Freshfields Bruckhaus Deringer Recovery and resolution planning October 2015 1 The Financial Services and the Treasury Bureau of the Hong Kong Government (FSTB) in conjunction with the Hong Kong Monetary Authority (HKMA), the Securities and Futures Commission (SFC), and the Insurance Authority (IA)1 on 9 October 2015 published a paper entitled An Effective Resolution Regime for Financial Institutions in Hong Kong: Consultation Response and Certain Further Issues (CP3).2 Background Following from the recent global financial crisis, the G20 tasked the Financial Stability Board (FSB) with developing robust alternatives to publicly funded rescues of financial institutions (FIs), such that critical or systemic FIs might be allowed to fail safely without requiring bail-outs from public funds. The FSB concluded that each of its member jurisdictions needs to establish a ‘resolution regime’ providing national authorities with administrative powers to bring about orderly resolution rapidly which stabilises and secures continuity for key parts of a failing FI’s business, and that any legislative reforms needed to implement the resolution regimes should be in place by the end of 2015. The essential features that each resolution regime should have are set forth in the FSB’s ‘Key Attributes of Effective Resolution Regimes for Financial Institutions’3 (Key Attributes). 1 The FSTB, HKMA, SFC and IA are referred to together in this briefing as the “authorities”. 2 CP3 is available here: http://www.fstb.gov.hk/fsb/ppr/consult/doc/resolutionregime_conclu_e.pdf 3 The Key Attributes paper is available here: http://www.financialstabilityboard.org/wp-content/uploads/r_141015.pdf Royce Miller T +852 2846 3498 E firstname.lastname@example.org Simon Hawkins T +852 2846 3312 E email@example.com Jesal Patel T +852 2913 2707 E firstname.lastname@example.org Recovery and resolution planning: Public consultation conclusions on a resolution regime for financial institutions in Hong Kong Recovery and resolution planning October 2015 2 In January 2014, the authorities issued an initial consultation paper on establishing an effective resolution regime in Hong Kong (CP1).4 In January 2015, the authorities issued a second consultation paper (CP2) which sets forth the authorities’ conclusions with respect to several of the questions that were raised in CP1 as well as further proposals on how the Hong Kong resolution regime should be structured, in many cases taking into account international developments on key resolution issues since CP1.5 CP3 discusses the major comments received and the authorities’ responses in respect of the proposals in CP2, generally in the same order as they appear in CP2: (i) the scope of the resolution regime; (ii) governance arrangements; (iii) resolution powers; (iv) safeguards and funding; and (v) cross-border resolution and information sharing. This is followed by a discussion of further issues which were referenced in CP2 as remaining under development internationally. No further specific questions are asked in CP3, but any party who wishes to raise substantive points regarding the contents of CP3 is invited to do so via the authorities. Any further comments should be provided swiftly as CP3 reaffirms the authorities’ intention to submit a Bill to the Legislative Council by the end of this year. The authorities intend to continue to discuss with various stakeholders throughout the legislative process and thereafter as they develop and issue rules, Codes of Practice and guidance on various aspects of the resolution planning process. Scope of the Resolution Regime Authorized institutions, financial market infrastructures, insurers and licensed corporations The scope of the resolution regime in respect of authorized institutions (AIs), financial market infrastructures (FMIs), insurers and licensed corporations (LCs) remains the same as that proposed in CP2. Exchanges It was proposed in CP2 that systemically important recognized exchange companies (RECs) (i.e., companies that operate systemically important stock or futures markets) be brought within the scope of the resolution regime and that the SFC be responsible for this process. However, CP3 states that the authorities now intend for the Financial Secretary (FS) to be responsible for designating systemically important RECs as being within the scope of the resolution regime, on the recommendation of the SFC. Other FIs In an endeavour to accommodate future developments in the potential risks posed by different types of FIs, it was proposed in CP2 that the resolution regime should provide the FS with a power to designate FIs (not initially covered by the resolution regime) as being within the scope of the resolution regime where their non-viability could result in systemic disruption. 