Foley & Lardner: Additional States Enact NAIC Model Qualified Financial Contracts Law

Foley & Lardner: Additional States Enact NAIC Model Qualified Financial Contracts Law

By Andrew Oberdeck, Senior Counsel, Foley & Lardner LLP

Several states have recently added provisions to their insurance rehabilitation and liquidation acts which address the rights of parties to certain derivatives transactions with an insurance company in the event that an order of rehabilitation or liquidation is entered against the insurer. In short, these laws allow parties to exercise certain early termination and close-out netting provisions without regard to the applicable stay mechanism under state insurance insolvency law.

Early termination and close-out netting provisions are standard in derivatives transactions, and apply when an event of default (such as bankruptcy or insolvency) occurs with respect to one party. Upon one party's event of default or upon the occurrence of another specified termination event with respect to one party, the non-defaulting party can terminate all the derivatives transactions outstanding under the applicable agreement, calculate a single net amount due by or to the defaulting party, and liquidate any pledged collateral. The ability of the non-defaulting party to exercise these rights is particularly important because the value of the derivatives are based principally on their fluctuating market value, and a stay that enjoins the rights of the non-defaulting party to exercise such rights could create escalating losses due to changes in market prices. Accordingly, the ability of the non-defaulting party to terminate derivatives transactions and net exposures quickly upon the other party's insolvency is often critical in limiting losses.

Federal laws provide a level of certainty with respect to the enforceability of certain provisions of derivatives transactions, through the U.S. Bankruptcy Code in the case of a general corporate bankruptcy, and through the Federal Deposit Insurance Act (FDIA) in the case of an insolvent federally or state chartered bank or thrift. These laws provide an exemption from the automatic stay mechanism for specific provisions of certain derivatives transactions, including netting provisions, certain collateral provisions and termination provisions. Accordingly, a counterparty to a derivatives transaction with a corporation or financial institution enters into the transaction knowing that its rights under these provisions are generally enforceable upon the bankruptcy or insolvency of its counterparty, unaffected by the automatic stay.

Counterparties of U.S. insurance companies do not uniformly have the benefit of similar legal certainty with respect to the enforceability of the termination, netting, and collateral realization provisions against U.S. insurance companies. The insolvency of insurance companies is governed by state law and not the U.S. Bankruptcy Code, and state insurance insolvency laws generally do not provide an exception to applicable automatic stay mechanisms for derivatives transactions. Although difficult to gauge, it seems likely that banks and other financial institutions have, at least in some instances, avoided entering into derivatives transactions with U.S. insurance companies or charged a premium for such contracts, out of concern that state insurance insolvency law will prevent them from exercising termination, netting, and collateral realization rights if the insurer becomes insolvent.

However, a growing number of states have addressed the concerns of potential counterparties to U.S. insurance companies by adding new provisions to their insurance rehabilitation and liquidation acts addressing "qualified financial contracts," including swap agreements and other derivatives transactions. The new provisions are based on Section 46 of the National Association of Insurance Commissioners' Insurers Rehabilitation and Liquidation Model Act, which provides protections for qualified financial contracts and netting agreements modeled upon the analogous provisions in the FDIA and U.S. Bankruptcy Code. In general, these provisions allow the non-defaulting party to exercise netting provisions, collateral realization provisions, and termination provisions without regard to the automatic stay mechanism. Thus far in 2011, Arizona, Delaware, Indiana, Maine, Nebraska, and Virginia each added such a provision (legislation has been introduced in New Jersey, New York, and Ohio). These six states join Connecticut, Illinois, Iowa, Maryland, Massachusetts, Michigan, Minnesota, Missouri, Texas, and Utah as states that have an exception for qualified financial contracts or netting agreements from the applicable stay mechanism in their insurance insolvency law. With increased certainty in additional states regarding their rights when entering into derivatives transactions with U.S. insurance companies, banks and other financial institutions are likely to be more willing to enter into such transactions with U.S. insurance companies, or to do so without charging a premium to compensate for the uncertainty under state insurance insolvency law.

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