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9 December, 2016
On 22 November 2016, the Financial Services and the Treasury Bureau, together with the Hong Kong Monetary Authority, the Securities and Futures Commission and the Insurance Authority, launched a consultation on the regulations relating to “protected arrangements”, to be made under section 75 of the Financial Institutions (Resolution) Ordinance (Cap. 628) (“FIRO”).
The FIRO was gazetted on 30 June 2016 following two consultations1. As mentioned in the second consultation conclusions2, the focus of the present consultation is on technical details on how the economic effect of certain arrangements is to be protected on the application of a stabilization option, exclusions from the scope of protection and remedies for inadvertent breaches.
Stabilization options
As a reminder, if an entity subject to the resolution regime (namely, a “within scope financial institution”) ceases to be viable, and if the other conditions to resolution are met, resolution authorities are to be given a menu of stabilization options to avoid or mitigate the risks posed to the financial system of Hong Kong by the non-viability of such financial institution. Such options include:
- transfer to a purchaser;
- transfer to a bridge institution;
- transfer to an asset management vehicle;
- bail-in; or
- transfer to temporary public ownership (or a ‘TPO company’).
Section 75 FIRO gives the Secretary for Financial Services and the Treasury the ability to make regulations to safeguard the economic effect of protected arrangements and prescribing requirements to be complied with by a resolution authority in exercising one of the stabilization options.
Part I: Protected arrangements
Regulators are mindful of the potential for some stabilization options to split up interlinking rights and liabilities under certain arrangements which ought to be protected. These “protected arrangements” are:
- clearing and settlement systems arrangements;
- netting arrangements;
- secured arrangements;
- set-off arrangements;
- structured finance arrangements; and
- title transfer arrangements.
Clearing and settlement systems arrangements
Financial market infrastructures that provide clearing and settlement services are critical to the functioning of financial markets. Regulators propose that a partial transfer arrangement (PTT) which disrupts a clearing and settlement systems arrangement will
be void to the extent that it splits up rights and liabilities that are part of the arrangement.
Secured arrangements
The proposal is that a resolution authority, in effecting a PTT, should not transfer any constituent part of a secured arrangement without all the other constituent parts. Thus, the benefit of the security may not be transferred without the liability which is secured (and vice versa).
Provided the charged assets are clearly identifiable under the terms of the secured arrangement, such safeguards apply regardless of whether the charges are fixed or floating charges. However, where foreign property forms part of a secured arrangement and the resolution authority is unable to transfer that foreign property because of a restriction or prohibition under the law governing the property, it is proposed that, in order to unduly restrict the resolution authority’s ability to conduct the resolution, the resolution authority should not be prevented from transferring the remainder of the constituent parts of the arrangement.
A person so affected by a PTT has 60 days from the PTT taking effect to notify the resolution authority. The resolution authority has 60 days (extendable by a further 60 days) to effect a supplemental transfer or reverse transfer to restore the constituent parts of the secured arrangement.
Structured finance arrangements
The intention of the authorities is to capture securitisation vehicles such as asset-backed securities issuers and asset-backed commercial paper issuers (as opposed to unsecured structured products). Recognising that structured finance arrangements provide a means of refinancing and allowing risk diversification the proposal is that a resolution authority, in effecting a PTT, be restricted from transferring some but not all of the property, rights and liabilities that form part of a structured finance arrangement.
Where foreign property forms part of a structured finance arrangement and the resolution authority is unable to transfer that foreign property because of a restriction or prohibition under the law governing the property, the proposal is that the resolution authority should not be prevented from transferring the remainder of the constituent parts of the arrangement. However, as a resolution authority may have to make a prompt transfer of deposit taking activity of the failing financial institution, this would not apply to any deposits that form part of the structured finance arrangement.
The proposal is that a person so affected by a PTT has 60 days from the PTT taking effect to notify the resolution authority. The resolution authority has 60 days (extendable by a further 60 days) to effect a supplemental transfer or reverse transfer to restore the constituent parts of the structured finance arrangement.
Set-off, Netting and Title Transfer Arrangements
The proposed approach is one which is similar to that in the UK. The ability of a resolution authority to split up the rights and liabilities that may be set off or netted under written contractual set-off, netting or title transfer arrangements, such as the ISDA Master Agreement, is to be restricted, with certain exclusions.
The following are proposed to be excluded from the protection:
- Deposits;
- Subordinated debt;
- Transferrable securities;
- “Operating” rights and liabilities, being rights and liabilities not related to financial activity such as real property leases; and
- Awards of damages or claims under an indemnity relating to the undertaking of “financial activity”
In addition, it is proposed that:
- Where foreign property forms part of a netting, set-off or title transfer arrangement and the resolution authority is unable to transfer that foreign property because of a restriction or prohibition under the law governing the property, the resolution authority should not be prevented from transferring the remainder of the constituent parts of the arrangement.
- A contract that contains a “walkaway” clause, namely one which permits the non-defaulting party to make no/limited payments to the defaulting party even if the defaulting party is in-the-money, will not receive protection.
The netting, set-off or title transfer arrangements must be in writing to benefit from the protection.
In the case of a splitting of the rights and liabilities otherwise subject to a protected set-off, netting or title transfer arrangement, the proposal is that the affected counterparty should continue to be permitted to set-off or net.
Part II: Safeguards in Bail-in
In relation to derivatives and bail-in, in the second consultation conclusions, authorities concluded that it is not appropriate to exclude derivatives completely from bail-in. However, the proposal is that derivatives will be bailed in on a net basis.
In order not to unduly restrict a resolution authority from exercising the bail-in stabilization option, there will be certain exclusions from the safeguard. These will be, for example, liabilities arising from any capital instrument issued by the entity in resolution or arising from subordinated debt or an unsecured debt instrument that is a transferrable security.
If a bail-in has occurred where a liability has been inadvertently bailed in on a gross basis, a person so affected by the bail-in has 60 days from the bail-in instrument taking effect to notify the resolution authority. The resolution authority has 120 days (extendable by a further 120 days) to determine the measures to be taken in order to put the affected party in the position it would have been had the bail-in been effected on a net basis.
Next steps
Subject to the outcome of the public consultation, the regulators target to introduce the regulations as subsidiary legislation under the FIRO into the LegCo for negative vetting in the first half of 2017.
In addition, further outstanding issues have to be addressed in a third consultation, namely, on how the “bail-in” resolution option will work, potentially including local implementation of the Financial Stability Board’s framework for total loss absorbing capacity (“TLAC”); on the mechanisms for the recognition of cross-border resolution actions and effective cross-border co-ordination; expanded proposals on how any costs of resolution should be funded and the protection of client assets in resolution.
- The first public consultation was from January to April 2014 and the second public consultation was from January to April 2015.
- An Effective Resolution Regime for Financial Institutions in Hong Kong, Consultation Response and Certain Further Issues dated 9 October 2015.
- An Effective Resolution Regime for Financial Institutions in Hong Kong: Financial Institutions (Resolution) Ordinance (Cap. 628) Regulations on Protected Arrangements
For further information, please contact:
Chin-Chong Liew, Partner, Linklaters
chin-chong.liew@linklaters.com
