INTRODUCTION

Combining or aggregating several financial obligations to arrive at a net obligation amount is one approach to mitigating risks in financial contracts (such as derivative contracts). Financial derivatives are contracts for differences performed with the exchange of cash flows. A financial derivative is a security or financial instrument whose value is determined by an underlying asset or group of assets. Simply put, they are contracts between two or more parties whose change or fluctuation in the underlying reference asset value determines the contract’s value.[1]

Netting is a method of reducing financial risks between two or more parties by reducing settlement, credit, and other financial risks.[2] In netting, the value of multiple positions is examined and offset and the parties that need to be paid, and pay are eventually decided.[3]

Netting refers to the process of settling pending transactions by balancing them in favor of one. For example, one party may demand that the other pay a net balance amount after deducting the amounts owed to them.[4]

In finance, netting appears to be quite beneficial to individuals or companies who owe a substantial sum of money to the other party. When the parties involved achieve an agreement, the sum owed is greatly reduced. As a result, it relieves the payer of a significant financial load. It is a widely used concept in financial markets, particularly in currency and security trading. Financial markets are, without a doubt, fraught with dangers. However, investors can use this approach to offset a position in one trading instrument with another in the same or a different tradable asset. They can then trade assets of their choice while balancing losses and gains.[5]

In financial contracts, netting seems to be similar to setting off and may be confused for another. In netting, two or more obligations are aggregated to achieve a reduced net obligation. In set-off, a debtor can set off the cross-claim owed to him against the main claim owed to his creditor. It can be simply stated as a method of payment based on the fulfillment of reciprocal obligations.

In light of the foregoing, this article provides an overview of the mechanics of netting in Nigerian corporate practice.

LEGAL FRAMEWORK FOR NETTING IN NIGERIA

There was no statutory structure or particular provisions for netting prior to the Companies and Allied Matters Act 2020. There were also no judicial authorities on the topic. However, under Chapter 28 of the Companies and Allied Matters Act 2020 (which governs the business activities of companies in Nigeria), netting received special attention, notably the implementation of contractual netting provisions.[6] According to PART 7[7],  any occurrence of a netting event by an industry sector-specific regulator must be reported to the Corporate Affairs Commission (regulatory body) within fourteen (14) working days.

It is crucial to note that the Act’s netting provisions were fashioned after the 2018 International Swaps and Derivatives Association (ISDA) Model Netting Act and Policy Guide (the Model Act), which is the globally recognized perfect method for assessing the sufficiency of netting laws.[8]

The Central Bank of Nigeria, the Securities and Exchange Commission, the National Insurance Commission, the National Pension Commission, and any other financial regulatory authority constituted by an Act of the National Assembly are all netting financial regulatory bodies in Nigeria.[9]

TYPES OF NETTING

According to the Act, netting can occur in the following:[10]

a.    the termination, liquidation, or acceleration of any payment or delivery obligation arising from one or more qualified financial contracts entered into pursuant to a netting agreement;

b.    the determination or estimation of a close-out value, market value, liquidation value, or replacement value for each obligation or entitlement or group of obligations or entitlements terminated, liquidated, or accelerated;

c.  the conversion into a single currency of any values calculated or estimated; and

d.  determining the net balance of the converted values calculated, whether by set-off or otherwise.

The basic types of netting are as follows:

i.  Payment/Settlement Netting: The set-off of reciprocal delivery obligations of the same asset that are due for delivery on the same day is known as payment/settlement netting. The amount outstanding between two or more parties is combined using this procedure to determine the remaining unpaid value. The net difference, or the total outstanding amount to close the contract is paid or received by the parties concerned. It lowers transaction costs while also assisting with liquidity difficulties.[11]

It is usually completed a few days before the real payments are due; otherwise, the netting procedure could take longer, and the party could suffer a penalty for the late payment.[12]

Worthy of note is the fact that, settlement netting differs from set-off in that it applies to deliveries under executory contracts that have yet to be completed, whereas set-off pertains to debts owed for completed work.[13]

ii. Close-out netting: Close-out netting is common in the event of a default. Existing transactions are canceled in this circumstance, and the transaction values are determined. The values are then added together, and the remaining amount is paid in one lump sum to the person who is owed the payment.[14]

