16 June, 2015
- The Bank Recovery and Resolution Directive (the "BRRD") is a key EU legislative initiative which EU member states were required to have implemented into national law by 1 January 2015. Amongst other things, it enshrines statutory "bail-in" powers for national regulators in relation to certain debt instruments, including senior ranked medium term notes.
- Article 55 of the BRRD requires that debt instruments of institutions incorporated in an EU member state but governed by a law other than that of such member state include 'contractual recognition of bail-in' terms.
- Member states have until 1 January 2016 to implement Article 55. Some member states, such as the United Kingdom, have moved early and already implemented Article 55 into national law.
- EU-incorporated financial institutions with Australian law-governed note issuance programmes should consider whether to include 'contractual recognition of bail-in' terms in the next programme update (or sooner if necessary), or supplement at the time of their member state's implementation of Article 55 or before the next drawdown of Australian law governed notes.
Background
The BRRD is applicable, broadly, to banks, building societies and significant investment firms and their holding companies and other financial institutions incorporated in an EU member state. 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. The mechanics are similar to conversion and write-off provisions for Tier 1 and 2 regulatory capital instruments.
One aspect of bail-in is the requirement for an applicable financial institution which is issuing relevant debt instruments 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 debt instrument may be subject to the exercise of the bail-in tool – referred to as 'contractual recognition of bail-in'.
Key Points For Australian Law Governed Debt Instruments
- Article 55 of the BRRD requires that, with certain exceptions, "in-scope" financial institutions must include a contractual term within relevant debt instruments governed by non-EEA law, such as Australian law, by which the creditor/holder recognises that the debt instrument is subject to write down or conversion following exercise of the 'bail-in' tool.
- Member states have until 1 January 2016 to implement the 'contractual recognition of bailin' requirement however certain member states such as the United Kingdom and The Netherlands have already implemented the 'contractual recognition of bail-in' requirement in whole or in part.
What Is The Bail-In Tool?
The concept of bail-in is relatively new, having arisen from the financial crisis of 2008. The aim of bail-in is that shareholders and creditors of a failing financial institution bear an appropriate part of losses arising from the failure of such 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 under the BRRD, 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 writedown 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 Article 55.
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 that country and the member state. At present, Australia has not entered into any such agreements.
What Are The Particular Contractual Terms That Must Be Included?
The European Banking Authority ("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 Spring 2015 following review and adoption by the European Commission.
In summary, the EBA's 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; or
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.
What Does This Currently Look Like?
In the Australian market, the documentation of the elements of 'contractual recognition of bail-in' is new and evolving. Currently, it is the practice to not only include the required specific 'contractual recognition' condition in an instrument's terms and conditions but also some disclosure and/or a risk factor in the information memorandum that outlines the application of the BRRD, Article 55 and possible consequences to instrument holders in the event of a bail-in of those instruments.
At present, member states that have implemented Article 55 have varying rules regarding the elements of 'contractual recognition of bail-in' provisions and these must be followed. For example, in the United Kingdom, the UK Prudential Regulation Authority Rules and the Financial Conduct Authority Rules adopt the approach of the EBA draft RTS, specifying the mandatory components of the terms for the 'contractual recognition of bail-in' to be included in the relevant debt instrument. The UK Prudential Regulation Authority has indicated that it will amend its rules as necessary so that they are in line with the requirements of the finalised RTS. Local counsel advice on the different rules should be sought as appropriate.
We note that certain relevant institutions will need to include contractual recognition of bail-in terms in debt instruments to be issued prior to the entry into force of the finalised RTS, and therefore there may be uncertainty as to (i) the contractual terms to include prior to the publication of the finalised RTS and (ii) whether such terms will need to be amended following finalisation of the RTS.
The Bail-In Concept In Australia Generally – APRA, The Financial System Inquiry 2014 And The G20 Summits 2013 And 2014
At present, there are no measures in place to institute a similar statutory bail-in regime in Australia. The Australian Prudential Regulation Authority's most recent position on this topic is that it prefers a contractual bail-in concept over statutory bail-in powers or "Total Loss Absorbing Capacity" ("TLAC") mechanisms. Currently, APRA believes that its compulsory transfer of business powers can be used to achieve a similar economic effect to bail-in.
However, the Financial System Inquiry 2014 has made two relevant recommendations in relation to the concept of bail-in: (i) Australia should implement a framework for minimum loss absorbing and recapitalisation capacity in line with emerging international practice and (ii) APRA's "crisis management toolkit" should be expanded, with support for the introduction of further directions powers, group resolution powers, and powers to assist with resolving branches of foreign banks. These recommendations have not yet resulted in any new measures.
In 2013, the St Petersburg G20 Summit made a commitment to enhance the certainty of crossborder resolution regimes. The Financial Stability Board prepared a consultative document that was considered by the Brisbane G20 Summit in 2014 and has now been tasked with developing an international framework for the recognition of cross-border resolution and bail-in provisions, as well as enhancement of cross-border bail-in contractual provisions in debt instruments. At this stage it is not clear what level of co-operation Australia will be providing in the development of such a framework.
Conclusion
EU-incorporated financial institutions with note issuance programmes which include Australian law governed notes should consider whether to include 'contractual recognition of bail-in' terms in their next programme update (or sooner if necessary), or supplement at the time of implementation of Article 55 of the BRRD in their member state or before their next drawdown of Australian law governed notes.
For further information, please contact:
Paul Jenkins, Partner, Ashurst
paul.jenkins@ashurst.com
Jamie Ng, Partner, Ashurst
jamie.ng@ashurst.com
James Morris, Ashurst
james.morris@ashurst.com
Caroline Smart, Ashurst
caroline.smart@ashurst.com