4 CP1 is available here: http://www.fstb.gov.hk/fsb/ppr/consult/resolution_e.pdf Our January 2014 briefing on CP1 is available here: http://www.freshfields.com/uploadedFiles/SiteWide/News_Room/Insight/RRP/RRP%20Public%20consultation%20 on%20a%20resolution%20regime%20for%20financial%20institutions%20in%20Hong%20Kong.pdf 5 CP2 is available here: http://www.gov.hk/en/residents/government/publication/consultation/docs/2015/RR.pdf Our February 2015 briefing on CP2 is available here: http://www.freshfields.com/uploadedFiles/SiteWide/Knowledge/Freshfields%20-%20Recovery%20and%20 Resolution%20Planning%20update.pdf Recovery and resolution planning October 2015 3 Although CP2 did not explicitly discuss whether the proposed designation power should be limited to regulated FIs or be extended to unregulated FIs, CP3 states that the authorities intend to provide the FS with the power to designate both regulated and unregulated FIs as being within the scope of the resolution regime so as to ensure that the resolution regime will be able to address risks potentially posed by any FIs. Governance Arrangements Lead resolution authority CP2 proposed that the FS should designate, in advance, a lead resolution authority (LRA) for each cross-sector financial group containing ‘in scope’ FIs based on an assessment of the relative systemic importance of, and business undertaken by, the ‘in scope’ FIs within that cross-sector group. CP3 indicates that the authorities intend to develop an assessment methodology by drawing upon the processes that have been developed internationally to assess the systemic importance of banks, insurers and other entities. CP2 proposed that in circumstances where consensus cannot be reached amongst the sectoral resolution authorities (RAs) on resolution planning and/or exercise of resolution powers in respect of a cross-sector group, the LRA would assume an ultimate decision-making role. To ensure that the LRA can act quickly and flexibly under all circumstances, the authorities have concluded that, as part of the LRA’s ultimate decision-making power, the LRA will have the power to direct another RA to take (or not to take) a specified action, and where necessary, to take an action itself in relation to an in-scope FI that would not usually be under its purview. However, the authorities expect that an LRA would only do this in rare circumstances. The authorities expect that the practical aspects of coordination will be set out in a Memorandum of Understanding between the RAs that specifically focuses on their respective resolution functions. Resolution Powers Statutory bail-in CP2 set out the authorities’ proposals for the execution of bail-in and on the scope of write-downs and conversions. In relation to the execution of bail-in, the authorities intend to issue guidance or a Code of Practice setting out the processes and procedures for carrying out bail-in once the legislation establishing the resolution regime comes into effect. In relation to the scope of write-downs and conversions, the authorities intend for liabilities that will be permanently excluded from the application of bail-in to be identified in the legislation establishing the resolution regime. In CP2, the authorities proposed 10 categories of liabilities6 that are intended to be excluded from any bail-in. Since CP2, the authorities have identified some additional liabilities that they now intend to exclude from any bail‑in, including: 6 See paragraph 108 of CP2 (pages 56 and 57). Recovery and resolution planning October 2015 4 i. liabilities relating to any deposits7 (and not just in respect of deposits protected by the Deposit Protection Scheme as proposed in CP2); and ii. liabilities relating to wages and certain benefits (e.g., holiday pay, sickness allowance, maternity/paternity leave pay, severance payment8 ) of the FI’s former or current employees (and not just in respect of the employees’ fixed salary and pension benefits as proposed in CP2). Annex 3 to CP3 sets out a full list of liabilities that the authorities propose to be excluded from bail-in.9 Bridge institution CP1 and CP2 proposed that RAs be empowered to transfer all or selected assets, rights and liabilities from a failing FI to a bridge institution. In CP3 the authorities have extended this proposal and now also intend to give RAs the power to transfer the shares of a failing FI to a bridge institution so as to give the RAs additional flexibility. As explained in CP2, the authorities envisage that a bridge institution would be used where the relevant RA assesses that there is a realistic possibility of concluding a purchase relatively soon but cannot arrange it immediately (e.g. over the course of a weekend). Accordingly, the authorities expect that the RA would seek to transfer the business to a third party purchaser and wind up the bridge institution without delay once the bridge institution has served its purpose. As such, the authorities intend that the legislation establishing the resolution regime will require an RA to wind up a bridge institution within 2 years after the last transfer was made to the bridge institution. An RA may be able to extend this 2-year period where such extension is necessary to meet the resolution objectives (e.g., where sale is pending but cannot be concluded before the end of the 2-year period). CP3 reaffirms the proposal in CP2 that a bridge institution will be a company limited by shares under the Companies Ordinance with the Hong Kong Government as the initial shareholder. With respect to the manner in which a bridge institution is capitalized and funded, the authorities intend for this to be determined on a case-by-case basis, depending to some extent upon the resolution strategy used. While capitalization by write-off or conversion of the FI’s debt would be preferable, in CP3 the authorities have indicated that some public funds might be temporarily used to capitalize a bridge institution in cases where it is necessary to do so in order to achieve a swift and orderly resolution. This would be on the basis that such public funds would be recovered from the sales of shares in, or assets from, the bridge institution or from the resolution funding arrangements. 