Contractual recognition of bail-in as a term of debt instruments

Background

The Bank Recovery and Resolution Directive (the BRRD) is a key EU legislative initiative which EU Member States were required to have implemented and applied by 1 January 2015.

The BRRD is applicable, broadly, to banks, building societies and significant investment firms and their holding companies and other financial institutions. It covers, among other things, pre-emptive recovery planning by financial institutions, powers of "resolution authorities" to intervene in the running of financial institutions, and tools of resolution authorities for the resolution of failing financial institutions.

One of the four main resolution tools available to resolution authorities is the so-called "bail-in" tool. The purpose of bail-in is to write down liabilities of a failing institution in order to ensure that the losses of a failing institution are borne by shareholders and creditors rather than by external sources, such as public funds.

One aspect of bail-in is the requirement for an applicable financial institution which is issuing or entering relevant liabilities governed under the laws of a non-EEA state, to include a contractual term in the debt instrument by which the creditor recognises that the liability may be subject to the exercise of the bail-in tool – referred to as "contractual recognition of bail-in".

In this briefing, we focus on the bail-in tool and specifically on "contractual recognition of bail-in", and its implementation in the UK.

For a broader discussion of the BRRD and other tools and powers in addition to bail-in, see our briefing "The BRRD, the Stay Protocol and the impact on derivatives".

What is the bail in tool?

The concept of bail-in is relatively new, having arisen from the financial crisis. The aim of bail-in is that shareholders and creditors of the failing institution bear an appropriate part of losses arising from the failure of the institution, in order to restore the institution to a sound financial condition and long-term viability.

In contrast to a bail-out, which involves the injection of capital into the relevant institution from an external source, bail-in achieves internal recapitalisation by the write-down of liabilities and/or conversion of liabilities into equity.

Exercise of bail-in is subject to the principle that no creditor should be left worse off following bail-in than they would have been in an ordinary insolvency proceeding.

Which liabilities could be subject to bail-in?

All liabilities of an applicable financial institution are potentially subject to bail-in, save for a number of excluded types of liabilities such as covered deposits, secured or collateralised liabilities to the extent of the security or collateral, short-term liabilities (i.e. less than seven days) owed to non-affiliated institutions or settlement systems, and certain other specific types of liabilities.

What is "contractual recognition of bail-in"?

Article 55 of the BRRD provides that all liabilities which are potentially subject to bail-in (other than preferred deposits) must include a contractual term by which the creditor or holder of the liability recognises and agrees to be bound by any write-down or conversion following exercise of the bail-in tool, provided that such liability is:

• governed by the laws of a non-EEA state; and
• issued or entered into after the date on which the relevant member state adopts this requirement (which may not be later than 1 January 2016). For PRA-regulated entities in the UK (other than mixed activity holding companies), with regard to most types of unsecured debt instruments, the implementation date is 19 February 2015.

In this briefing, we refer to such liabilities as "Bail-in Liabilities".

There is an exception for the laws of a non-EEA state in respect of which the exercise of bail-in would be enforceable either directly or through an agreement reached between the third country and the Member State. Also, the European Banking Authority (EBA) is charged with further determining the list of excluded liabilities.

What are the particular contractual terms that must be included?

The EBA is charged with developing the mandatory elements of the "contractual recognition of bail-in" requirement to be included in relevant debt instruments. On 5 November 2014, the EBA published draft regulatory technical standards (RTS), and the EBA has until 3 July 2015 to submit the finalised proposed RTS to the European Commission. It is expected that the finalised RTS will come into force in Autumn 2015 following review and adoption by the European Commission.

In summary, the EBA Draft RTS provide that relevant debt instruments must contain the following elements:

1) acknowledgement, agreement and consent by the creditor/holder that the liability may be subject to the exercise by a resolution authority of its write-down and conversion powers;

2) identification of each relevant resolution authority and applicable legislation;

3) specification of the particular write-down and conversion powers of the resolution authority, in particular to:

a) reduce, in full or in part, the principal amount or amount due;

b) convert, in full or in part, into ordinary shares or other instruments of ownership of the borrower/issuer entity or another person; and

c) cancel debt instruments;

4) acknowledgement, agreement and consent by the creditor/holder that:

a) it is bound by any: 

i. reduction in the principal amount or amount due;
ii. conversion into ordinary shares or other instruments of ownership, that may result from an exercise by a resolution authority of its write-down and conversion powers;

b) the terms will be varied as may be necessary to give effect to the exercise of write-down and conversion powers and the creditor/holder will be bound by such variations; and

c) it will accept any ordinary shares or other instruments of ownership into which the liability may be converted; and

5) an "entire agreement" clause as to these matters.

How is "contractual recognition of bail-in" being implemented in the UK? 

PRA and FCA rules

The "contractual recognition of bail-in" requirement is being implemented in the UK by way of separate rules for PRA-regulated entities and FCA-regulated entities.

Early implementation

The rules are identical in substance save that, for PRA-regulated entities, the requirement is being implemented in two phases:

Phase 1: from 19 February 2015

In the first phase, the "contractual recognition of bail-in" requirement shall apply to the following entities issuing the following types of securities:

• all PRA-regulated entities, including firms which are dual regulated by PRA and FCA, but excluding mixed activity holding companies
• issuing or entering into Bail-in Liabilities (as described above) which are unsecured debt liabilities (including additional Tier 1 and 2 regulatory capital instruments) on or after 19 February 2015.

Phase 2: from 1 January 2016

For all other types of Bail-in Liabilities issued or entered into by PRA-regulated entities (including mixed activity holding companies), implementation of the "contractual recognition of bail-in" requirement will be from 1 January 2016.

For the Bail-in Liabilities of FCA-regulated entities, the "contractual recognition of bail-in" requirement also applies from 1 January 2016.

Content

Both the PRA Rules and the FCA Rules adopt the approach of the EBA draft RTS of specifying the mandatory components of the terms for the "contractual recognition of bail-in" to be included in the relevant debt instrument. The PRA has indicated that it will amend its rules as necessary so that they are in line with the requirements of the finalised RTS. This raises the concern that PRA-regulated entities will need to include contractual recognition of bail-in terms in unsecured debt instruments prior to the entry into force of the finalised RTS, and therefore there may be uncertainty as to: (i) the contractual terms to include from 19 February 2015 prior to the publication of the finalised RTS; and (ii) whether such terms will need to be amended following finalisation of the RTS.

PRA-regulated entities issuing Tier 1 or 2 regulatory capital instruments governed by non-EEA law on or after 19 February 2015 must provide the PRA with a legal opinion for the jurisdiction of the third country on the enforceability of the contractual bail-in term.

Conclusion

Most PRA-regulated entities which are issuing unsecured debt instruments which are governed under non-EEA law (e.g. New York law or Swiss law) must include "contractual recognition of bail-in" provisions in the relevant debt instrument from 19 February 2015. Presumably, the contractual terms should be based on the EBA draft RTS for the time being, but these could change when the finalised RTS are published and come into force in the UK.

Both PRA-regulated and FCA-regulated entities with unsecured securities issuance programmes that will extend to and beyond 19 February 2015 (for most PRA-regulated entities) or 1 January 2016 (for FCA-regulated entities) and which include an option for the securities to be governed under non-EEA law, should consider whether to include "contractual recognition of bail-in" terms in the next update (or sooner if necessary), or supplement at the time of the implementation or before the next drawdown of non-EEA law governed securities.

Authors: James Knight, Partner; Lorraine Johnstone, Partner