Legal development

BRRD update: does recognition of bail-in go too far?

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    EU Directive 2014/59 (often referred to as the Bank Resolution and Recovery Directive or the BRRD) contains wide-ranging recovery and resolution powers for EEA regulators to facilitate the rescue of a failing EEA financial institution. These powers include the ability for a regulator to write-down and/or convert into equity a failing institution's liabilities ‒ the so-called "bail-in tool".

    EEA member states are obliged to recognise each other's exercise of resolution powers (including exercise of the bail-in tool). There is therefore no need for any express language recognising the effectiveness of the bail-in tool in any contract expressed to be governed by the law of an EEA member state.

    However there is a question as to whether the courts of countries which are not EEA member states would recognise the exercise of the bail-in tool by an EEA regulator. In an attempt to overcome this problem, Article 55 of the BRRD requires contracts which are expressed to be governed by the law of a country which is not an EEA member state and which create relevant liabilities owed by in-scope institutions to contain provisions by which creditors expressly recognise the effectiveness of the bail-in tool – contractual recognition of bail-in.

    BRRD is fully in effect and member states were required to apply their implementing legislation and regulations from 1 January 2015, except that the BRRD permits member states to apply the provisions on the bail-in tool (including contractual recognition of bail-in) from 1 January 2016 at the latest.  Some member states, such as Germany and the UK, moved early and implemented the contractual recognition of bail-in requirement before this date: in the case of Germany from 1 January 2015, and in the case of the UK from 19 February 2015 for unsecured debt instruments and additional tier 1 and tier 2 instruments issued after that date, and from 1 January 2016 for all other liabilities. Other member states, such as Luxembourg and Sweden, missed the 1 January 2016 deadline. 

    Key points 

    • Scope of "liabilities": The scope of liabilities which are required to include contractual recognition of bail-in has surprised many market participants and triggered difficult conversations with non-EEA contractual counterparties. UK regulators have recognised this and made rules allowing any affected institution to apply for a temporary modification of the relevant rules.
    • Fungibility issues? The implementation of the provisions of BRRD relating to contractual recognition of bail-in may have created a discontinuity for fungibility purposes between debt instruments which contain an express contractual recognition of bail-in and those which do not.
    • Overwrought risk factor? ESMA may have taken a step too far in its proposal for a BRRD risk factor in relevant prospectuses.

    All those liabilities? Really?

    BRRD requires in-scope institutions to include an express contractual recognition of bail-in in each agreement or other instrument creating a liability for that institution where the agreement or instrument is issued or entered into after the relevant implementation date described above. The only exception to this is where the relevant liability falls into a very limited category of excluded liabilities, such as various types of deposit, secured liabilities (to the extent of the security), certain short-term liabilities (less than seven days), certain liabilities arising by virtue of a fiduciary relationship, liabilities critical to daily operations (such as liabilities to IT service providers and utilities), certain liabilities to employees, and liabilities to tax and social security authorities.

    Many market participants have expressed surprise at the breadth of the scope of liabilities which are required to contain an express contractual recognition of bail-in. This point is particularly acute for UK-regulated institutions where implementing rules made by one of the UK regulators, the Prudential Regulation Authority (PRA), include a broad definition of "liability" that is not derived from either BRRD or the draft regulatory technical standards (RTS) published by the European Banking Authority (EBA) referred to below. That definition encompasses any debt or liability to which the in-scope institution is subject, whether it is present or future, certain or contingent, ascertained or sounding only in damages. In addition, the PRA rule applies to a liability arising after the implementation date under a pre-existing agreement, with no requirement for this to be triggered by a material amendment to that pre-existing agreement, as contemplated by the draft RTS.

