This advisory discusses current bail-in legislation adopted in the EU and England in response to the global financial crisis, and then takes a peek into the future.

As a consequence of the financial crisis, Europe implemented laws and regulations (as did the United States) to protect the financial health of, and the banking services provided by, its banks and investment banks (EEA Financial Institutions). As the contagion from the banking crisis spread quickly, it was a logical extension of the legislation to implement a means of permitting regulators to deal with troubled banks before their financial instability resulted in a suspension or curtailment of their banking services. Hence, on January 1, 2016, The European Union Bank Recovery and Resolution Directive (the BRRD) became effective.

The BRRD and the implementing legislation required each member country (“Bail-In Legislation”) to confer on bank regulators the power to write down, modify the terms of, cancel completely and/or convert into equity the liabilities of a failing bank before it becomes insolvent. The goal is to protect “good liabilities” at the expense of those holding “bad liabilities.” Good liabilities are often referred to as “financial liabilities” ─ i.e. obligations only a bank (or other financial firm) can incur ─ some examples are deposits, repos, insurance policies and derivative contracts ─ these are liabilities that banks use to finance their operations which quickly disappear when there is a run on a bank. “Bad liabilities” are written down or off and pay for the “good liabilities” (hence, the term “bail-in”). It is an important element of a bail-in that it happen quickly, before the value of financial liabilities erode.

The legislators realized, of course, that many liabilities of banks (especially the “bad” ones) are incurred under laws of non-EU countries to which the BRRD does not apply. Hence, Article 55 of the BRRD requires that EEA Financial Institutions ensure that all agreements that (a) create a liability on the part of the institution, (b) are governed by other than EEA law and (c) are entered into after the first of this year or make material amendments to an agreement entered into prior to 2016 include a provision (“Contractual Recognition Provision”) recognizing, and agreeing to be subject to, the Bail-In Legislation.

The initial legislation indicates that the term “liabilities” is to be read very broadly, but the market place has not reacted favorably. Discussions are taking place in London concerning this issue, and it is anticipated that there will be some guidance forthcoming reducing the scope of the term “liabilities.” However, for now, any agreement pursuant to which an EEA Financial Institution may incur any liability is likely to contain a Contractual Recognition Provision ─ to name a few ─ bond, credit, derivatives, trade finance, agency and underwriting agreements.

Financial institutions and their counsel are still learning to live with the Bail-In Legislation. The most immediate impact on EEA Financial Institutions (and their counterparties) is that such institutions generally must include the Contractual Recognition Provision in their documentation; failure to do so can result in fines and public censure.

The impact on U.S. banks that do not have subsidiaries in Europe (primarily in London) and on their customers is less direct, but nonetheless significant. Certainly a priority from a bank’s perspective is to review carefully clauses dealing with the consequence of bail-ins in syndicated credit documentation. As bail-ins happen quickly, banks will want to be sure that their rights and obligations in the event of a bail-in are clearly spelled out and enforceable. For example, suppose a lender is bailed in but has not defaulted under a credit agreement ─ the other lenders will surely want to be able to remove the bailed in institution from the syndicate. Bank customers will want similar rights and other protections from bail-in consequences; for example, suppose a borrower default is the direct consequence of the bailed-in institution no longer being required to meet its obligations to make further extensions of credit.

Finally, we turn to the future- what impact will Brexit have on the bail-in legislation? In the short term the answer is nothing. The extraction of Great Britain from the EU will be a lengthy (and painful process). There is talk of passing legislation which simply repeals all EU compelled laws, but that talk seems more emotional than real. Great Britain is bound by treaty to begin its withdrawal from the EU by sending notice of its intention to Brussels, and it is further bound to remain a member of the EU until the withdrawal process is complete (anticipated to take as long as two years).

Even when Great Britain is no longer a member of the EU, there seems to be good reason to believe it will choose to be bound by the present legislation or that it will pass similar legislation of its own.