7 This would include all deposits falling within the definition of “protected deposit” under the Deposit Protection Scheme Ordinance (irrespective of the amount of the deposit) and deposits taken by restricted license banks or deposit-taking companies that would have fallen within such definition had they been taken by a DPS member. 8 See paragraph 16 of CP3 (page 7) for all the benefits that the authorities propose to be excluded from bail-in. 9 See pages 65 and 66 of CP3. Recovery and resolution planning October 2015 5 Temporary stays on early termination rights CP2 proposed that RAs be empowered to stay early termination rights of counterparties in respect of financial contracts. In CP3 the authorities have extended this proposal and now intend for the scope of the temporary stay to be extended to financial and non-financial contracts whose early termination may impede the RA’s ability to achieve resolution objectives. The authorities expect that the FIs will, in the course of their resolution planning, identify the contracts that are critically important to their business and must continue in resolution, and the extent to which those contracts contain early termination rights that could pose a threat to the FI’s business continuity on resolution. Powers of RAs in relation to the filing of a winding up petition CP2 highlighted that a petition for the winding-up of an FI within the scope of the resolution regime could frustrate the underlying resolution objective of maintaining financial stability and, to counter this, the authorities proposed that RAs be given 14 days to consider whether to initiate resolution before any winding-up petition could be filed with the Court. In CP3 the authorities propose to shorten this period to 7 days. In the context of bail-in, the authorities intend that the resolution legislation precludes winding-up actions against an FI while an RA is taking steps to apply the bail-in stabilization option. However, in respect of other stabilization options where critical financial services would end up being transferred out of a residual FI, the authorities propose that winding-up actions can be taken against the residual FI. Supporting the transferred business The authorities intend for RAs to be empowered to direct the residual FI to continue to provide any support services (e.g., information technology, human resources and compliance functions) that are crucial to the continuity of any critical financial services that have been transferred out of the residual FI during its resolution. Where an RA issues such a direction, the residual FI should receive consideration on reasonable commercial terms for the provision of such support services. As mentioned above, in this situation the authorities do not intend to prevent winding-up actions being taken against the residual FI. However, the authorities intend that any winding up of the residual FI that commences should not immediately affect an RA’s ability to direct the residual FI to continue to provide services that are essential to the continuity of critical financial services that have been transferred out of the residual FI. Winding-up proceedings can commence in relation to any other parts of the residual FI’s assets and when the liquidator eventually needs to deal with the assets used to provide the support services, the authorities intend for the liquidator to give 6 months’ notice to the relevant RA so that the RA can make other arrangements for the provision of such services. CP3 also states that the liquidator should be obligated to support the relevant RA if it is necessary, following the application of a stabilization option, to undertake any supplemental or reverse transfer of assets, rights or liabilities out of, or into, the residual FI. Remuneration claw-back As described in CP2, the authorities intend for RAs to be able to apply to the court for claw-back of remuneration at any time once the resolution of an FI has been initiated. The authorities intend to apply claw-back to both fixed and variable remuneration but to limit claw-back to the period of 3 years before the resolution is initiated. It should be possible for an RA to apply to the court for an extension of up to 3 further years back in cases where there is dishonesty. Recovery and resolution planning October 2015 6 Safeguards and Funding Safeguards NCWOL compensation mechanism CP2 considered how the ‘no creditors worse off than in liquidation’ (NCWOL) compensation mechanism will work. To determine whether pre-resolution shareholders and creditors of an