6 December, 2016
The Financial Institutions (Resolution) Ordinance (Ordinance), which sets out the framework for a cross-sector regime for the orderly resolution of financial institutions (FIs) in Hong Kong, was passed by the Legislative Council (LegCo) on 22 June 2016. The Ordinance largely follows the legislative proposals introduced into the LegCo for consideration in December 2015 (see our earlier article here for an overview of such proposals).
The Ordinance will commence operation on a date to be appointed by the Secretary for Financial Services and the Treasury, following the passing of the necessary regulations to be made as subsidiary legislation under the Ordinance. The government has also indicated that it will, along with the Hong Kong Monetary Authority (HKMA), the Securities and Futures Commission (SFC) and the Insurance Authority (IA), maintain close liaison with the industry and the relevant stakeholders in the formulation of the relevant regulations, rules and codes of practice.
On 22 November 2016, the Financial Services and the Treasury Bureau of the Hong Kong government, in conjunction with the HKMA, the SFC and the IA, published a consultation paper (Consultation Paper) in relation to the regulations on "protected arrangements" to be made under section 75 of the Ordinance, which are expected to become operational at the same time as the Ordinance is brought into operation.
PROTECTED ARRANGEMENTS
"Protected arrangements" are vital to the daily functioning of financial markets. Financial market participants rely on such arrangements to mitigate credit risk exposure to counterparties and provide sources of liquidity and financing. The proposed protected arrangements regulations (PARs) will give certainty that such financial arrangements, when entered with an entity within the scope of the Ordinance, will be protected, which in turn, will help prevent an increased cost of funding for such entities and a reduction in liquidity in the markets.
The financial arrangements identified as "protected arrangements" under section 74 of the Ordinance are:
- clearing and settlement systems arrangements;
- netting arrangements;
- secured arrangements;
- set-off arrangements;
- structured finance arrangements; and
- title transfer arrangements.
To recap, the Ordinance makes available the following five stabilisation options, which may be applied to an in-scope FI to stabilise a failing FI's business:
- transfer of some or all of the failing FI’s business (by way of transfer of shares or assets, rights and liabilities) to a purchaser;
- transfer of some or all of the failing FI’s business to a bridge institution;
- transfer of assets, rights or liabilities of the failing FI to an asset management vehicle;
- statutory bail-in (ie, write-off or conversion into shares) of liabilities of the failing FI to absorb losses and recapitalise the failing FI; and
- (as a last resort) transfer of the failing FI to temporary public ownership.
Amongst the five stabilisation options, the protected arrangements are most vulnerable to a partial property transfer (PPT) order or a bail-in where liabilities are written off and/or converted without taking into account "linked" assets or rights.
The Consultation Paper therefore invites views on the scope and the degree of protection for the different classes of protected arrangements in a PPT or bail-in situation, as well as the remedial actions to be taken by a resolution authority (RA) should its actions inadvertently result in the constituent parts of a protected arrangement being treated otherwise than as envisaged in the regulations.
SAFEGUARDS IN A PPT
|
Protected arrangements |
Proposed safeguards in a PPT |
Proposed remedy in case of RA's inadvertence |
|
Clearing and settlement systems arrangements |
Cannot transfer some (but not all) of the property, rights or liabilities in a way that will disrupt the operation of a clearing and settlement systems arrangement |
The PPT is void to the extent that it splits the property, rights and liabilities which are part of the arrangement |
|
Secured arrangements |
Cannot transfer any constituent part of a legitimate secured arrangement, without all other corresponding constituent parts, whether or not the security is by means of a fixed or floating charge |
Affected party to notify the RA, which will then assess the effect of the PPT and take necessary steps to reverse the transfer |
|
Structured finance arrangements |
Cannot transfer some (but not all) of the property, rights and liabilities which are or form part of a structured finance arrangement Any deposit which forms part of a structured finance arrangement is carved out from the protection |
Affected party may notify the RA, which will then take steps to restore the party's position |
|
Set-off, netting and title transfer arrangements |
Cannot split the rights and liabilities that may be set off or netted under such arrangements to which the entity in resolution is a party, if such rights are provided for in written contracts Specific rights or liabilities relating to deposits, subordinated debt, transferable securities, "operating" rights and liabilities, as well as awards of damages or claims under an indemnity relating to the undertaking of financial activities are excluded |
Affected counterparty should be permitted to continue to set-off or net any amount it owes to the entity in resolution |
SAFEGUARDS IN A BAIL-IN FOR SET-OFF, NETTING AND TITLE TRANSFER ARRANGEMENTS
The authorities are of the view that set-off, netting and title transfer arrangements require additional protection, even when the Ordinance has in place a number of protections for counterparties in bail-in by defining a list of "excluded liabilities" which cannot be subject to bail-in.
It is proposed that the PARs should provide a safeguard that an RA should only make bail-in provision in respect of the net amount that the entity in resolution and its counterparty are entitled by contract to set-off or net under any set-off, netting or title transfer arrangements.
At the same time, to prevent undue restriction on an RA from exercising the bail-in stabilisation option effectively, liabilities arising from any capital instrument, subordinated debt, or unsecured debt instrument being a transferrable security issued by the entity in resolution are suggested to be excluded from protection.
In the case of any inadvertent bail-in of a liability that is part of the protected arrangement, the affected counterparty is entitled to notify the RA, which will make a determination and take appropriate measures to restore its position.
INFORMATION REQUIREMENTS
The Consultation Paper concludes by highlighting the need to identify the constituent parts of any protected arrangements to which in-scope FIs are counterparties, and the rights and liabilities which are included or excluded from the PARs protection, sufficiently promptly and accurately. Although further thought needs to be given to the precise form of the information and reporting capabilities which will need to be maintained, in-scope FIs will be expected to put in place sophisticated management information systems.
CONCLUSION
The approach to the PARs is built on the responses to the authorities' previous two consultation papers of January 2014 and January 2015. It is also intended to be consistent with the standards set by the Financial Stability Board's Key Attributes of Effective Resolution Regimes for Financial Institutions.
In this regard, the authorities have largely adopted the approach in the United Kingdom and the European Union's Bank Recovery and Resolution Directive.
Interested parties are invited to submit comments to the list of consultation questions annexed to the Consultation Paper by 21 January 2017. Depending on the outcome of this consultation, the government aims to introduce the PARs into the LegCo for negative vetting in the first half of 2017. We would expect that the effective date of the Ordinance will be visible shortly after the passing of the PARs.
For further information, please contact:
William Hallatt, Partner, Herbert Smith Freehills
William.Hallatt@hsf.com