When one party fails to reimburse the other, a single amount is calculated and paid by only one party who is responsible. For example, X owed Y ₦3,000, whereas Y owed X ₦5,000. They both agreed on the same day for settlement. They decided against making matters more complicated by splitting the payments because they were obliged to repay each other on the same day. Instead, they consolidated the full amount using the netting method. X owed Y only ₦3,000, which was less than the ₦5,000 X was owing by Y. X requested that Y settle the ₦3000 debt with the ₦5,000 and pay the balance. The ultimate payable sum was ₦2,000, which Y had to pay X to complete the transaction.[15]

iii. Novation Netting: The existing contract between the parties is void in this case. A new transaction is issued in place of the old agreement, containing the net due amount. As a result, this kind offers a more holistic approach to handling transactions.[16]

Novation netting is the process of replacing an existing obligation with a new one. Instead of netting the amounts and paying the difference when two parties owe each other specific amounts and the transactions have the same settlement date, novation netting cancels the existing contracts and replaces them with a new transaction that amounts to the net amount. In financial transactions, novation netting is employed.[17]

iv.   Multilateral Netting: This entails settling financial obligations among several parties, as the name implies. A central exchange or unit functions as a liaison between the parties engaged in this system to ensure proper transaction regulation. Companies with several subsidiaries choose this strategy for resolving payment disputes and ensuring seamless operations.[18]

When multilateral netting takes place, the parties use a clearinghouse or central exchange to regulate the transactions and netting’s impact. Multilateral netting can be used by some corporations with several subsidiaries to offset payments received and payable to their various divisions.[19]

ENFORCEABILITY OF NETTING AGREEMENTS

Certain terms mentioned in this article, such as Qualified Financial Contracts, Netting Agreements, and Parties in a Netting Agreement, must be addressed because they are decisive factors to examine when determining the enforceability of the netting provisions under the Act.

Parties in a Netting Agreement

It should be noted that netting provisions apply to certain persons and the Act defines a party as a person who is one of the parties to a netting agreement. Furthermore, the Act defines a person as any partnership, company, a regulated entity such as a bank, insurance company, pension fund administrator, or any other body corporate (including statutory corporations or statutory bodies) whether organized under the laws of Nigeria or any other jurisdiction and any international or regional development bank or other international or regional organization.[20] This demonstrates that the provisions apply to natural, corporate, and statutory entities, as well as foreign entities, supranational, and international organizations.

Qualified Financial Contracts (QFCs): From the definition of netting under Section 718, the transaction in question must be a qualified financial contract for its enforceability. A qualified financial contract means a contract, including any terms and conditions incorporated into any such financial contract, under which payment or delivery obligations that have a market, or an exchange price are due to be performed at a certain time or within a certain period, without limitation. QFCs include all types of swaps in relation to currencies, interest rates, basis rates, and commodities; foreign exchange, securities, or commodities transactions; cap, collar, or floor transaction; forward rate agreements; currency or interest rate future/option; various types of derivatives such as credit, energy, bandwidth, freight, emissions, economic statistics, and property index derivatives; amongst others qualify as agreements under this definition.[21] It also includes any other agreement, contract, or transaction a financial regulatory authority designates as such.[22]

Netting Agreements: Netting agreement is defined in three ways under the Act. It could be any agreement between two parties that provides for netting in connection with one or more Qualified Financial Contracts entered into in relation to a master netting agreement; or any master agreement that provides for netting of two or more master netting agreements called (master-master netting agreement); or any collateral arrangements related to the foregoing.[23]

Section 721 (1) provides to the effect that a netting agreement is final and enforceable even against insolvent parties or persons providing security in support of insolvent parties. Due to bankruptcy or insolvency proceedings or the appointment of a liquidator in connection to that party, a party’s obligations to make payments under a netting agreement will not be terminated or suspended, and any netting agreement will take effect according to its terms.

This provision implies that it gives the netting provision precedence over other acts, laws, regulations, or directives, including any provision of law relating to bankruptcy, reorganization, composition with creditors, receivership, or any other insolvency proceeding or provision of law that an insolvent party may be subject to; subject to the terms of the applicable netting agreement.

