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The Impracticability of Contractual Bail-In

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Introduction

Article 55 of the BRRD requires Member States to ensure that in-scope institutions include a contractual term by which the creditor or party to the agreement creating a liability recognises that the liability in question may be subject to the write-down and conversion powers within the BRRD and agrees to be bound by any reduction of the principal or outstanding amount due.  In the absence of statutory recognition frameworks, this is designed to ensure the effectiveness of the bail-in tool in a cross-border resolution and to promote equal treatment between EU and third-country liability holders.

The UK has transposed the Article 55 requirement within the “Contractual Recognition of Bail-In” Part of the PRA Rulebook.  Currently, this requires firms to include a bail-in recognition clause in all eligible liabilities governed by non-EU law which are “issued, entered into or arising after 31 December 2015”.  The PRA phased in the requirements, as set out below:

Phase Liability Deadline
1 Unsecured debt instruments, additional tier 1 instruments and tier 2 instruments 19 February 2015
2 All other in-scope liabilities, specifically unsecured liabilities which are not debt instruments (e.g. trade finance, operational liabilities, liabilities to non-EU FMI and uncovered corporate deposits) 1 January 2016

 

In November 2015, the PRA issued a “Modification by Consent” which, in effect, disapplied the contractual bail-in requirement in relation to Phase 2 liabilities in circumstances where compliance was “impracticable” until the earlier of (a) 30 June 2016 or (b) when the relevant rules are amended or revoked.  Any firm wishing to take advantage of this relief was required to contact the PRA for approval.

On 15 March 2016, the PRA issued a consultation paper[1] regarding amendment of the “Contractual Recognition of Bail-In” Part of the PRA Rulebook.  It recognises that the scope of its rules in this area is broad and proposes an amendment (consistent with the previous Modification by Consent) which, broadly, requires firms to include a bail-in recognition term in all eligible liabilities governed by non-EEA law, specifically:

  • Liabilities (other than liabilities created under a debt instrument) created:
    • after 31 December 2015 – even if created under a master agreement entered into on or before that date;
    • on or before 31 December 2015 if the agreement governing the liability is subject to “material amendment” after 30 June 2016; and
  • A liability under a debt instrument issued:
    • on or after 19 February 2015;
    • before 19 February 2015 which is subject to “material amendment” after 30 June 2016

However, the above would not apply with respect to a ‘Phase 2’ liability where it would be “impracticable” for the regulated firm to comply.  The PRA proposes that the amended rules would apply from 1 July 2016 (the day after the relief granted by the Modification by Consent expires).

The consultation paper also proposes three additional technical amendments to PRA rules to ensure consistency between the PRA Rulebook and the final draft European Banking Authority (EBA) Regulatory Technical Standards (RTS) on the contractual recognition of bail-in (which were adopted by the EU Commission on 23 March 2016 – see here and which are materially identical to the draft EBA RTS). The amendments are:

  • the inclusion of contractual recognition language into contracts for liabilities:
    • which are not fully secured and for secured liabilities which are not under a continuous full collateralisation requirement in accordance with EU or equivalent third-country law;
    • created before the date of application of the contractual recognition requirement if the agreement governing the liability is subject to a “material amendment”[2] after 30 June 2016; and
  • the replacement of the reference to liabilities “arising” after a certain date in PRA rules with a reference to liabilities “created” after that date.

Impracticability

Under the PRA proposals, BRRD firms must include contractual recognition language into ‘Phase 2’ liabilities unless doing so is “genuinely” impracticable.  Firms are expected to make a reasoned assessment as to whether this is the case in relation to any given ‘Phase 2’ liability.  A non-exhaustive list of circumstances in which this might be so includes:

  • a relevant third-country authority has informed the firm that they would not allow the inclusion of such language or that local laws would not permit it;
  • if liability contracts are governed by international protocols, which the firm has no power to amend;
  • liabilities falling under standard international documentation which may not be practicably amendable by firms (e.g. trade finance);
  • contractual terms which are imposed on a firm by virtue of its membership and participation terms in non-EU bodies, whose use is necessary on standard terms for all members and impracticable to amend bilaterally; or
  • liabilities which are contingent on a breach of contract.

Conclusion

The definition of “liability” in the PRA Rulebook is extremely vague and somewhat circular, making the proposed formalisation of relief by the PRA an extremely welcome development.  Nonetheless, firms are far from being let off the hook.  The concept of ‘impracticability’ still creates issues of interpretation and practical application, although it is known that the PRA does not consider loss of competitiveness or profitability as grounds for compliance being “impracticable”.  Moreover, liabilities created under derivatives master agreements remain clearly in-scope.  Unlike many other recent regulatory outreach programmes undertaken by banks, negative affirmation on the part of the counterparty will not be an option this time round[3].  ISDA is known to be working on a protocol solution, but the date of publication is not currently known and a degree of bilateral renegotiation will inevitably still be required in order to mop up counterparties which, for whatever reason, choose not to adhere.  It should also be remembered that a liability cannot count towards “minimum requirement for own funds and eligible liabilities” (MREL) calculations unless it contains contractual bail-in recognition language.  This should, as the PRA hopes, act as incentive enough to ensure that firms self-regulate and limit their ‘impracticability assessments’ to that which is genuinely unachievable.  Unsurprisingly, neither the PRA (nor the Bank of England) will approve a firm’s judgement of ‘impracticability’, but they will require firms to justify their own assessments.

Firms are currently giving a lot of attention to the way in which they will comply with the WGMR non-cleared margin rules, both in terms of the variation margin ‘first wave’ in September 2016 and particularly the bigger ‘second wave’ in March 2017.  Whilst this is entirely understandable, focus on contractual bail-in must not be allowed to slip as a result.  If you are to have any hope of being compliant, ‘impracticability assessments’ should already have been completed and implementation plans to amend documentation should largely be in place.  Given the 1 July deadline and the complexity of the task at hand, you can’t afford to let contractual bail-in get pushed into the long grass.

 

 

[1] The consultation period closes on 16 May 2016

[2] One which affects the substantive rights and obligations of a party to a relevant agreement, such as changes to signatory contact details, typographical changes and automatic adjustment of interest rates

[3] The PRA consultation paper itself envisages “contract renegotiation”

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