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By Noble Obasi
In Nigeria, enforcing counter parties debt obligations in financial contracts during commencement of insolvency process could be quite cumbersome, unpredictable and time consuming. Where counterparties in a financial transaction are indebted to each other, debts cannot be offsetted as there is no provision laid down in the extant laws for the satisfaction of the parties debts except through the provisions of insolvency laws. This process of recovery of debt is quite challenging as; there is no time line for the conclusion of the insolvency process, parties are not assured of recovering their full debt exposure, the value of assets might not be preserved during the process and the endless court processes also frustrates the enforcement entitlements of the parties.
This slow pace of recovery of debt could be as a result of several issues such as; the inability of the borrower to repay the debt obligation, and the financial contract not being brought under a master agreement. This tedious insolvency process created a lacuna bordering on enforcement of financial contracts as debt obligations could not be immediately offsetted by the counterparties upon the commencement of insolvency process, but rather being subject to the raw application of insolvency laws, which sometimes are fraught with negatives such as parri passu and fraudulent preferences.
In order to simplify the counterparties obligations in a financial transaction, and to encourage the offsetting of debts by counterparties, netting was introduced by the recently enacted Companies and Allied Maters Act, 2020 (‘‘CAMA’’) (the “Act”), identified under Sections 718-721 of the Act. This provision was totally absent in the repealed Companies and Allied Matter Act 2004 (the ‘‘Repealed Act’’). Netting arises where a financial exposure or obligation under one or more financial contracts which is consummated under a netting agreement is reduced and parties’ obligations are balanced accordingly. Netting is different from a set off. In a set off, payment is discharged through reciprocity of obligation. Parties set off claims among themselves to repay their debt obligations. The International Swaps and Derivatives Association (ISDA) Master Agreement universally recognises the provision of netting under its Master Agreement. Close out netting provisions is one of the inclusions to the
In counterparties’ financial transactions, netting plays vital roles in transactions consummated under it; for example, it simplifies financial transactions among parties, thereby removing the transaction overhead. Also, in foreign currency transactions, netting can reduce transaction volume, save cost and encourage the reduction of foreign exchange conversion charge on various transactions. In view of that, a party can decide to hedge the currency risk by balancing the exposure of one currency with another similar currency; this encourages currency risk management and flexibility in transactions. In hedging the risk, there is an exposure of the various currencies that the party transacts. Where the currency exposure is positive, gains from one currency balances the other currency’s deficit; however, if the currency exposure is negative, gains would be short-changed.
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Close out netting is a type of netting where obligations of parties are netted and offset among them. According to the Corporate Finance Institute, there are other types of netting such as; novation, settlement /payment, bilateral or multilateral. Netting by novation occurs where the existing obligation is nullified and replaced with a new obligation. Also, settlement netting concerns the aggregation and offsetting of all amounts owed to parties and payment of the difference thereon. Bilateral netting or multilateral netting concerns netting of default obligations between two or more parties. In multilateral netting, parties involved employ the use of a clearinghouse or central exchange to regulate the transaction. In close-out netting, a default of obligations by a party activates the netting mechanism
The enactment of the close-out netting is a novel introduction by the Act to the Nigeria legal and financial system. Similarly, depending on the financial instruments involved and choice of the counterparties in transaction, close out netting is usually a preferable type of netting used in financial contracts due to its simplicity in execution and ease of exposition. Close out netting occurs in a lending transaction where parties are indebted to each other and the balance of the indebtedness of one party is netted off and paid under the transaction to the other party. This allows parties to have a head room for preservation of liquidity in a netting arrangement and could lead to a reduction of credit, settlement and liquidity risk among the parties.
Prior to the enactment of the Act, insolvency laws governed financial obligations in Nigeria. Parties could not claim until superior ranked creditors have satisfied their claim. However, under S.721 of the Act, netting provisions are now enforceable, such as; against guarantors, liquidator and insolvent person, hence; financial obligations under a netting agreement no longer fall under the purview of insolvency laws. Notably, parties under a netting arrangement can rely on being protected upon the consummation of any financial contracts and have their financial interests covered whenever an insolvency procedure is commenced on the transaction. Equally, the unenforceability of financial obligations under derivatives transaction under the Repealed Act becomes enforceable under the Act as parties in a derivative transaction can exert confidence on the movement of the underlying financial instruments to engage in their transactions.
Under S.718 of the Act, closed out netting enforcement can only commence during insolvency proceedings. The Act is clear on the trigger factors for the commencement of netting enforcement, such as; occurring after termination, liquidation or acceleration of any payment obligation or delivery under one or more qualified financial transactions, consummated under a netting agreement. According to an analysis of close out netting provisions under sections 718 – 721 of the Act by Centurion Legal Group, parties can not push for early termination of obligations, but would wait until termination; liquidation or acceleration of any payment or delivery obligation or entitlement is triggered. Clearly, under a netting arrangement, parties are confident of consummating netting transactions and creditors are statutory assured of prioritised enforcement rights independent of other creditors in the insolvent counterparty’s transaction.
Obasi writes via [email protected]