FI would be worse off on resolution than in liquidation, and consequently whether any NCWOL compensation may be due, CP2 proposed that an NCWOL valuer would contrast a hypothetical valuation of how pre-resolution shareholders and creditors of an FI would have been treated in a winding-up with an assessment of the actual treatment that they have received as a result of resolution. In certain cases, counterparties of an FI may stand to benefit from the resolution of an FI. For example, counterparties of an in-scope FI that is subject to bail-in, but whose liabilities are not included within the scope of the bail-in provision, would benefit from maintaining their relationship with a financially stronger entity. As such, the authorities intend to create a rebuttable presumption that counterparties in this position are no worse off in resolution and should therefore not be entitled to receive NCWOL compensation. Although the majority of the respondents supported the proposal in CP2 that the relevant RA be responsible for appointing an NCWOL valuer, the authorities now intend, instead, to provide for the FS to appoint a person who, in turn, would appoint an NCWOL valuer based on the independence and expertise criteria set out in CP210 so as to ensure that the valuation process is (and is seen to be) independent. The FS would approve any terms and conditions for the appointment of the NCWOL valuer by the appointing person. As noted in CP2, the authorities will set out in the legislation establishing the resolution regime some high level valuation principles that the NCWOL valuer must comply with when discharging his functions. These relate to: i. adherence to the creditor hierarchy in the hypothetical liquidation valuation; ii. disregard of any public financial support; and iii. disregard of the effect of any stabilization option. The authorities intend for the legislation establishing the resolution regime to provide the Secretary of Financial Services and the Treasury (SFST) with the power to make rules in relation to the NCWOL valuation process and any further assumptions to be made by the NCWOL valuer (e.g., the valuation reference date for the hypothetical liquidation valuation). Appeal against NCWOL valuation CP2 proposed that a Resolution Compensation Tribunal (RCT) be established to specifically hear appeals on NCWOL valuations. The authorities intend for the legislation establishing the resolution regime to provide for the setting up of RCT and for the Chief Justice to set rules in relation to the RCT’s operation. The authorities also intend for the RCT to have the power to revoke the appointment of the NCWOL valuer on the grounds set out in CP2 where a pre-resolution shareholder or creditor or the relevant RA has applied for such.11 10 See Box F in CP2 (page 92 of CP2). 11 See paragraph 174 of CP2. Recovery and resolution planning October 2015 7 RA’s decisions in requiring FIs to adopt appropriate measures to remove barriers to orderly resolution and appeal mechanism CP2 proposed that an RA should be empowered to issue a direction requiring an FI within the scope of the resolution regime to make changes for the purpose of improving its resolvability (ex ante resolvability measures). To ensure that this power is subject to checks and balances, the authorities intend to set out in the legislation establishing the resolution regime certain factors that an RA must consider before issuing a direction concerning an ex ante resolvability measure. The authorities also intend to extend the scope of an RA’s powers such that the RA may require ex ante resolvability measures to be taken by holding companies of FIs so as to deal with cases where the orderly resolution of an FI can only be achieved by initiating resolution at the holding company level. The authorities recognize that, because of the potentially intrusive nature of such powers, there is a need to provide an avenue of appeal in respect to the exercise of ex ante resolvability measures (to supplement the process between the RA and the FI/holding company during the course of which formal representations against ex ante resolvability measures can be made to the RA). The legislation establishing the resolution regime should provide for a separate Resolvability Review Tribunal (RRT) to be set up specifically for the purpose of hearing appeals relating to ex ante resolvability measures. Protecting certain types of financial arrangements in resolution As resolution powers create the potential for contractual rights and obligations, which collectively constitute ‘financial arrangements,’ to be separated from one another or dealt with in a way that undermines the economic purpose of those financial arrangements (e.g., to limit their exposure to loss in the event of the failure of their contractual counterparty, the FI), CP2 proposed that the following financial arrangements are to be treated as ‘protected’: i. secured arrangements; ii. set-off and netting arrangements; iii. title-transfer arrangements; iv. structured finance arrangements; and v. clearing and settlement systems arrangements. In respect of bail-in, CP2 noted that certain arrangements may need specific protection