Contractual recognition of EEA bail-in powers in non-EEA law governed contracts
From 1 January 2016, financial institutions established in EEA member states (and their overseas branches) are required under Article 55 of the Bank Recovery and Resolution Directive (2014/59/EU) (BRRD), to include contractual terms in any agreements governed by the laws of non-EEA Member States, which create certain payment and other liabilities specifying that those liabilities may be subject to bail-in under the BRRD. ‘Bail-in’ refers to powers exercisable by resolution authorities (e.g. regulators like the UK’s Prudential Regulation Authority) in the relevant EEA member states to rescue troubled European banks by writing-down their debt or converting bonds into equity. The aim of Article 55 is to reduce the likelihood of a creditor in a non-EEA jurisdiction successfully challenging the bail-in rights of an EEA resolution authority.
Generally speaking, the requirement will apply to a very broad spectrum of payment and potentially other contractual and non-contractual liabilities of EEA financial institutions (including those under loan agreements, letters of credit, demand guarantees, swap arrangements, intercreditor agreements and security documents) which are:
- governed by laws other than laws of an EEA member state (this would include contracts with no express governing law which would be determined by relevant conflict of laws principles to be governed by such non-EEA laws); and
- entered into by EEA financial institutions (or their overseas branches) after the date national law transposing the BRRD gives effect to the Article 55 requirement (1 January 2016 at the latest, and as of 1 February 2016, 27 out of 31 member states had implemented).
So for example, liabilities of a Nigerian branch of an EEA bank which are governed by Nigerian law will be subject to the requirements (unless an exception applies).
There are a limited number of exceptions to the requirement under Article 44(2) and 55(1)(b) BRRD.
The European Banking Authority (EBA) has published final draft regulatory technical standards listing the requirements of an Article 55 provision but example drafting has not been provided. Broadly (among other matters), the EBA requires express acknowledgement, agreement and consent by a counterparty that an EEA financial institution’s liability to it may be subject to the exercise of write-down and conversion powers by the relevant resolution authority, together with a description of those powers as set out in national law and the potential effects in terms of liability under the agreement.
The Loan Market Association (LMA) and the Loan Syndications and Trading Association (LSTA) published suggested recognition of bail-in clauses in December 2015 for use in facility agreements but which may be easily adapted for other types of agreement. The LMA model clause may be useful for EEA financial institutions transacting under facility agreements based on the LMA Developing Markets, South African law and East African and Nigerian law precedents or other (non-LMA) finance documentation e.g. local law security or intercreditor documents.
The International Securities Lending Association (ISLA), International Capital Markets Association (ICMA) and International Swaps and Derivatives Association (ISDA), are considering possible protocols in respect of securities lending, repo transaction and derivatives, respectively.
One sector which has been particularly vocal in its objections to the new rules is the trade finance industry (which has a huge presence in commodity-rich Africa).
It will be difficult (if not impossible) to include recognition of bail-in clauses in trade finance instruments like letters of credit or demand guarantees and to obtain the requisite counterparty acknowledgement and acceptance of them, since these instruments are often unilateral in nature, based on standardised terms (such as UCP or URDG) and/or issued by SWIFT.
In the case of letters of credit in particular, these instruments customarily do not contain a governing law clause so determining whether Article 55 applies will not necessarily be straightforward.
If EEA financial institutions (and their overseas branches) are required to insist on a recognition of bail-in clause in these instruments they are likely to find themselves at a competitive disadvantage to other banks which can continue to offer standard terms to customers. Taken to its extreme, banks could cease certain product lines with a resulting impact on the availability and cost of trade finance.
We would expect that bail-in of such contingent, uncertain liabilities of a failing EEA financial institution would be low on the list of priorities for the regulator in a recovery and resolution situation and, in the majority of cases, would be unlikely to boost recoveries at the failing EEA financial institution (noting in particular the short-term nature of those liabilities and the fact that payment of such liabilities by the bank invariably triggers matching reimbursement obligations by the bank’s customer or another bank).
Accordingly, the argument being made by various industry bodies (including ICC, BAFT and the British Bankers Association) and financial institutions is that trade finance liabilities were not intended to be caught by the BRRD; it is impossible for a bank to comply; and even if an EEA financial institution could comply, the time, costs and impact of compliance would be disproportionate to the benefits.
The Prudential Regulation Authority (PRA) in the UK has transposed Article 55 through rules in the PRA Rulebook and phased in the requirement, making it applicable to unsecured debt instruments, additional tier 1 instruments and tier 2 instruments (“phase one liabilities”) from 19 February 2015 and to all other relevant liabilities under the scope of the rule (“phase two liabilities”) from 1 January 2016.
The PRA has now confirmed that UK financial institutions affected by the rules can apply for a “modification by consent” to effectively postpone the requirement to comply in certain circumstances. The modification provides that the contractual recognition of bail-in rule will not apply in respect of a “phase two liability” where it would be impracticable for the relevant bank to comply in respect of that liability. The changes are set out in the modification direction. If a bank wants to take up the modification it will need to apply to the PRA. The modification will apply until 30 June 2016 or, if earlier, when the relevant rules are amended or revoked.
We are monitoring the situation in other EEA member states where it is envisaged there will be similar developments in the coming days and weeks.
For more details please refer to the Norton Rose Fulbright Financial Services: Regulation tomorrow blogsite.
 By “financial institutions” we refer to the undertakings specified at Article 1(1)(a) – (d) of the BRRD