Contractual Bail-In Creates Monster Document Headache

Introduction

On 3 July 2015 the European Banking Authority (EBA) published final “Draft Regulatory Technical Standards on the contractual recognition of write-down and conversion powers under Article 55(3) of Directive 2014/59/EU” (the BRRD).

The requirement to include Write-Down Clauses

In order to guard against the possibility that a third country court may not recognise the write-down and conversion powers of EU resolution authorities – frustrating attempts to resolve a failing institution – Article 55(1) of the BRRD requires firms to include a contractual term in agreements creating a liability (an “Eligible Liability”) by which the creditor or party to the agreement recognises that the liability in question may be subject to the write-down and conversion powers within the BRRD and agrees to be bound by any reduction of principal or outstanding amount due, conversion or cancellation that is effected by the exercise of those powers (a “Write-Down Clause”).  The requirement applies to any agreement (a “Relevant Agreement”) which:

• is governed by the law of a third country; and
• is created or entered into:
  • after 1 January 2016; or
  • after 1 January 2016 under an agreement (including a master agreement) entered into before 1 January 2016; or
  • before 1 January 2016, but which is subject to “material amendment” (being any amendment which affects the substantive rights and obligations of a party) after 1 January 2016.

The form of a Write-Down Clause

Keen to avoid being overly prescriptive, the EBA does not specify an actual form of Write-Down Clause for use by firms.  Instead, it defines the key ‘boxes’ that any Write-Down Clause must ‘tick’, as set out below.  These requirements must also be satisfied if a liability is to qualify as “minimum requirement for own funds and eligible liabilities” (MREL) for the purposes of Article 45(5):

• an acknowledgement and acceptance that a liability may be subject to the exercise of write-down and conversion powers by a resolution authority;
• a description of the write-down and conversion powers of each relevant resolution authority;
• an acknowledgement and acceptance:
  • that the counterparty is bound by the effect of an application of write-down and conversion powers, including:
    • any reduction in the principal amount or outstanding amount due, including any accrued but unpaid interest; and
    • the conversion of an Eligible Liability into ordinary shares or other instruments of ownership;
• that the terms of the Relevant Agreement may be varied as necessary to give effect to the exercise of write-down and conversion powers and such variations will be binding;
• that ordinary shares or other instruments of ownership may be issued to or conferred on the counterparty as a result of the exercise of   write-down and conversion powers; and
• an acknowledgement and acceptance that the contractual term is exhaustive on the matters described therein to the exclusion of any other agreements relating to its subject matter.

Are there any exclusions?

The requirement to include a Write-Down Clause within an agreement does not apply:

• if the liability is a[1]:
  • “Covered deposit”;
  • Secured liability;
  • Client asset;
  • liability that arises by virtue of a fiduciary relationship;
  • certain type of liability with an original maturity of less than seven days;
  • certain type of liability owed to employees, trade creditors providing critical functions, tax authorities and deposit guarantee schemes; or
  • certain type of deposit held by natural persons and micro, small and medium-sized enterprises;
• where the relevant resolution authority determines that an Eligible Liability can be subject to write down and conversion by the resolution authority pursuant to the law of a third country or to a binding agreement concluded with that third country.  An EU resolution authority can only make such a determination if an administrative or judicial procedure exists which:
  • enables a third country authority, within a period which the EU resolution authority determines will not compromise the effective application of the write-down and conversion powers by that authority, to recognise and give effect to, or to support, the exercise of the write-down and conversion powers by the resolution authority; and
  • provides that the grounds on which a third country authority may refuse to recognise or support the exercise of write-down and conversion powers by an EU resolution authority are clearly stated and are limited to circumstances where they would:
    • have adverse effects on financial stability in the third country concerned;
    • result in third country creditors (particularly depositors), being treated less favourably than similar EU creditors;
    • have material financial implications for the third country concerned; or
    • have effects contrary to the public order of the third country concerned.