    In light of this, the PRA and the other UK regulator, the Financial Conduct Authority (FCA), have made supplementary rules allowing any in-scope institution to apply to the PRA or FCA, as appropriate, for a temporary modification of the relevant rules if it considers that the scope of liabilities subject to the requirement for contractual recognition of bail-in, which took effect on 1 January 2016 (i.e. second-phase liabilities), is impracticable. The PRA and the FCA intend to consult on amending their contractual recognition of bail-in rules once the RTS are adopted, and the possibility of such a temporary modification is being provided to delay the rules' application to second-phase liabilities while their consultations are prepared and conducted. Any such modification (if granted) will only be valid until the earlier of 30 June 2016 or the date when the relevant rules are amended or revoked following the relevant consultation. A number of UK-regulated institutions are understood to have applied for and obtained such temporary waivers.

    In accordance with its mandate under Article 55(3) of the BRRD, the EBA has examined restricting the scope of the liabilities subject to contractual recognition of bail-in but has concluded that it is not competent to do so as this would involve changing an essential element of the BRRD (such matters being reserved to the European Parliament and the Council). The EBA has proposed draft RTS concerning the contents of contractual provisions recognising bail-in but the RTS have yet to be adopted by the European Commission. In the meantime, a number of bodies such as the Loan Market Association (LMA), the Association for Financial Markets in Europe (AFME), the Loan Syndications and Trading Association (LSTA) and the International Capital Market Association (ICMA) have published suggested texts, and we understand that the International Swaps and Derivatives Association, Inc. (ISDA) is preparing a protocol but this is not yet published.

    Bank of England concerns

    On 1 February 2016, the Bank of England published its response to the European Commission's call for evidence on the EU regulatory framework for financial services. Among its answers, the Bank highlighted a need to reassess the current scope of Article 55 of the BRRD to ensure it is proportionate in its reach. The Bank is concerned that the current scope is too wide and gives the following as examples:

    • liabilities to clearing and settlement systems outside of the EU, often subject to non-negotiable standard-form contracts or rules;
    • liabilities connected to the financing of international trade (letters of credit, bank guarantees and performance bonds), where the beneficiary to whom the liability will be owed is not the client of the bank; and
    • standard term contracts under local law or with foreign public authorities (leases, purchases and rental of equipment, IT, supplies, services, utilities).

    The Bank also says it is further considering its position on this subject and intends to engage further with the Commission in due course.

    No tapping

    One result of all this is that there is likely to be a discontinuity for fungibility purposes between debt instruments which contain an express contractual recognition of bail-in and those which do not. Furthermore, the threshold date from which that discontinuity applies will depend upon which EEA member state's regulator is the issuer's (or guarantor's) regulator for BRRD purposes. Therefore, in-scope financial institutions may find that they are now unable to tap issues of debt instruments expressed to be governed by the law of a country which is not an EEA member state for which the issue date of the first tranche was before the relevant threshold date.

    ESMA joins in

    On 15 December 2015, the European Securities and Markets Authority (ESMA) published a newly revised version of the ESMA Q&A on Prospectuses. The principal change from the previous version is the addition of a new question (Q&A 96) relating to the appropriate disclosure to be included in a prospectus when the securities which are the subject of the prospectus may be subject to write-down or conversion powers in accordance with the BRRD. However, ESMA appears to have gone a step too far in proposing a risk factor saying that taxpayer support "should only be used as a last resort after having assessed and exploited, to the maximum extent practicable, the resolution tools, including the bail-in tool". In most cases, it will not be appropriate for those responsible for the prospectus (such as the issuer) to say what public authorities should or should not do. The most that should be said in such a risk factor is that there is a likelihood (of whatever degree) that taxpayer support will only be used as a last resort.

    Watch this space

    The BRRD and the bail-in tool continue to generate much discussion and uncertainty. At the very least we can expect further comment and consultation from the UK regulators and some response from the European Commission to the concerns expressed by the Bank of England. Also, we understand that the European Commission may adopt the RTS in March or April 2016.

    The information provided is not intended to be a comprehensive review of all developments in the law and practice, or to cover all aspects of those referred to.
    Readers should take legal advice before applying it to specific issues or transactions.

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