in bail-in because any bail-in of a gross liability under one part of an arrangement might similarly have the effect of undermining the economic purpose of the agreement. Therefore, the authorities consider that it may be appropriate to impose restrictions on an RA such that the RA should seek only to bail-in the ‘net’ amount under any secured, set-off, netting or title-transfer arrangement. Furthermore, where there is any inadvertent bail-in of a gross amount in breach of this safeguard, the authorities consider that it may be appropriate to give an RA the power to take remedial action to reinstate, restore or otherwise address the position of a person negatively affected. The authorities intend for the legislation establishing the resolution regime to provide the SFST with a rule-making power that enables it to prescribe requirements regarding an RA’s treatment of protected arrangements when applying stabilization options. These rules would set out: i. the technical details of how arrangements are to be protected; ii. exclusions from the scope of protection; and iii. remedies for inadvertent breaches under bail-in and partial transfer. Recovery and resolution planning October 2015 8 Resolution funding arrangements The resolution regime provides means by which the costs of resolution can be imposed on the shareholders and creditors of a failing FI, rather than on taxpayers. It is, however, recognized that, in certain cases, the costs of resolution may exceed the costs that can actually be imposed on shareholders and creditors through the resolution process. CP2 proposed that the resolution regime make provision for resolution funding arrangements such that recovery of the ‘excess’ costs of resolution may occur once it is clear how much needs to be recouped (i.e., on an ex-post basis, rather than an ex-ante basis). In relation to the costs that can be met through the resolution funding arrangements, although there was more support from the respondents for an exhaustive list, the authorities consider that any list would necessarily have to be non-exhaustive as the types of costs would likely vary in practice. However, the authorities emphasize in CP3 that resolution funding can only be used for, or in relation to, the application of a stabilization option(s), including costs from the preparatory work leading directly to the application of a stabilization option(s) and costs that follow as a result of the application of the stabilization option(s). Before using any such funds, an RA would be obligated to first consider the available resources at the failed FI. In respect of the scope of the ex post levy which FIs would be required to contribute, the authorities intend to provide in the legislation establishing the resolution regime for a mechanism for an ex post recovery of the relevant costs incurred in the resolution of an FI, after any ‘proceeds of resolution’ that may contribute to the resolution funding arrangement have been taken into account. The authorities consider that an ex post levy would still be necessary in most cases as it would be highly unlikely that any ‘proceeds of resolution’ would adequately cover all costs of resolution in excess of those that can be imposed on shareholders and creditors of the failed FI. However, in an exceptional case where there is a ‘surplus’ of funds in the resolution funding arrangement once resolution has been completed, the authorities intend to provide in the legislation for the FS to have the power to make rules in relation to the entitlements to, and distribution of, any surplus. In relation to the apportionment of a levy to the financial sector, the authorities intend for it to be imposed on those FIs that are both within the scope of the resolution regime and within the same sector as the failed FI. For cross-sector groups, the authorities intend for a mechanism to be established on a case-by-case basis to allocate contributions across the relevant sectors by reference to the composition of the failed cross-sector group. In the case of FMIs and RECs within the scope of the resolution regime, the authorities are minded to adopt a ‘user pays’ levy model.12 The authorities believe that the mechanism for raising the levy should be able to take into account the particular circumstances of each resolution and apportion cost in a proportionate manner in each case, while still respecting the overarching approach. To achieve this, the authorities intend for the legislation to provide for the rate of levy to be prescribed by the Legislative Council for any given resolution case and for the rules made by the FS (after public consultation and subject to vetting by the Legislative Council) to set out the detailed mechanism for the calculation and apportionment of the levy. 12 A ‘user’ of an FMI or exchange refers to a participant of the FMI or the exchange or a client of such a participant. Recovery and resolution planning October 2015 9 Cross-border resolution and information sharing Cross-border resolution The authorities continue to hold the view that a coordinated and cooperative approach to the resolution of a cross-border FI has the potential to better protect financial