Bail-in recognition clauses decrypted

Author: Amélie Labbé | Published: 9 Aug 2016
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There could be some testing times ahead for the Banking Recovery and Resolution Directive’s (BRRD) contractual recognition of bail-in mechanisms.

Article 55 of the BRRD requires EU financial institutions to insert bail-in requirements in any new contract agreed on or after January 1 2016 governed by non-European law. According to the directive, the creditor or party to the agreement creating the liability is expected to recognise that the liability may be written-down or converted, and reduced in value in some cases, in the event of an EU bank rescue situation.

The clauses are intended to ensure that parties outside of EU member states are aware they may be drafted in to bear any losses incurred by a failing financial institution. More generally, the idea is to prevent a return to the use of public funds to recapitalise a bank which may be in danger of collapsing – as was the case before the 2008/9 financial crisis.

However, while the rationale underpinning the insertion of such clauses is sound, it may raise some implementation issues. These could include uncertainty as to the scope of the so-called eligible liabilities covered, the timeline and even legal interpretations differing between member states.

This is where some industry associations have stepped in – to help create standard clauses to implement the bail-in requirement. The European Banking Authority has worked on draft technical standards outlining conditions for bail-in, while sector-specific bodies have worked on their respective asset classes.

Most recently, the Association for Financial Markets in Europe (Afme) released its finalised version of model clauses for debt and equity instruments.

 KEY TAKEAWAYS
  • The European Banking Authority has worked on draft technical standards outlining conditions for bail-in, while sector-specific bodies have worked on their respective asset classes;
  • The BRRD does not set out any definition of what type of liability would come under the contractual bail-in requirement;
  • The AFME’s most recent version the recognition clause acknowledges the variety of legal approaches; 
  • The BRDD does not mention a specific sanction for breach of bail-in requirements. It may be up to individual member states to set out their own breach framework.


What is eligible?

The BRRD does not set out any definition of what type of liability would come under the bail-in requirement. Rather, it takes a negative approach, listing exclusions under article 44(2) – these include covered or protected deposits, short term interbank instruments as well as employee, tax and trade liabilities.

Any resolution authority can also chose to unilaterally exclude a liability from the scope of bail-in because of exceptional circumstances relating to timeframe, practicality or cost.

For the sake of certainty, there has been a call to align the definition of eligible liability with that of the Financial Services Board. According to Afme, for instance, this would include all liabilities that are eligible for minimum requirement for own funds and eligible liabilities (MREL), all other debt instruments and any additional liabilities that ensure the financial institution can repay its debts.

“While cross-border recognition of bail-in is important for resolution to work, there is a very broad scope of liabilities within the scope of article 55,” said Oliver Moullin, director in Afme’s prudential regulation division. “Some in-scope liabilities wouldn’t produce a lot of loss-absorbing capacity for the entity yet create substantial challenges for implementation, so the scope should be reviewed.”

In the UK, the Prudential Regulation Authority has mandated that any debt or liability to which the BRRD undertaking is subject is eligible bail-in – this covers a huge range of creditors and situations such as swaps, securities lending, repo transactions, loan agreements, letters of credit and security agreements. The situation regarding derivatives is a bit less clear.

Geography

Afme’s most recent version the recognition clause acknowledges the variety of legal approaches, mentioning specific provisions for entities regulated by UK, French, Italy, Belgium and Germany.

“Our most recent model clauses were drafted very broadly to enable use in different types of agreement that are within scope of article 55 - but the document does not advise on what is or is not in scope,” said Moullin. “We have left it to members and law firms to advise on the precise scope of the requirements.”

This confirms the view set out by the Loan Market Association. The organisation told IFLR earlier this year that their version of the clause, drafted by Clifford Chance, was intentionally broad to suit the most situations possible.

In contrast, AFME’s first iteration of model clauses in September 2015 was specifically aimed at debt securities of issuers governed by New York law, as were the Loan Syndications & Trading Association’s.

However, there is still ongoing uncertainty as to which entities the clauses would apply. According to a note from Chadbourne & Parke partner Marian Baldwin Fuerst, a German bank serving only an administrative role in a US loan agreement after selling off its lending exposure would also still be required to notify the borrower in accordance with the bail-in rules”.

“People are struggling to figure out what is eligible for bail-in and what is not, beyond those categories that we are already certain about,” said John McGrath, a global finance and derivatives partner in Sidley Austin’s London office. ”There are several layers of legislation and recommendations – at EU and national levels - which say slightly different things and this adds to the lack of clarity.”


"People are struggling to figure out what is eligible for bail-in and what is not beyond those categories that we are already certain about"


What happens in practice?

Best case scenario

The insertion of model clauses would likely prevent a challenge in a non-European Economic Area (EEA) court in relation to aspects of bail-in covered by the contract.

Beyond that, there could be some short-term issues to iron out. In first instance, it could possibly be difficult to persuade the counterparty to include the language in the contract, and gain their consent in that respect.

According to Oliver Favre, partner at Schellenberg Wittmer, Swiss entities don’t voluntarily adhere to protocols, EU or otherwise, but will be primarily bound by what is agreed in the contract.

It is expected, however, that the contractual recognition of bail-in will become widespread, in a similar way that model clauses are now used in the field of data protection.

“We wanted to create a structure and wording for the clause that was as painless as possible for in-scope entities,” said David Toube, regulatory securities law counsel at Cleary Gottlieb Steen & Hamilton, the law firm which worked with Afme to draft the latest version of the clauses. “We are now happy that there is a consensus between law firms and institutions as to the form and content of the clause.”

Because the model clauses are drafted in a general language, as mentioned previously, the scope of the provision that the counterparty “acknowledges, accepts, consents and agrees” to be bound by the contract seems to apply to everything and anything. However, individual issues including the terms of the bail-in – how does the conversion, write-down or cancellation happen in practice? how does the variation in terms to make the exercise of the bail-in power work? – need to be fleshed out by the parties as well.

Ultimately, the US could also in time resort to bail-in to save an ailing bank. The Dodd-Frank Act has already created the framework for it although nothing has happened so far in practice.

Bail-in pic
BRRD requires widespread bail-in clauses

Worst case scenario

What happens if the non-EEA party refuses to agree to be drafted in in the event of a bail-in situation, or objects to the insertion of clauses in the contract?

Not much, beyond the contract not being enforceable, especially as the BRDD does not mention a specific sanction for breach of bail-in requirements. It may be up to individual member states to set out their own breach framework.

“The ultimate sanction would be for a bank to stop trading with a reluctant counterparty if they don’t include the language in the contract,” said McGrath. “Beyond that, I am not sure what one could do.”

In any event, whether the language of a clause is included or not, there is no guarantee the regulators won’t bail in the liability anyway. Afme has been vocal in highlighting possible issues that could exist when bail-in is triggered, saying recently that inserting clauses to this effect would be in many cases impracticable. This is notably due to varying interpretations between member states, and the layers of legislation at national and EU-levels. All of those can contribute to creating potential inconsistency. 

Brexit

The likelihood of Brexit having an impact of the applicability of these model clauses by and within the UK remains undefined. Following its exit from the EU, the UK will effectively become a third party country - notwithstanding the existence of an agreement which gives it EEA country status for example. As such, UK investors and financial institutions may find themselves on the receiving end of a bail-in request.


See also:

The birth of bail-in
LMA’s bail-in clause explained
Bankers’ poll: TLAC and the future of bad debt

 


 

 

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