To the rescue? Contractual recognition of bail-in for financial institutions

From 1 January 2016, firms are required to implement article 55 of the Bank Recovery and Resolution Directive (BRRD), which requires EU firms to include a contractual recognition of bail-in clause in a wide range of non-EU law governed contracts. Doug Shaw, managing associate at Linklaters, examines the potential effect of the requirement on transactions, and the current difficulties it is posing for firms.

What are the requirements of BRRD, art 55?

Article 55 forms part of the bail-in provisions under the BRRD that provide for creditors to absorb the losses of failing banks, rather than the government or taxpayers (which, in contrast, is referred to as a ‘bail-out’). It achieves that by giving resolution authorities the power to write-down liabilities of the bank (for the purposes of loss absorption) and to convert certain creditors into shareholders (for the purposes of recapitalising the bank).

In the modern banking sector, institutions typically operate cross-border. One of the related issues is whether the bail-in tool will be effective in respect of liabilities governed by a separate system of law. For example, if a UK bank or investment firm were to be subject to resolution action, there is a question as to whether counterparties to New York law-governed contracts would need to respect any decision of the Bank of England to bail-in liabilities under that contract. Essentially, can the counterparty enforce the contract in New York irrespective of the resolution action?

While the BRRD sets out mutual recognition requirements throughout the EEA (such that, within the EEA, courts are obliged to recognise resolution action taken by EEA resolution authorities), there remains a potential issue where liabilities are governed by non-EEA law. Article 55 addresses this issue by requiring relevant entities to negotiate provisions into the relevant contract itself. Under those provisions, the counterparty recognises the effect of the bail-in tool and agrees to any amendment to the terms of the contract required to give effect to it.

What is the timing?

The requirement has been implemented in the UK under new provisions in the Prudential Regulation Authority (PRA) and Financial Conduct Authority (FCA) rulebooks, both of which were published in January 2015. Those rules impose the requirements in respect of liabilities issued or entered into after 1 January 2016. The European Banking Authority also published a draft regulatory technical standards (RTS) in July 2015, which makes clear that the requirements also extend to older liabilities that are subject to material amendment after the implementation date. While there is no clear definition of what constitutes ‘material’ in this context, the draft RTS state that changes that do not alter the substantive obligations of the parties will not be caught (eg a change of contact details). The presumption therefore is that any other change to an existing contract after the implementation date will be sufficient to trigger the requirements.

At the end of 2015, the PRA and the FCA each published modification processes, whereby institutions may apply for a temporary variation of the current rules. The variation, if granted, runs until 30 June 2016, or such earlier date as the rules themselves are revised. Under the modified rules, an institution is permitted not to comply with the BRRD, art 55 requirement where it determines that it is ‘impracticable’ to do so in respect of a particular liability.

There is no particular reason to distinguish derivatives (or repos and stock loans) from any other potential liability of a relevant institution. Subject to a limited list of exceptions, each type of contract will require an amendment to include new wording. A number of industry bodies have already published suggested wording that parties may wish to use.

Are other industry bodies considering preparing protocols to address BRRD, art 55?

The International Swaps and Derivatives Association (ISDA) are reportedly preparing a protocol in order to amend existing ISDA Master Agreements between adhering parties. There is some suggestion that the scope of that protocol may extend beyond simply the ISDA Master Agreement and also capture other master agreements, like the Global Master Repurchase Agreement and Global Master Securities Lending Agreement. Publication has been delayed, however, until the RTS have been finalised. Among other things, those technical standards will set out the detailed requirements of what the contractual wording needs to address. There is some sense in waiting until there is certainty about the requirements before finalising the language to address them.

What problems are they facing?

As I have already mentioned, we are still waiting for the final RTS to be endorsed by the Commission. As a result, even where parties are able to successfully amend the terms of their contract, it remains uncertain whether the terms of the change will meet the details of the final requirements, which makes future-proofing of compliance far more difficult.

I mentioned the modification by consent currently available from the UK regulators. There is currently no guidance as to the meaning of ‘impracticable’ in that context, and this has meant that many institutions have needed to develop internal policies for identifying instances that they believe fall within the exemption. The fact that the modification has been made available implicitly recognises that the current regime gives rise to practical difficulties. This has led to a broader questioning of the scope of BRRD, art 55 and whether it should be refocused on a narrower range of liabilities. The recent responses from the Treasury and the Bank of England to the Commission as part of its Call for Evidence on the EU Regulatory Framework on Financial Services both recommended that the Commission reassess the scope of BRRD, art 55.

What should practitioners do in the meantime for new derivative, repo and securities lending transactions?

Practitioners that are advising affected entities should continue to assess non-EEA law governed liabilities on a case-by-case basis and ensure that, where required, appropriate language is included in contracts. Where an institution has applied for the modification made available by the regulators, practitioners will also be involved in assessing whether compliance would be ‘impracticable’ in a given case. That determination may not be straightforward. It has been made clear by the regulators that, notwithstanding the availability of the modification, they expect institutions to be proactive in seeking to include appropriate language in relevant contracts.

Doug Shaw is a managing associate in the capital markets department at Linklaters LLP. Doug has experience working on a variety of over the counter (OTC) and securitised derivative products. His OTC experience includes the full spectrum of derivative assets classes, including equity, credit, interest rate and cross–currency derivatives and he regularly advises clients on the application of EMIR and BRRD.

Interviewed by Duncan Wood.

The views expressed by our Legal Analysis interviewees are not necessarily those of the proprietor.

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