stability in both home and host jurisdictions. Therefore, an RA should be expected to recognize and support a cross-border resolution action, provided that it will not disadvantage local creditors relative to foreign creditors and will bring a satisfactory outcome for stability in Hong Kong. In CP3, the authorities propose to make provision for a statutory recognition framework that enables an RA, after consultation with the FS, to recognize all or part of a foreign resolution action, to the degree that it would produce largely the same legal effect as a resolution in Hong Kong. An RA would be able to recognize a foreign resolution action regardless of whether the ‘trigger conditions’13 for initiation of resolution locally are met. Such recognition can affect all FIs (and not just within-scope FIs). However, other conditions also would have to be satisfied before an RA can recognize a foreign resolution action. Specifically, recognition must not be granted if the RA believes that recognition would: i. have an adverse effect on financial stability in Hong Kong; ii. not deliver outcomes that are consistent with the resolution objectives; or iii. disadvantage Hong Kong creditors or shareholders (or both) when compared to their overseas counterparts. Furthermore, an RA can only recognize a foreign resolution action if it believes that there is an arrangement in place such that any Hong Kong shareholders or creditors would be eligible to claim compensation to an extent which is largely consistent with what they would have been eligible to claim had the resolution been initiated in Hong Kong. In deciding whether to recognize a foreign resolution action, an RA can also consider any fiscal implications that it may have on Hong Kong. In addition to this framework for recognizing foreign resolution actions, if the ‘trigger conditions’ for resolution are met, an RA can also use the stabilization options in the Hong Kong resolution regime in respect of FIs within the scope of the resolution regime to support foreign resolution actions. The authorities accept that the use of contractual provisions can support the application of stabilization options by underpinning powers to impose stays and to effect bail-in, especially in a cross-border situation. As such, the authorities intend for the legislation establishing the resolution regime to provide for: i. amendments to the Banking (Capital) Rules so that the terms and conditions of Additional Tier 1 and Tier 2 capital instruments issued by AIs must contain provisions by which the holder of any such instruments explicitly recognizes the potential for such instruments to be written off or converted by the RA; ii. the RA to be empowered to make rules requiring the terms and conditions of other liabilities that are not expressly excluded from bail-in to contain provisions by which the holder explicitly recognizes that the liability may be subject to bail-in; and iii. the RA to be empowered to make rules requiring the terms and conditions of certain financial and other contracts (considered to be crucial in maintaining the continuity of critical services) to contain provisions by which each counterparty consents to being bound by a temporary stay on early termination imposed by the RA to the contract. 13 These ‘trigger conditions’ are that the FI is non-viable and poses systemic risk locally and no private sector solution is at hand (see paragraph 59 of CP2). Recovery and resolution planning October 2015 10 Information Sharing The authorities intend for the legislation establishing the resolution regime to provide for a broad confidentiality requirement to attach to the undertaking of resolution-related functions. However, the legislation would also provide for specified gateways that would enable an RA to disclose information, amongst others, to: i. other RAs (and authorities that carry out functions relating to resolution), including those overseas, where disclosure will help the recipient to perform its functions and the recipient is itself subject to adequate confidentiality restrictions; ii. NCWOL valuers so as to enable them to undertake the necessary valuation exercises; and iii. the RCT and the RRT. To support advance resolution planning, the information sharing powers in relation to other RAs will apply continuously (i.e., not just when an FI is failing). The authorities also intend that the legislation establishing the resolution regime will give RAs the power to require information, records, and documents that are needed to perform their functions. These powers will be supported by powers of inspection and investigation, which include the application for a magistrate’s warrant to enter premises to search for, seize and remove necessary records and documents. Discussion of Further Issues Deferral of authorization criteria Where a regulated business is transferred from a failing FI to a bridge institution, the bridge institution would normally need to be authorized or licensed to conduct that business. However, in these circumstances, the authorities are minded to defer the application of certain authorization criteria required under the Banking Ordinance, the Securities and Futures