Contractual Stays in Resolution - FSB and PRA release final positions and ISDA extends Stay Protocol to SFTs

Introduction

This briefing covers three recent developments in the area of resolution stays, from the FSB, ISDA and the PRA.

In January this year we published our briefing "The BRRD, the Stay Protocol and the impact on derivatives", which explained the powers given to resolution authorities under the Bank Recovery and Resolution Directive ("BRRD") to "stay" certain termination and enforcement rights of counterparties to financial contracts with entities in resolution, and the ISDA 2014 Resolution Stay Protocol (the "2014 Protocol") which requires adhering parties to give cross-border contractual recognition to resolution stays.

In July, we published a further briefing "BRRD: valuation of derivatives and contractual stays in financial contracts", which discussed the PRA's May 2015 consultation which proposed that contractual recognition of UK resolution stays be required in certain financial contracts entered into by PRA firms if those contacts are governed by the law of a jurisdiction outside the EEA.

There have been three significant publications in these areas during November, which are the subject of this briefing. Firstly, on 3 November, the Financial Stability Board (the "FSB") published a final guidance paper advocating the contractual recognition of resolution action until statutory frameworks for cross-border recognition are established. Secondly, on 4 November, ISDA re-launched the 2014 Protocol to bring securities financing transactions into scope. And thirdly, on 13 November, the PRA finalised the rules on which it had consulted in May, making some changes to the scope of financial contracts and entities caught by the rules. Prior to discussing these developments, a brief recap of the legal provisions and their scope may be helpful.

Background - The BRRD Resolution Stays

BRRD provides that resolution authorities should have a variety of powers to stay or otherwise override the rights of counterparties facing entities in resolution under certain financial contracts. By way of a recap of our January briefing, the relevant provisions of BRRD include:

• The power temporarily to suspend termination rights of any party to a contract with either (A) an institution in resolution or (B) a subsidiary of such institution whose obligations are guaranteed or otherwise supported by that institution where the relevant termination right is based solely on the insolvency or financial condition of the institution in resolution (the "Temporary Stay"). The temporary stay is subject to the condition that payment, delivery and collateralisation obligations continue to be performed under the relevant contract, and is lifted at midnight at the end of the business day following the imposition of the temporary stay if (the intervening period being the "Stay Period") neither a transfer nor a bail-in of the relevant obligation has been effected.
• The power to impose a temporary restriction on secured creditors of an institution in resolution from enforcing security interests over any assets of that institution (the "Security Stay"), except that this does not affect rights of CCPs and clearing systems in relation to margin.
• The power to suspend any contractual payment or delivery obligations of an institution in resolution (the "Performance Stay"). If this power is used, the counterparty's obligations will also be suspended for the duration of the stay period, having a similar effect to that of the condition precedent in Section 2(a)(iii) of the ISDA Master Agreement.
• Ancillary powers to modify certain contracts of an institution in resolution when using any of the resolution tools.
• BRRD further provides that neither a crisis prevention measure nor a crisis management measure, nor any event directly linked to the application of such a measure, is allowed to constitute a trigger for contractual termination, netting or set-off rights or enforcement of security in relation to the institution in resolution or a member of its group on a cross-default basis. In each case this is subject to the condition that payment, delivery and collateralisation obligations continue to be performed. This briefing refers to this provision as the "General Stay".

This briefing refers to the stays described above together as the "Resolution Stays".

Note that the Resolution Stays override the provisions of the Financial Collateral Directive which otherwise protect such enforcement or close-out rights. Furthermore, no crisis prevention measure under BRRD nor any event directly linked to such a measure can be treated as an enforcement event for the purpose of the Financial Collateral Directive, so cannot result in the right to realise or appropriate financial collateral, or trigger close-out netting.

The UK implementation of the Resolution Stays

The entities within scope of the special resolution regime (the "SRR") under the Banking Act 2009 and therefore subject to possible resolution action are UK banks and investment firms which are subject to the capital requirements under EU Commission Regulation 575/2013 ("CRR"), together with certain of their group companies which meet the specified conditions for resolution. These conditions are specific to the type of entity in each case but broadly relate to the entity's financial condition and likelihood of failure without intervention, and/or that of the related group company.

