What should lawyers be considering as the Bank Recovery and Resolution Directive continues its journey to full implementation? Dennis Dillon, a US-qualified partner in the international finance group at Hogan Lovells, looks at the cross-border effectiveness of the bail-in power contained in art 55.
Implementation of the Bank Resolution and Recovery Directive
Regulatory Technical Standards (RTS) on the Minimum Requirement for Own Funds and Eligible Liabilities (MREL) and on the contractual recognition of bail-in have been published by the European Banking Authority (EBA). Both standards provide further specification of essential elements to ensure the effectiveness of the resolution regime established by the Bank Recovery and Resolution Directive 2014/59/EU (BRRD).
What is the background to the RTS?
The BRRD sets out a recovery and resolution process for certain ‘institutions’. The purpose of the BRRD is to lay down rules and procedures relating to the recovery and resolution of institutions by providing national authorities with harmonised tools and powers to tackle crises at banks and certain investment firms at the earliest possible opportunity to minimise consequences for the broader financial system and remove the moral hazard of taxpayer funded bail-outs.
The BRRD became effective on 2 July 2014. Member States were required to enact domestic implementing legislation by 31 December 2014, with the exception of the bail-in power and the contractual recognition of bail-in provisions which do not need to come into force until 1 January 2016. In the UK, the BRRD has been implemented by way of changes to the Banking Act 2009. However, the UK chose to implement the bail-in provisions at the same time as most of the other provisions, from 1 January 2015.
Under the BRRD, the EBA is required to issue technical standards on a number of issues which will become binding once approved by the European Commission. RTS 2015/06 is the RTS dealing with the requirements of BRRD, art 55. Although issued as a final draft on 3 July 2015, we understand it has not yet been adopted by the European Commission.
Article 55 is aimed at ensuring the cross-border effectiveness of the bail-in power. Where liabilities within the scope of the write-down and conversion powers are governed by the law of a third country, art 55 requires agreements concerning such liabilities to include a contractual recognition term. This is a contractual term by which the creditor (or party to the agreement creating the liability) acknowledges the liability may be subject to these powers and agrees to be bound by:
- any reduction of the principal or outstanding amount due
- conversion, or
- cancellation that is affected by the exercise of the powers by an EU resolution authority
Article 55(1) specifies the list of liabilities which are excluded from the requirement to include the contractual term. The requirement does not apply in relation to a liability that is:
- excluded under BRRD, art 44(2)
- a deposit referred to in point (a) of BRRD, art 108
- governed by the law of a Member State
- issued or entered into before the date on which a Member State applies the provisions adopted in order to transpose section 5 (The bail-in tool) of Chapter IV (Resolution tools) of Title IV (Resolution) of the BRRD
In addition, the requirement does not apply where the resolution authority of a Member State determines that liabilities or instruments governed by the law of a third country can be subject to the write-down and conversion powers by a Union resolution authority pursuant to:
- the law of the third country, or
- a binding agreement concluded with that third country (see the second subparagraph of BRRD, art 55(1))
BRRD, art 55(3) requires the EBA to develop draft RTS in order to further determine the list of liabilities to which the exclusion in BRRD, art 55(1) applies and the contents of the term required in that paragraph, taking into account banks’ different business models. However, because any change to the exclusions would require a change to the BRRD itself, the RTS doesn’t apply a de minimise threshold or introduce new exclusions for the requirement. What it does do is set out what needs to be covered in the contractual recognition statement and clarify certain elements of the art 55 text.
In the UK, the Prudential Regulation Authority (PRA) issued PS1/15 which contains the PRA’s requirements for contractual recognition of bail-in. It proposes a phased implementation of the contractual recognition of bail-in until 1 January 2016 as follows:
‘From 19 February 2015—unsecured debt instruments, except mixed activity holding companies; 1 January 2016—all other liabilities.’
What entities are within scope of BRRD, art 55?
