An issue that has seen an increase in interest following the Brexit vote in June is that of the BRRD’s requirement for contractual recognition of bail-in.

What are the BRRD and “bail-in”?

The Banking and Recovery Resolution Directive (2014/59/EU) (BRRD) was passed in an effort by the EU to provide “adequate tools at EU level to deal effectively with unsound or failing credit institutions and investment firms”1. The 2008 global financial crisis had demonstrated that institutions which had previously been considered to be too big to fail could in fact do so. The BRRD has as one of its primary aims the preservation of systemically important functions when a bank fails, to allow a quicker return to stability.

The key features of the BRRD are as follows:

Preparation – this includes recovery and resolution planning and resolution assessments.

Early Intervention – this includes extensive regulatory powers to direct remedial action for an institution and the power to appoint a special manager.

strong>Resolution – this includes a common set of resolution tools for the EU markets, harmonised objectives and triggers and a cross-border recognition framework. It also includes ‘resolution stays’ which are a limit on the right of counterparties of distressed institutions to exercise early termination rights.

In overview, bail-in is the process whereby the relevant authorities are permitted to write-down and/or convert certain of the bank’s liabilities into equity, with the aim of the bank being able to continue, albeit perhaps fundamentally restructured.

Broadly speaking, the BRRD applies to EU incorporated banks, and large investment firms, their EU incorporated holding companies and any EU subsidiaries of such institutions.

For creditors, this is of some importance. Debt owed to them by such an institution can be converted, reduced or written off altogether.

Article 55

Article 55 states that from 1 January 2016, non-EU law governed contracts entered into by applicable institutions must include a clause recognising the effectiveness of actions permitted under the BRRD. The rationale is that objections to such actions are less likely to be successful if the party has explicitly agreed to the possibility of them occurring in the underlying contract. For EU law governed contracts, the BRRD will automatically apply and no explicit clause is required.

Whilst there is no specimen clause provided in the legislation, there is a list of elements which the clause must contain. ISDA and AFME, amongst others, have produced specimen bail-in clauses.

Whilst there are some exceptions for the requirement under Article 55, these are, at present, not clear.

The HFW view - impact on trade finance

Trade finance documentation presents some particularly complex issues for an Article 55 clause. For example, a letter of credit would be a relevant liability covered by the BRRD. However, it is very common for letters of credit not to specify any governing law. How then should it be determined whether the requirement is applicable?

The UK regulator2 has recognised some of the challenges which market participants may face and has allowed an exception for UK entities caught by the BRRD where compliance with the Article 55 requirement would be impracticable. One example given was the creation of liabilities governed by an international protocol which the UK financial institution has in practice no power to amend. An obvious example of this is the UCP rules which are incorporated into almost all letters of credit.

The Brexit vote has brought renewed interest in this issue, as it could mean that when the UK leaves the EU, it would be classed as a third country and therefore any UK based relevant institutions entering into contracts creating a relevant liability with a counterparty based in the EU, but governed by English law would be required to incorporate an Article 55 clause. Such wording would already be required for contracts governed by, for example, New York or Swiss law.

However, with reports in the market of significant pushback from counterparties outside the EU who do not understand the need for such a clause, it remains to be seen how the banks will negotiate the challenges Article 55 presents for trade finance in particular.