The UK has implemented the Resolution Stays by amendments to the SRR and adjustments to the Financial Collateral Arrangements (No.2) Regulations 2003, which specify that those regulations will not prevent the Bank of England from imposing a restriction on the enforcement of a financial collateral arrangement or the effect of a close-out netting provision or a security financial collateral arrangement in the exercise of its powers under the SRR. Further, although, under the Banking Act 2009 (Protection of Partial Property Transfers) Order 2009, a partial property transfer instrument made in the context of a resolution cannot transfer part of the arrangements covered by a close-out netting or title transfer financial collateral arrangement, the safeguards which protected netting arrangements and financial collateral arrangements from being subject to a termination stay in the context of such a partial property transfer have been removed. We discussed the impact of these points on derivative transactions in our January briefing.

The need for contractual recognition

Since BRRD is a directive, the Resolution Stays are required to be implemented into the local law of EEA Member States. Under Directive 2001/24/EC on the winding-up of credit institutions ("CIWUD"), EU Member States (and the additional EFTA countries which have acceded to CIWUD) must recognise each other’s reorganisation measures with respect to banks and investment firms. ‘Reorganisation measures’ within CIWUD includes measures which are intended to preserve or restore the financial situation of a credit institution and which could affect third parties' pre-existing rights, including measures involving the possibility of a suspension of payments, suspension of enforcement measures or reduction of claims. BRRD has amended CIWUD so that the latter applies expressly to recognise resolution measures of the entities within scope of BRRD. Member States must therefore recognise resolution tools and powers and other reorganisation measures used by other Member States (including a mandatory write down of capital instruments, and use of the bail-in tool).

However, where an EU institution has entered a financial contract subject to non-EEA law, there is no automatic recognition of any resolution action in respect of such EU institution which may affect the enforceability of the contract. BRRD does not require any contractual recognition of the resolution stays where an EEA institution enters into a financial contract governed by the law of a non-EEA country.

Thus, contractual recognition of these provisions of EU law is a matter for the courts of the relevant non-EEA jurisdiction. As there is no universal system of cross-border recognition of resolution regimes of countries outside the EEA, in order to ensure that the Resolution Stays are binding on both parties to the financial contract, contractual recognition is required. At a global level, the FSB has published proposals to address this issue.

The FSB Guidance

In September 2014, the Financial Stability Board published a consultation document entitled "Cross Border Recognition of Resolution Action" in which it called for member jurisdictions to create legal frameworks for cross-border recognition and set out proposals for such frameworks. Whilst such legal frameworks are pending, the FSB proposed contractual recognition as an interim solution and cited the development of the ISDA stay protocols (see below) as an example of how this could operate.

On 3 November 2015, the FSB finalised its proposal, in "Principles for Cross-border Effectiveness of Resolution Action" (the "FSB Principles"). The FSB Principles state that statutory frameworks for cross-border recognition should remain the ultimate objective, but, since these will take time to develop, FSB members have committed to promote, by way of regulation or other enforcement measures, contractual approaches to recognition of resolution stays as well as the write-down or conversion of loss-absorbing instruments.

The PRA final rules on contractual stays in contracts governed by non-EEA law

In our May briefing, we outlined the PRA's proposed rule requiring contractual recognition of UK resolution stays (the "Proposed Rule"). The PRA's final rule (the "Final Rule") is now set out in Policy Statement PS25/15, which also includes a statement of feedback to the previous consultation on the proposed rule. The Final Rule reflects the PRA's intention to give effect to the FSB Principles regarding contractual recognition of stays.

The Prohibition

The Final Rule applies to PRA-authorised UK banks, building societies and PRA-designated UK investment firms as well as certain parent undertakings ("Firms") in respect of specified financial contracts governed by the law of a non-EEA jurisdiction. It prohibits Firms from entering a new obligation or materially amending an existing obligation under such a financial contract, unless the counterparty has agreed that, if resolution action is taken in relation to the Firm or any member of its group, it will be entitled to exercise termination rights or enforce security interests in connection with the contract only to the extent that it would be entitled to do so under the SRR if the contract were governed by the laws of the United Kingdom (the "Prohibition").

Where the Firm is a parent undertaking within the scope of the rule (i.e. certain financial or mixed financial holding companies as defined in CRR), it will be required to ensure that its bank and investment firm subsidiaries (as well as those which are financial institutions under CRR - such as certain holding companies and providers of payment systems) which are not themselves Firms also comply with the prohibition as though they were Firms (the "Parent Requirement").

