and broad functional protection for close-out netting arrangements will apply, both being similar to those under the FCD. Most importantly, close-out netting arrangements will be protected irrespective of the opening/continuation of insolvency/restructuring, the latter being broadly defined to encompass all such existing and future Bulgarian proceedings as well as foreign proceedings for Bulgarian entities whose center of main interest is abroad. The subject matter scope (i.e., the list of eligible transactions that will benefit from close-out netting protection) will encompass inter alia derivatives, repos, and securities lending transactions.
The Expected Reform Law is expected to bring legal certainty to financial transactions and reduce the need to have complex additional AET clauses. We believe counterparties may still take steps now to avail of the Expected Reform Law by having some forward-looking arrangements for a fast-track replacement of AET clauses. In particular, it may be agreed that if and when the Expected Reform Law enters into force, the financial institution counterparty that is normally more experienced will unilaterally replace AET arrangements by termination via notice of the non-defaulting counterparty. In this manner, potential losses for the non-defaulting counterparty associated with AET will be significantly reduced.
By Tsvetan Krumov, Partner, Schoenherr
This article was originally published in Issue 11.4 of the CEE Legal Matters Magazine. If you would like to receive a hard copy of the magazine, you can subscribe here.
