The Burden of Contractual Bail-In

DRS’ Michael Beaton explores the burden of contractual bail-in rules under the Bank Recovery and Resolution Directive including the impact on derivatives.

Introduction

On 5 November 2014, the European Banking Authority (EBA) published a consultation paper regarding draft Regulatory Technical Standards (RTS) on the contractual recognition of write-down and conversion powers under the Bank Recovery and Resolution Directive (BRRD).

Liabilities which would otherwise be subject to bail-in under the BRRD may be governed by the law of a third country.  In these circumstances, it is possible that a third country court might not recognise the power of an EU Member State resolution authority to exercise its powers to write-down and convert, undermining efforts to restore financial stability.  Article 55(1) of the BRRD (“Contractual recognition of bail-in”) is designed to address this situation.  Broadly, it states that credit institutions, investment firms and certain related entities[1] must include a contractual term in any agreement which creates a liability in which the creditor recognises the fact that the liability may be subject to write-down and conversion and agrees to be bound by any reduction of the principal or outstanding amount due, or any conversion or cancellation that is effected by the exercise of those powers.

Certain liabilities are excluded from the above requirement – the most relevant of which are those that are secured[2].  In addition, the requirement only applies to the extent that:

• — the liability is governed by non-EU law;
• — the liability relates to the period after the date on which a Member State transposes Article    55 into its national law[3]; and
• — it is not possible for the resolution authority of a relevant Member State to determine that    the laws of the third country or a binding agreement with the third country means that the    resolution authority will be able to effectively exercise its write down and conversion powers.

The Impact on Derivatives

Article 55 adds another item to the long list of amendments which firms with portfolios of derivative documentation have been forced to execute over recent years.  Due to the fact that liabilities relating to derivatives transactions are included within the scope of bail-in,[4] any counterparty which is subject to the BRRD will have to amend its derivative trading documentation to the extent that it is not governed by EU law and no mechanism exists for the recognition of EU resolution authorities’ bail-in powers within the relevant jurisdiction.  Moreover, the fact that a derivative liability may be secured will not necessarily assist those looking to avoid the application of Article 55.  This is because resolution authorities are entitled to exercise their powers with respect to “any part of a secured liability or a liability for which collateral has been pledged that exceeds the value of the assets, pledge, lien or collateral against which it is secured”[5].  More specifically, under the RTS, the contractual term is required:

• –— to apply to any unsecured portion of a liability even if the liability is otherwise secured;
• –— where a liability is fully secured but may become unsecured (for example due to unexpected falls in the value of collateral).[6]

Unfortunately, the ambit of contractual bail-in is not limited merely to new transactions.  In an effort to prevent regulatory arbitrage, the RTS proposes that the contractual term must apply to any liability:

• — under agreements entered into after the transposition date;
• — created after the transposition date under agreements entered into before that date; or
• — under agreements entered into before the transposition date but amended after that date (whether or not the liability was created after that date).[7]

In practice, this implies the whole-scale amendment of document portfolios.  Indeed, the EBA specifically envisages just this outcome, stating that, where netting arrangements are in place to cover liabilities pre-dating the transposition date and any new liabilities created after that date, it is to be expected that parties to the contract would prefer that the contractual terms apply to the full netting set rather than split the netting set into pre-transposition set and post-transposition set.

Unfortunately for any firm looking for a quick and efficient solution, contractual bail-in clauses seem unlikely to be particularly simple in nature and appear unlikely to be candidates for inclusion within an ISDA protocol.  In its consultation paper, the EBA did not consider it appropriate to provide a specimen clause due to the fact that it might not be effective in all jurisdictions or suitable for all forms of liability.  Rather, the RTS proposes an extensive list of mandatory elements which must be present in the required contractual term.  These include:

• — the legal enforceability and effectiveness of contractual recognition terms included in liabilities governed by the law of a third country[8]; and/or
• — that any decision of the resolution authority to write-down or convert a liability would be effective under the law of that third country[9].

Currently (with the possible exception of the US and the UK) the prospect of an agreement between regulatory regimes regarding the mutual recognition of contractual bail-in seems remote.  In these circumstances, legal opinion as to enforceability may be nothing more than a pipe dream.  The risk associated with contractual bail-in promises to be a nightmare to manage, requiring firms to map (and monitor) contractual agreements against product type, trade date, liability type and jurisdiction.  Some would be forgiven for thinking that firms are paying the price for a lack of co-ordination and co-operation between regulators.  Either way, those that wish to make their voice heard should do so quickly.  The consultation period remains open until 5 February 2015, with a view to the RTS being submitted to the EU Commission by 3 July 2015.