The contracts within the scope of the prohibition are "financial arrangements", which is defined to mean;

• contracts within the list of "financial contracts" set out in Article 1 of BRRD, but excluding short-term inter-bank borrowing, being:

  - contracts for the purchase, sale or loan of, or options on, or repo or reverse repo on a security or group or index of securities;

  - contracts for the purchase, sale or loan of a commodity or commodities for future delivery, or options on,       or repo or reverse repo on a commodity or group or index of commodities;

- futures and forward contracts on commodities or any other property, service, right or interest; and

- swaps and options on interest rate and currency, equity or equity indices, debt or debt indices,
          commodities or commodity indices, weather, emissions or inflation, and spot foreign exchange;

• all derivative contracts as defined in Regulation 648/2012/EU on European Market Infrastructure and
• all master agreements relating to any the above, and master agreements relating to currency contracts.

Thus the scope of the Prohibition would not extend to activities in financial instruments outside the scope of Directive 2011/61/EU on Markets in Financial Instruments. Therefore contracts for the transfer of loan portfolios would not be included in "financial arrangements", nor would the sale of a commodity unless for future delivery.

The prohibition does not apply to financial arrangements made solely with an "excluded person", which includes operators of financial markets infrastructure, such as payment and settlement systems, central counterparties and central banks.

Changes to Proposed Rule

Whilst broadly similar to the Proposed Rule, the Final Rule has been amended as a result of the consultation feedback. The main changes are the following:

• Under the Proposed Rule, Firms would also have been obliged to ensure that, where subsidiary credit institutions, investment firms and financial institutions trade in the relevant financial contracts under third-country law, then (regardless of the place of incorporation of the subsidiary) those subsidiaries must also obtain written agreement (the "recognition agreement") to the stay from their counterparties. In the consultation on the Proposed Rule, the PRA stated that this focus on banking and investment firm groups matched the scope of the resolution framework under the Banking Act. However, the Banking Act actually provides, as does BRRD, that the general stay will only apply to the obligations of a subsidiary of a Firm in resolution if the subsidiary's obligations are guaranteed or otherwise supported by the Firm in resolution, and the termination rights are triggered by the insolvency or financial condition of that bank or investment firm. Therefore the Final Rule only subsidiaries whose obligations are so guaranteed or supported will be within the scope of the prohibition.
• The Final Rule clarifies that the Prohibition applies only to contracts governed by the law of a non-EEA country which contain security enforcement rights or termination provisions which would be suspended or disregarded under the SRR (a "third-country law financial arrangement"). Under the Proposed Rule, the prohibition could have applied to contracts under which such rights would not be subject to the resolution stays in the SRR.
• The Proposed Rule required a recognition agreement only in respect of termination rights, not rights to enforce security. However, the Final Rule clarifies that the recognition agreement must specifically acknowledge that rights to enforce security will extend only to where the counterparty would be entitled to exercise such rights under the SRR if the contract were governed by UK law.
• It is confirmed that parent undertakings within scope of the Parent Requirement, include only parent undertakings whose registered or head office is in the UK.
• In response to industry requests for clarification, the Final Rule makes clear that "termination rights" which are subject to the general stay include not just the right to terminate the contract or accelerate or close out obligations, but also rights under the list of "default event provisions" set out in the Banking Act. These include events which terminate, modify or replace rights under the contract, such as delivery or payment becoming due, accruing, changing or lapsing, or provisions which take effect only as long as en event does not occur, or only while a situation lasts. An example of such a clause would be Section 2(a)(iii) of the ISDA Master Agreement.
• References to "securities" incorporated into the definition of "financial arrangement", will be deemed to mean "transferable securities" as defined in MiFID, which captures securities which are negotiable on the capital market such as shares, bonds and warrants.
• The list of "excluded persons" with whom firms can make financial arrangements outside the Prohibition now includes all central counterparties, central banks, central governments and operators of financial infrastructure who are established in third countries, and is not confined to such entities established in the EU.
• The recognition agreement need no longer be in writing, but must be made in an "enforceable manner". The PRA has clarified that this does not require a legal opinion as a matter of course, however firms are responsible for satisfying themselves that they and any relevant subsidiaries are in compliance with the Final Rule. Breaches of the Final Rule will be dealt with "in accordance with standard PRA policy".
• The date of application of the prohibition has been delayed. For non-EEA law financial arrangements entered (or materially amended) by a credit institution or investment firm, or an undertaking which would be an investment firm if established in the EEA, the applicable date has changed from 1 January 2016 in the Proposed Rule to 1 June 2016 in the Final Rule. For all other non-EEA law financial arrangements the applicable date is 1 January 2017. The Proposed Rule included a further applicable date for third country law financial arrangements entered by financial counterparties such as AIFs, UCITS and insurers, however this distinction is now removed and those contracts will be subject to the prohibition from 1 January 2017.

