The sudden collapse of Lehman Brothers in September 2008 sent shockwaves around the globe. As the largest insolvency in history, Lehman’s collapse was a pivotal moment in the 2007-2008 financial crisis and a startling illustration of the fragility of an outwardly robust institution and system. A failure to recognise and act upon early signs of distress turned what might have been a controlled descent into a freefall.
The risk that the failure of a systematically important financial institution will affect the global economy is not new: the Panic of 1825 provides an early example. Policymakers have, however, reacted vigorously to the global financial crisis. One such response is that many jurisdictions have implemented or are planning to implement regulations requiring financial institutions to adopt pre-emptive recovery plans. A pre-emptive recovery plan is a document prepared by a financial institution that considers risks that could lead to an institution experiencing a financial crisis and options to restore its financial position.
For instance, the European Union’s Bank Recovery and Resolution Directive of 2014 (BRRD) and proposed Insurance Recovery and Resolution Directive (IRRD) (likely to be adopted this year), are examples of regulatory initiatives that require specified financial institutions to prepare pre-emptive recovery plans. In Bermuda, the Insurance Act 1978 was amended in 2023 to give the Bermuda Monetary Authority the power to require certain insurers to prepare a recovery plan; a consultation on the implementation of these requirements is ongoing.
Some argue that minimising the risk or consequences of failure is the wrong approach and that regulators instead ensure that no institution is allowed to take on such systemic importance that it is too big to fail. As restructuring and insolvency lawyers, we are not qualified to comment on these broader political questions. We do, however, on a regular basis, advise businesses in a state of crisis and observe successful and less successful responses to these events. Banks and insurers may be required to make plans for recovery but businesses in other sectors may well benefit from having a recovery plan in place.
Sometimes, the onset of insolvency is slow and the result of incremental deterioration in financial position over time. Sometimes however, the onset of insolvency is sudden and unexpected. Unexpected events that call into question an entity’s solvency can make it difficult to plan, make and implement those decisions quickly and effectively. In our experience, the prospect of recovery of any business in a crisis is improved where the business has a recovery plan in place. In general, a recovery plan should be clear in its scope and contain information, at a minimum, on:
- corporate governance of the entity or entities in scope;
- risks that might trigger the recovery plan;
- options for addressing those risks; and
- plans for communication and disclosure.
When a crisis occurs, it can often strain corporate governance processes. It is common sense that a document delineating responsibility in a crisis is useful. Uncertainty about decision making processes can cause delay (while advice is sought) or lead to litigation if a decision is taken without the necessary corporate authority. If there are any governance documents that are unclear, for instance a shareholders’ agreement that conflicts with articles of association, it may prove impossible to amicably resolve governance issues once a crisis has arisen. Pre-emptive discussion of these issues is generally possible and in the best interests of all parties and the preparation of a recovery plan provides a useful opportunity to ensure that these documents will function as intended.
A recovery plan should include certain predefined triggers that will result in the plan’s activation. Triggers for a recovery plan may be objective measures, for instance, financial metrics (e.g. capital, liquidity, profitability or asset quality) reaching critical thresholds. Alternatively, these measures may be more subjective, with reference to market trends, performance of key counterparties, macroeconomic conditions or customer sentiment. The recovery plan should note how these triggers are to be monitored, including how frequently. Triggers will inevitably vary to reflect the commercial reality of the business in question. It may be useful, when defining triggers, to consider whether a risk forms part of the ordinary course of business or threatens to disrupt the ordinary course of business.
If a risk is identified as a trigger of the recovery plan, the recovery plan should also include the options for dealing with that risk. Options might be as simple as monitoring a developing situation more closely or taking advice. More involved options might include seeking fresh capital, reducing costs, restructuring or realising assets and liabilities or entering into a formal restructuring or insolvency process. More than one option might be adopted in parallel and, where possible, a broad range of available recovery options increases the prospect that one or more of the options proves feasible in practice.
Identifying these options will not only streamline a business’ response to a crisis but will also identify whether there are any risks that the business has no good option to address. The entity can then either work on identifying options or reducing its exposure to that risk. The identification of risks should also include matters relevant to business continuity. For instance, if an entity enters an insolvency process, what will an officeholder need to know on day one to maintain operations and preserve recovery prospects?
An entity may need to adopt multiple approaches to communication with employees, regulators, counterparties, customers or the public generally. Having a plan that identifies the people who need to be kept informed in a crisis and gives thought to the content and mode of communication, increases the prospect of management being perceived as cool, controlled and professional in their response to a crisis.
For further information, please contact:
John Wasty, Partner, Appleby
jwasty@applebyglobal.com