Ordinance or the Insurance Companies Ordinance for a relatively short period of time (not more than 12 months). The relevant licensing authority (e.g., HKMA, SFC or IA) would be responsible for making the decision of whether to provide such a temporary deferral on a case-by-case basis upon an application by a bridge institution. In the case where shares in a within-scope FI are transferred to a bridge institution or a temporary public ownership company owned by the Hong Kong Government, the authorities consider that there would be less of a need for deferral of authorization criteria as the FI would continue to conduct the regulated business and would retain its existing authorization. In the case where all or part of the failing FI’s regulated business is transferred to a commercial purchaser, the authorities are not inclined to provide for a deferral of authorization criteria as they consider it crucial that any acquirer be financially and operationally capable of absorbing and running the transferred business. In respect of asset management vehicles (AMVs), the authorities consider it unlikely, at least in the case of AIs, insurers and FMIs, for any business requiring ongoing compliance with authorization criteria to be transferred to an AMV. However, the authorities can conceive of a situation where an AMV set up to hold the assets and/or outstanding positions of a failed FI might be conducting SFC regulated activities and would therefore be required to be licensed by the SFC. In these circumstances, the authorities consider that the licensing authority (e.g., the SFC) should also have the ability to defer the application of authorization criteria to an AMV on a temporary basis in the same manner as that proposed for a bridge institution. Total loss-absorbing capacity (TLAC) As noted in CP2, international developments are currently underway in relation to requirements for global systemically important banks (G-SIBs) to maintain in issue a sufficient minimum level of loss-absorbing instruments so as to facilitate resolution and, in particular, make bail-in a feasible and credible resolution option. Recovery and resolution planning October 2015 11 Currently, the FSB is revising its TLAC Term Sheet for G-SIBs in light of the consultation responses it received on a draft TLAC Term Sheet and the results of various impact studies. It is expected that the final version of the TLAC Term Sheet will be finalized ahead of the G20 Summit in November 2015. G-SIBs would, thereafter, be granted a ‘conformance’ period to comply with the TLAC standard. In order to: i. provide a way to operationalize the TLAC Term Sheet once it is finalized; ii. adapt resolution strategies involving bail-in to banks other than G-SIBs; and iii. facilitate the imposition of loss-absorbing capacity requirements on FIs from other sectors, the authorities propose that the legislation establishing the resolution regime empowers RAs to make rules prescribing loss-absorbing capacity requirements applicable to classes of FIs within the scope of the resolution regime (or their holding companies or subsidiaries). By doing so, the rules (in the form of subsidiary legislation) will give effect to international standards on loss-absorbing capacity issued by the FSB subject to any adjustments for the local context that an RA thinks necessary. This approach could also be used to extend the application of the TLAC Term Sheet to other classes of AI (in addition to G-SIBs) if an RA considers it appropriate to do so in the local context. Where the instruments included within the required loss absorption pool are governed by foreign law, there is a risk that the exercise of bail-in power under Hong Kong’s resolution regime would not be recognized in the jurisdiction of the instrument’s governing law. To address this issue, the authorities intend that an RA should be able to require any such instruments to include ‘contractual recognition clauses’ within their terms and conditions. Write-off and conversion of capital instruments issued by AIs The current bank regulatory capital framework in Hong Kong (which reflects the international Basel III standard) requires banks to maintain regulatory capital in a form that is considered loss-absorbing. Accordingly, the Banking (Capital) Rules provide that Additional Tier 1 and Tier 2 capital instruments be issued on terms that allow conversion into common equity or written-off in if the issuing AI reaches the point of non-viability. In the case where these contractual provisions for write-off or conversion of the capital instruments have not been triggered before an RA decides to initiate resolution, the FSB’s Key Attributes envisage that the write-off or conversion of the capital instruments should occur before any stabilization option is applied. As such, the authorities intend for the legislation establishing the resolution regime to provide for the HKMA, in its role as the RA for AIs, to either convert into equity or write-off Additional Tier 1 or Tier 2 capital instruments in accordance with their terms once it has decided that the conditions for resolving an AI have been fulfilled but before it applies a stabilization option to