Here to stay

What does the policy statement from the Prudential Regulation Authority (PRA) on contractual stays mean in practice? Christopher Leonard, partner at Akin Gump Strauss Hauer and Feld, comments on the final proposals related to contractual stays in financial contracts governed by third-country law.

Original news

PRA rules on contractual stays in financial contracts governed by third-country law, LNB News 16/11/2015 110

A policy statement from the Prudential Regulation Authority (PRA) sets out final rules aimed at reducing the risk of contagion from the failure of a relevant firm and supporting its orderly resolution. The rules ensure resolution action taken in relation to a firm would not immediately lead to the early termination of its financial arrangements (or those of its subsidiaries) governed by third-country law while similar financial arrangements governed by the UK laws, or those of another European Economic Area jurisdiction, are stayed.

What is the background to final rules?

In the summer of 2008 you would have been hard-pressed to find many people outside central banks, university economics departments and a small number of hedge fund managers with exceptional foresight who spent much time thinking about ‘financial contagion risk’ or who even really understood what it meant. When Lehman Brothers collapsed in September of that year the dominoes began to fall—the collapse triggered a series of contractual defaults and cross-defaults that quickly spread from Lehman through its counterparties and into the ‘real economy’—and all of a sudden the term was observed in action and widely understood.

In the aftermath of the financial crisis there has been a great deal of work—both within the UK and at international level—to provide governments, central banks and financial regulators with an enhanced ‘toolkit’ of powers which are intended to help them manage and mitigate the consequences of a significant financial institution suffering an insolvency event.

One of those tools is the EU Bank Recovery and Resolution Directive 2014/59/EU (BRRD) which establishes a harmonised framework for the recovery and resolution of credit institutions—or banks—and investment firms across the EU. As implemented in the UK through the amended Banking Act 2009, the BRRD provides the Bank of England with the power to temporarily suspend the rights of persons that are party to certain types of contracts with a PRA-authorised firm to terminate those contracts and to suspend the right of secured creditors of a PRA authorised firm to enforce that security. These powers are referred to as the ‘temporary stays’.

The BRRD also provides that a pre-resolution or resolution action by the Bank of England, PRA or Financial Conduct Authority in respect of a PRA-authorised firm cannot give rise to any counterparty right under a contract with that firm to accelerate or terminate the contract or rights over collateral. This is known as the ‘general stay’.

It is hoped that the temporary and general stays will prevent resolution action taken by the regulators in respect of a financial institution being the first domino to fall and trigger financial contagion. However, the effectiveness of the stays is limited by the fact that they apply only to contracts governed by the laws of the UK or other EEA member states. Counterparties are currently able to put themselves into a better positon relative to others by electing to contract under the laws of a non-EEA member state—this allows them to close-out contracts in the event the PRA-authorised firm enters into resolution and potentially undermines the resolution process. The rules set out in PS25/15 are intended to address this weakness by requiring a PRA-authorised firm to ensure that their relevant contractual arrangements include terms which prevent termination or acceleration of obligations in the event of resolution action by its regulators.

What should businesses be particularly aware of in the final rules?

The rules set out in PS25/15 prohibit PRA-authorised firms from entering into financial arrangements (or materially amending existing arrangements) which would be subject to the temporary and general stays if they were governed by the laws of the UK unless the counterparty to the arrangement agrees to enforceable contractual terms that have a similar contractual effect to the temporary and general stays in the event the PRA-authorised firm enters resolution. The rules will come into effect on 1 June 2016 in respect of counterparties that are credit institutions or investment firms and on 1 January 2017 in respect of all other counterparties.

Has the PRA dealt with industry concerns in the final rules and are there any special issues of interest?

Some industry participants felt that the objectives of the rules could be better achieved through a statutory cross-border recognition framework. The PRA accepted that this would be the better long-term solution and indicated that it would work toward it through international bodies including the Financial Stability Board. However, such a framework does not yet exist and in the meantime the PRA has decided to implement the rules.

What action if any should firms take in light of the rules?

PRA-authorised firms will need to ensure that the terms of their financial arrangements include the new limitations. This task will be made significantly easier by the development of standardised terms designed for this purpose, including the International Swaps and Derivatives Association resolution stay protocol.

How should lawyers advise their clients in relation to the new requirements?

This will depend on who the clients are. For PRA-authorised firms the resolution stays will quickly become standard business practice. Lawyers advising non-EEA counterparties may need to explain the impact these provisions have on the risk profile of the relevant contracts and the fact that—if the client wants to transact with a UK financial institution—they are obligatory.

Interviewed by Anne Bruce.

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

Relevant Articles
Area of Interest