F. Eligible Financial Contracts

Author:Roderick J. Wood
Profession:Faculty of Law. University of Alberta

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Derivatives are financial contracts whose value is derived from the value of some other thing, such as a commodity, currency, stock, bond, index, or interest rate. They may take many forms, including futures contracts, options, and swaps. Derivatives are used to manage risk by taking the opposite position in the futures market against the value of the underlying asset. For example, an exporter may use derivatives to protect itself against currency fluctuations. In order for "over-the-counter"110derivatives to work efficiently, there must be certainty as to the rights and the liabilities of the parties. Insolvency risk - the risk that the counterparty will not be able to satisfy the obligation pursuant to the derivative contract - must be minimized. The rights associated with derivative contracts are designed to achieve this goal. A counter-

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party is required to provide security if the party is "out of the money." If this is not forthcoming, the party may terminate the contract. This permits the party to enter into a new contract with some other counter-party. Often the parties enter into a master agreement that provide for a netting of all "in the money transactions" against all "out of the money" transactions.

The termination and netting out of financial obligations is considered to be of fundamental importance to the efficient operation of capital markets, and a failure to ensure that the legal framework governing derivatives is in accord with international standards would put Canadian financial markets at a competitive disadvantage. For this reason, insolvency legislation has been amended to ensure that parties are able to exercise their right to terminate and net out in respect of these obligations despite the fact that the counterparty is subject to insolvency proceedings.

In the absence of any special statutory provision, the principles governing executory contracts would apply to derivatives contracts and would interfere with a party’s ability to terminate or net out financial obligations under derivatives contracts. The CCAA and BIA have been amended to ensure that this will not occur. The legislation creates a class of contracts referred to as "eligible financial contracts." The provisions in the CCAA and the BIA governing executory contracts do not apply to an eligible financial contract.111The statutes further provide that the stay of proceedings does not interfere with a party’s ability to enforce a...

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