the AI. Preparatory powers The orderly resolution of an FI within the scope of the resolution regime requires substantial advance planning. In CP3, the authorities propose to include in the legislation a range of preparatory powers that an RA can exercise before (and in certain cases continue to be exercisable after) the commencement of resolution. The first such power relates to the gathering of information needed for: i. ‘business as usual’ resolution planning and assessment of resolvability; and ii. the evaluation of the FI’s financial condition and the determination of the potential systemic impact of the FI’s failure in contemplation of any resolution. In any lead-up to a potential resolution, certain parties both within and outside the FI may become aware of sensitive information relating to the resolution which, if disclosed, could threaten the success of the resolution. freshfields.com This material is provided by the international law firm Freshfields Bruckhaus Deringer LLP (a limited liability partnership organised under the law of England and Wales) (the UK LLP) and the offices and associated entities of the UK LLP practising under the Freshfields Bruckhaus Deringer name in a number of jurisdictions, and Freshfields Bruckhaus Deringer US LLP, together referred to in the material as ‘Freshfields’. For regulatory information please refer to www.freshfields.com/support/legalnotice. The UK LLP has offices or associated entities in Austria, Bahrain, Belgium, China, England, France, Germany, Hong Kong, Italy, Japan, the Netherlands, Russia, Singapore, Spain, the United Arab Emirates and Vietnam. Freshfields Bruckhaus Deringer US LLP has offices in New York City and Washington DC. This material is for general information only and is not intended to provide legal advice. © Freshfields Bruckhaus Deringer llp, October 2015, 04202 In CP3, the authorities propose that RAs be empowered to require specified persons not to disclose certain information to the public or to third parties without the relevant RA’s prior written consent in order to preserve confidentiality. Prior to a potential resolution, officers of a failing FI might act in a way that hinders an RA’s ability to effectively exercise a stabilization option. In CP3, the authorities intend for an RA to have the power to issue directions to a failing FI under its purview, or to the FI’s directors, or senior management in relation to the FI’s affairs, business and property, as the RA deems fit. This power would supplement an RA’s powers to seek to improve an FI’s resolvability by requiring barriers to resolution to be removed. As the respondents to CP2 generally did not favour the automatic removal of all directors or senior management of a failing FI entering into resolution, in CP3 the authorities propose that RAs have the power to remove directors and senior management of an FI and its holding company on a case-by-case basis both in the period immediately before a resolution and at the time of application of any stabilization options. Initiation of Resolution Before initiating a resolution, the authorities intend that an RA should first issue a ‘letter of mindedness’ to the relevant FI to inform the FI that the RA is inclined to initiate a resolution. The RA should allow the FI a reasonable period of time to make representations to the RA. The length of time would depend on the particular circumstances of the FI and how urgent it is for the RA to take resolution action. In practice, the authorities expect that the senior management or directors will be closely engaged in the course of resolution planning well before the RA formally issues a letter of mindedness. Client assets in resolution CP2 consulted on whether an additional resolution objective in respect of the protection of client assets should be introduced. The authorities propose to include such an objective in the legislation establishing the resolution regime, which is in line with the approach adopted in the EU, the UK and in the FSB’s Key Attributes.14 CP2 proposed that client assets held by or on behalf of a within-scope FI that are protected under applicable domestic laws and regulations should be excluded from bail-in. In CP3, the authorities propose to adopt and expand the definition of ‘client assets’ contained in the Securities and Futures Ordinance to cover assets held by an FI within the scope of the resolution regime or its affiliated operational entity and/or holding company in the course of conducting the business of acting as a trustee or custodian. The purpose of having the extended definition is to ensure that trust/custody assets would continue to be protected from the insolvency of trustees/custodians despite the introduction of the resolution regime. Tax treatment on exercise of certain resolution powers In respect of the treatment of stamp duty and profits tax in relation to the exercise of stabilization options, the authorities intend to consider requests for such tax exemptions on a case-by-case basis. 14 See Article 31 of the EU Bank Recovery and Resolution Directive, Section 4(8) of the UK Banking Act, and the Preamble and Section 2 in Appendix II Annex 3 of the Key Attributes.