The Challenge

The practical burden of complying with the RTS should not be underestimated.  It must be assumed that the number of third-country assessments by EU resolution authorities – which obviate the need for Write-Down Clauses – are likely to be very low.  Given that there is no de minimis level below which a Write-Down Clause would not be required, the starting point must be that all documents creating Eligible Liabilities which are not governed by EU law should be considered candidates for amendment, a universe that would cover, at the very least, many ISDA Master Agreements and Credit Support Annexes, loan documentation and note issuances.  As such, firms will need to undertake a significant initial discovery and scoping exercise, mapping counterparties and Relevant Agreements to both Eligible Liabilities and excluded liabilities.  Completion of this exercise is complicated by challenges in interpretation under both the BRRD and the RTS.  For example, how should firms best capture the requirement that Write-Down Clauses must apply to (a) any unsecured portion of an otherwise secured liability (for example, the “Threshold” allocation under a CSA), and (b) any liability which is fully secured but is not governed by contractual terms that oblige the debtor to maintain the liability fully collateralised “on a continuous basis in compliance with regulatory requirements specified of Union law or of a third country law achieving effects that can be deemed equivalent to Union law”?  As only trade creditors providing critical functions are excluded pursuant to Article 44(2), does this mean that firms are required to amend contracts containing liabilities with non-critical trade suppliers?

Implementation of any amendment programme on this scale also presents logistical challenges.  The reference to “acknowledgement and acceptance” as a ‘key element’ of any Write-Down Clause raises the prospect that mere notification or negative affirmation by a firm may not suffice.  If positive agreement is indeed required, this would vastly increase the resource required in order to execute such a programme of work.  It also ignores the fact that not all documents creating Eligible Liabilities – such as notes – lend themselves well to positive agreement between counterparties.  The next stage of the process – negotiation of documentation – will also be impacted by the fact that firms can be required to provide resolution authorities with legal opinions as to the enforceability and effectiveness of Write-Down Clauses and the eligibility of liabilities as MREL.  This, coupled with the need to ensure that clauses meet the minimum requirements for acceptable Write-Down Clauses will mean that, in practice, the ability of firms to agree amendments to documentation will be limited.

Even ongoing monitoring activities – normally designed to track execution of amendments (whether effected bilaterally or by way of protocol) – will have to be extended into robust and ongoing processes designed to keep all potential Relevant Contracts under review for subsequent “material amendments”, a definition which itself creates huge grey areas.  Examples of non-material amendments are provided – including (a) a change to the contact details of a signatory or the addressee for the service of documents, (b) typographical changes to correct drafting errors, or (c) automatic adjustments of interest rates.  However, this leaves much undefined.  For example, do draw-downs of existing facilities constitute a “material change”?

How we can help

Coming hot on the heels of regulation requiring the inclusion of contractual stays in, and the mining of data from, financial contracts, recovery and resolution planning promises to keep documentation teams extremely busy over the next 12 months.  In light of these requirements, a single, strategic exercise to acquire full insight into documentation portfolios, followed by a single, focused remediation effort, would seem to be a more efficient and cost-effective approach than separate, tactical fixes.  Either way, balancing these requirements against BAU needs will present resourcing challenges for many firms.  DRS specialises in helping firms manage portfolios of documentation in light of changing regulatory and business needs.  We provide a flexible and scalable resourcing utility to undertake client outreach, document negotiation and data extraction projects, either on-site or off-site and across time zones.  Allying subject matter expertise, delivery capabilities and technology accelerators, we provide a complete end-to-end managed solution at a competitive price point and with a low exception rate.  In doing so, we help to reduce the cost and administrative burden associated with maintaining regulatory compliance.  In an environment of budgetary restraint, our services take the form of a menu of options, all designed to fit seamlessly into a client’s existing operational processes.  They are the perfect solution for those firms without the permanent headcount to resource projects of this type or the appetite to recruit, train and manage significant numbers of temporary staff.  Contact us today and take the first step in optimising your documentation processes.