- institutions that are established in the Union
- financial institutions that are established in the Union when the financial institution is a subsidiary of a credit institution or investment firm, or of a company referred to in point (c) or (d), and is covered by the supervision of the parent undertaking on a consolidated basis in accordance with arts 6 to 17 of Regulation (EU) 575/2013
- financial holding companies, mixed financial holding companies and mixed-activity holding companies that are established in the Union
- parent financial holding companies in a Member State, Union parent financial holding companies, parent mixed financial holding companies in a Member State, Union parent mixed financial holding companies
- branches of institutions that are established outside the Union in accordance with the specific conditions laid down in this Directive
Each ‘institution’ and ‘financial institution’ has their own definitions. In addition, the BRRD goes on to provide that when establishing and applying the requirements under the BRRD and when using the different tools at their disposal in relation to an entity resolution, authorities and competent authorities shall take account of:
- the nature of its business
- its shareholding structure
- its legal form
- its risk profile
- size and legal status
- its interconnectedness to other institutions or to the financial system in general
- the scope and the complexity of its activities
- its membership of an institutional protection scheme (IPS) that meets the requirements of art 113(7) of Regulation (EU) 575/2013 or other cooperative mutual solidarity systems as referred to in art 113(6) of that Regulation, and
- whether it exercises any investment services or activities as defined in point (2) of art 4(1) of Directive 2014/65/EU
In very broad terms, this means that the BRRD (including art 55) will apply to most large EU-incorporated banks and financial institutions and may catch smaller institutions if they are considered systemically important.
What is the impact of BRRD, art 55 on in-scope entities?
Considerable. The requirement is that contracts governed by the laws of non-EU jurisdictions should contain contractual recognition clauses if they give rise to liabilities which could be bailed-in by the relevant resolution authority.
However, the RTS makes it clear that the requirement applies to liabilities which are:
- created after the relevant domestic implementation date (the relevant date), regardless of whether they are created under relevant agreements entered into before that date (including under master or framework agreements between the contracting parties governing multiple liabilities)
- created before or after the relevant date under relevant agreements entered into before that date which are subject to a material amendment
- under debt instruments issued after that date
- under debt instruments issued before or after that date under relevant agreements entered into before that date which are subject to a material amendment
The PRA policy statement adds to the difficulty by stating that the requirement applies to liabilities issued, created or arising after that date. The impact is that in-scope institutions will have to try to introduce recognition clauses when existing contracts are materially amended, or if new liabilities arise under existing agreements.
The other issue is the very wide scope of the term ‘liability’. In some cases where the financial institution is the borrower or is the entity raising funds by issuing bonds it will be clear that a liability has arisen. However, it will also potentially apply to other liabilities such as an undrawn commitment under a loan where the financial institution is the lender, any indemnity given by the financial institution (for example under a loan agreement or an intercreditor agreement), or contingent liabilities under guarantees or letters of credit. It would also catch liabilities of the financial institution to certain non-essential suppliers. Liabilities to commercial or trade creditors in respect of goods or services that are critical to the daily functioning of its operations are excluded from the scope of bail-in and so from art 55 (these include IT services, utilities and the rental, servicing and upkeep of the premises). However, it is up for debate as to which services are ‘critical’ and which aren’t—how about the catering company providing an in-house restaurant? Even though it is generally thought that these liabilities would be unlikely to be bailed in in practice, the requirement for a contractual statement of recognition still applies.
When will the provisions of BRRD, art 55 and the recommendations of the RTS come into force, both in the UK and throughout the EU?
See above for the BRRD and the UK. For the rest of the EU, the implementation date should be 1 January 2016 at the latest—however, we are aware that some jurisdictions have not yet implemented any part of the BRRD and that would include art 55.
What should affected entities do to ensure compliance with BRRD, art 55 and the RTS, and what challenges is this likely to pose?
Ensure new contracts contain the relevant clause and ensure systems are put in place so the clause is inserted in any material amendment to that agreement. However, the issues will be:
- identifying all relevant contracts—as there is no de minimis this will be time consuming and expensive. It may not always be simple as some forms, such as letters of credit, often do not have a governing law clause so it may be difficult to assess whether the letter of credit is governed by the laws of an EU or non-EU jurisdiction
- getting the counterparty to accept the clause—this is not a given, particularly if the financial institution has to contract on standard terms
What advice should lawyers be giving to their clients?
As there is no de minimis threshold and failure to comply with the requirement can lead to regulatory sanction, lawyers need to be advising clients to consider what types of contract they are likely to be entering into (and with whom) and which will be affected—they then need to review existing contracts governed by the laws of a non-EU jurisdiction to the extent liabilities will be created or arise under them after 1 January 2016 and put in place systems to ensure new contracts entered into contain the relevant contractual recognition clause. Early discussions with key counterparties (ie those with whom the institution contracts on a regular basis) should be encouraged—it might, for example, be possible to agree a single side agreement which would apply to all contracts entered into with that counterparty and under which a contractual recognition clause is deemed included in each relevant contract. Finally, the institution needs to be able to demonstrate to the regulator that they have appropriate and robust systems in place for ensuring compliance. All of which is easier said than done.
Interviewed by Jon Robins.
The views expressed by our Legal Analysis interviewees are not necessarily those of the proprietor.