It goes further to provide that following the initiation of insolvency proceedings against a party, either party’s only obligation to make payment or delivery under a netting agreement, if any, shall be equal to its net obligation to the other party, as determined by the terms of the applicable netting agreement.[24] Also, after the beginning of bankruptcy proceedings against a party, any party’s only right to receive payment or delivery under a netting arrangement is equal to its net entitlement to the other party, as calculated per the applicable netting agreement’s terms.[25]

It should be noted that an agreement would not be disqualified as a netting agreement notwithstanding the lack of any such label or recognition under Section 718 so long as it falls under the definition of a qualified financial contract under Chapter 28.[26]

The applicability of the restrictions on preference or fraudulent transfer has been examined in the Act to ensure the execution of netting agreements in QFCs. To this end, an insolvent party’s liquidator may not avoid any transfer, substitution, or exchange of cash, collateral, or other interests from the insolvent party to the non-insolvent party under a netting agreement; or any payment or delivery obligation incurred by the insolvent and owing to the non-insolvent party under a netting agreement because it constitutes a preference by the insolvent party to the non-insolvent.[27]

If there is clear and convincing evidence that the non-insolvent party made such transfer or incurred such obligation with actual intent to hinder, delay, or defraud any entity to which the insolvent party was indebted or became indebted on or after the date such transfer or obligation was incurred, a liquidator may, as an exception to the general rule, avoid the enforcement of such netting arrangement.

CONCLUSION

CAMA 2020’s netting provisions are projected to usher in a new wave of innovative advances, considerably enhancing the ease of doing business in Nigeria and ushering in a new paradigm in the Nigerian financial industry. This Act has been credited with playing a key role in the successful launch of Nigeria’s derivatives market, which will provide a wide range of risk management opportunities, increased market liquidity, improved price discovery, lower risk capital charges and transaction costs, and increased financial market stability, among other things.[28]

It represents another welcome and dynamic step in Nigeria’s rapidly maturing legal system to promote greater financial activity in the country and strengthen the country’s position as a premier global commercial and financial hub.

It can, however, be enhanced by more comprehensive and specific legislation that addresses these issues in greater depth, including, but not limited to, the treatment and applicability of netting regulations after insolvency begins.[29]

 FOOTNOTES:

[1] https://www.riskink.com/the-risks-in-financial-derivative-contracts/ accessed on the 2nd  of May 2022.

[2] https://www.investopedia.com/terms/n/netting.asp accessed on the 2nd  of May 2022.

[3] https://corporatefinanceinstitute.com/resources/knowledge/deals/netting/ accessed on the 2nd  of May 2022.

[4] https://www.wallstreetmojo.com/netting/ accessed on the 22nd  of May 2022.

[5] Ibid

[6] Companies and Allied Matters Act 2020

[7] Insolvency Regulations 2022

[8]https;//www.olaniwunajayi.net/An-Appraisal-of-Netting-Provisions-Under-the-Companies-and-Allied-Matters-ACT-2020.pdf; https://www.isda.org/a/cUDDE/the-effectiveness-of-netting.pdf accessed on the 20th  of May 2022.

[9] Section 718 Companies and Allied Matters Act 2020

[10]  Section 718 of the Companies and Allied Matters Act 2020

[11] https://www.wallstreetmojo.com/netting/ accessed on the 20th  of May 2022.

[12] https://corporatefinanceinstitute.com/resources/knowledge/deals/netting/accessed on the 20th  of May 2022.

[13]https://www.mondaq.com/nigeria/securities/982072/chapter-28-of-the-companies-and-allied-matters-act-2020-netting-in-nigeria accessed on the 20th  of May 2022.

[14] https://corporatefinanceinstitute.com/resources/knowledge/deals/netting/ accessed on the 20th  of May 2022.

[15] https://www.wallstreetmojo.com/netting/ accessed on the 24th  of May 2022.

[16] Ibid

[17] https://corporatefinanceinstitute.com/resources/knowledge/deals/netting/ accessed on the 20th  of May 2022.

[18] https://www.wallstreetmojo.com/netting/ accessed on the 24th  of May 2022.

[19] https://corporatefinanceinstitute.com/resources/knowledge/deals/netting/accessed on the 20th  of May 2022.

[20] Section 718 Companies and Allied Matters Act 2020

[21] Ibid

[22] Section 719 Companies and Allied Matters Act 2020

[23] Ibid

[24] Section 721 (2) Companies and Allied Matters Act 2020

[25] Section 721 (3) Companies and Allied Matters Act 2020

[26] Section 721(8) Companies and Allied Matters Act 2020

[27] Section 721(6) of Companies and Allied Matters Act 2020

[28]https://fmdqgroup.com/cama-2020-netting-provisions-game-changer-fmdq-derivatives-central-counterparty-agenda-positions-nigerian-financial-market-radical-transformation/ accessed on the 21st of May 2022.

[29]https://www.mondaq.com/nigeria/securities/982072/chapter-28-of-the-companies-and-allied-matters-act-2020-netting-in-nigeria accessed on the 21st of May 2022.


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