Although not a change to the Final Rule itself, the PRA has confirmed in PS25/15 that an amendment will be considered to be "material", and therefore subject to the Prohibition, if it changes the commercial parameters of the obligation in a way that would achieve the commercial intent of an ongoing trading relationship without technically creating a new obligation. Non-exhaustive examples include a change to the determinant of the payout or risk profile of a transaction, e.g. modification of interest or exchange reference rates, reference assets, maturity or payment dates, prepayment events, etc. However the PRA has clarified that changes that occur automatically such as a roll-over or renewal of the contract, will not be caught, nor will administrative or technical amendments such as changes to business day conventions or payment details.

However there is still scope for uncertainty here. It is not clear whether embedded optional provisions in the original documentation would be caught. For example, a rollover, renewal or extension that arises by virtue of one party's unilateral exercise of an option or right included in the pre-existing terms of the agreement may not be caught, although this is not certain in the absence of specific guidance. Any rollover, renewal or extension effected by an act of agreement between the parties is likely to be caught.

As the Prohibition is not required by BRRD itself, it remains to be seen whether other EEA Member States, and indeed other jurisdictions outside the EEA, implement the FSB Principles in a similar manner.

The ISDA 2015 Universal Resolution Stay Protocol - extension to SFTs

As discussed in our January briefing, the 2014 Protocol amended ISDA Master Agreements and related credit support documents, for existing trades and future trades.

The 2014 Protocol

The 2014 Protocol provided an "opt-in" mechanism, under which each adhering party agreed to be bound by the resolution regime applicable to its counterparty to each "covered agreement" and the resolution regime applicable to each "related entity" of that counterparty (including Credit Support Providers, Specified Entities and certain parents). This put the parties effectively in the same position as if their agreement were governed by the laws of the jurisdiction of the applicable resolution regime rather than the express governing law of the contract. Under the opt-in, transfers of a covered agreement to successors of an institution in resolution would be effective to the extent they would be effective if the agreement were governed by the law of the jurisdiction of the applicable resolution regime.

The 2015 Protocol

On 4 November 2015, ISDA re-launched the protocol as the ISDA 2015 Universal Resolution Stay Protocol (the "2015 Protocol"), which was developed in conjunction with the FSB. Twenty-one major banks adhered to the 2015 Protocol at launch. The 2015 Protocol works in the same way as the 2014 Protocol, however it extends the scope of "covered agreements" which will be within scope.

Whereas the 2014 Protocol covered ISDA Master agreements and related credit support documents, and gave the adhering parties the ability to specify other covered agreements in a further adherence letter, the 2015 Protocol additionally includes (automatically by way of an "SFT Annex") securities financing master agreements entered into by the adhering parties prior to the date on which ISDA accepts the later of the two adherence letters from the two adhering parties. The SFT Annex was produced by ISDA working jointly with other trade associations active in the securities financing market. The master agreements included are set out in more detail in the definitions to the SFT Annex, but the list includes many industry standard master agreements for securities lending and repo.

The 2014 Protocol also included in scope any master agreement entered between the adhering parties after the adherence date and before closure of the Protocol by ISDA. The 2015 Protocol retains this mechanism to include ISDA agreements entered between parties after adherence and prior to such date as ISDA closes the Protocol, however securities financing agreements are only included as "covered agreements" if they are entered prior to the date the second party adheres to the Protocol.

The resolution regimes currently covered by the Protocol are those of the UK, France, Germany, Japan, Switzerland and the US. For each of the UK, France and Germany, the relevant regime implements BRRD.

The 2015 Protocol also contemplates that new regimes in the other jurisdictions represented in the FSB could be added, provided that they satisfy certain conditions which are primarily for the protection of creditors, including that any stay must be no longer then two business days, and that netting agreements and set-off rights must be preserved (subject to the stay).

It should be noted that in PS25/15 the PRA declined to express a view that the 2014/2015 Protocol automatically satisfies the requirements in the Final Rule. Whilst supportive of the ISDA Protocols, the PRA noted that the Final Rule covers a broader range of financial arrangements than is currently covered by the 2015 Protocol. It therefore remains the responsibility of the individual firm to ensure compliance.

Planned expansion

In addition, ISDA is developing a separate protocol for market participants other than financial institutions and plans to publish this next year.