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The Central Bank of Bahrain has issued a new regulation on the enforceability of netting agreements

Regulation No. 44 of 2014 (the “Regulation”)

The Central Bank of Bahrain (“CBB”) has recently issued Regulation No. 44 of 2014 (the “Regulation”) concerning close-out netting under Market Contracts. The Regulation came into effect in the second half of December 2014 at the end of a lengthy consultation process. The purpose of the Regulation is to strengthen the legal basis for concluding that netting agreements are enforceable in the Kingdom of Bahrain (“Bahrain”) regardless of whether the counterparty is insolvent or bankrupt.

The principle of recognition of netting agreements is reflected in Articles 108 and 109 of Decree No. (64) of 2006 (the “CBB Law”). The settlement and clearance side of netting and collateral was partially implemented through the CSD Module of the CBB Rulebook, issued in 2009, whereas the liquidation side of the system has now been completed through the issue of the Regulation. The Regulation is modeled after the 2006 Model Netting Act (the “ISDA Model Act”) published by ISDA and aims at ensuring the enforceability of close-out netting upon the occurrence of any termination event or event of default under a Market Contract containing a netting provision, both prior to and following the commencement of insolvency proceedings, in each case in accordance with the terms of the parties’ contract.

The most innovative feature of the Regulation is the introduction of a concept of netting agreement distinctively separate from the concept of set off under the Bahrain Civil Code of 2001. In the absence of the Regulation there was a lack of a unitary concept of netting agreement embracing all phases of the liquidation process (from termination to netting by way of determination of liquidation or close-out values and conversion into a single currency). The Regulation should alleviate uncertainties and misunderstandings on closeout netting which were persistent before their implementation (Article 3 of the Regulation also regulates the enforceability of multibranch netting agreements in case of insolvency of a branch or agency of a foreign party).

Having introduced a definition of netting agreement, it seems now much easier to give adequate application to the fundamental paragraph (b) of Article 108 of the CBB Law providing for the prevalence of close-out netting agreements over conflicting provisions of insolvency law. The Regulation clarifies the definition of “Market Contract” (whose definition is absent from the CBB Law), as it encompasses a broad array of financial transactions identified, using the terminology of the ISDA Model Act, as “qualified financial contracts”. Most importantly, this definition is not limited, unlike the definition of “Market Contract” contained in the CSD Module, to contracts centrally cleared through licensed clearing agencies. It remains to be seen whether the older CSD Module will be revisited in light of the Regulation.

Article 110 of the CBB Law

There are a few provisions which could be misinterpreted or which arguably exceed the CBB Law’s mandate. All in all, however, the import of the Regulation is likely to change consolidated views as to unattractive mechanisms to ensure effective netting and represents a major step forward in connection with the recognition and enforceability of close-out netting agreements. Still, much needs to be done in connection with the provision of collateral and challenges remain. It is hoped that the CBB will make use of the powers delegated under Article 110 of the CBB Law in order to overcome many of the problems likely to be faced by a party seeking to post its Bahrain issued securities as collateral.

In closing, financial institutions must now reconsider their jurisdictional analysis on Bahrain in relation to the effectiveness of close-out netting and to adjust the attribution of their exposures vis-à-vis Bahraini counterparties for capital adequacy purposes.

We hope this update on the Bahrain legal system is informative and helpful. ASAR is a leading firm in Kuwait and Bahrain with a breadth of experience in banking and finance including Market Contracts. We are positioned to provide comprehensive opinions on close-out netting under the Regulation and Bahrain law generally to support our clients’ needs.

Please do not hesitate to contact us for further information on close-out netting in Bahrain. We can be reached at +973 17 533 182 or asarbh@www.asarlegal.com.

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