On 26 May 2015, the Prudential Regulation Authority (PRA) published their consultation paper (CP 19/15) on contractual stays in financial contracts governed by non-EEA law (theConsultation Paper). This overlaps with on-going work on the contractual recognition of bail-in. Comments are requested by 26 August 2015 with a policy statement (and final rule) expected towards the end of 2015.
In order to ensure effective resolution, resolution authorities need powers to suspend (or ‘stay’) the exercise of early termination rights under financial contracts so as to avoid disorderly close-out and/or liquidation of collateral. For foreign law governed contracts this requires recognition of those powers. The Financial Stability Board (FSB) has committed to making adherence to contractual recognition of resolution stays in cross-border contracts subject to regulatory requirements by 2017. As a result, global regulators have been discussing the extension of the ISDA Resolution Protocol (ISDA Protocol), which provides for a stay, to other traded products.
The EU Bank Recovery and Resolution Directive (BRRD), as transposed into the Banking Act 2009, enables (in certain prescribed circumstances), the Bank of England (BoE) to temporarily suspend termination rights (the stay power) in addition to being able to ensure that a resolution action (or pre-resolution action) will not give rise to a counterparties right to terminate a contract with a firm in resolution (the override power). Whilst the BRRD ensures that a stay power and an override power would be recognised and given effect throughout Europe, it is unclear whether a court in a non-EU jurisdiction would enforce the exercise of either power over contractual terms unless the law of that jurisdiction expressly recognised foreign resolution actions. The proposed rules contained in the consultation paper aim to fill this gap by requiring contractual recognition. This approach is similar to the requirement for contractual recognition of bail-in for non-EU law-governed contracts under Article 55 of the BRRD.
The document linked here sets out a table which compares the proposed rule with the PRA's requirements on contractual recognition of bail-in.
Whilst the PRA had indicated that the application of the proposed rule would be consistent with Article 55 of the BRRD (contractual recognition of bail-in), its scope is wider. Section 1.2 of the proposed rule extends the scope of the rule to UK credit institutions, PRA-designated investment firms, their holding companies, and also to all credit institutions, investment firms and financial institutions that are subsidiaries of any of the foregoing, regardless of their location (together in-scope entities). In-scope entities would therefore include banks, brokers, asset managers and other providers of related financial services, and intermediate holding companies – regardless of whether they are within scope of any resolution powers – where they are members of UK banking groups.
The draft rule applies to “financial arrangements”. This captures securities contracts, commodities contracts, futures and forwards contracts, swap agreements, all other derivatives and master agreements for any of the above or for contracts for the sale, purchase or delivery of a currency.
The rule would apply to financial arrangements between an in-scope entity and any counterparty, except designated payment and securities settlement systems, recognised central counterparties, central banks or central governments.
As currently drafted, not all non-EEA financial market infrastructure (FMI) will be excluded. This will give rise to similar issues currently being faced by firms implementing Article 55 of the BRRD.
The proposed rule would prohibit an in-scope entity from creating new obligations or materially amending an existing obligation under a financial contract from the relevant implementation date unless (in broad terms) the counterparty has agreed in writing to be subject to the same restrictions on termination, acceleration, close-out, set-off and netting as would apply on resolution to a UK law-governed financial contract with a UK bank.
The PRA has suggested that ‘new obligations’ would include a rollover or renewal of a transaction and a ‘material amendment’ would not include changes that occur automatically by the terms of the contract, such as interest or exchange rate resets – nor would it apply to simple administrative changes.
The consultation paper briefly considers record-keeping requirements. Section 3 refers to the ongoing European Banking Authority (EBA) work in this area (as required under the BRRD) and states that while the PRA is not proposing further requirements for record-keeping, it does expect firms to be able to provide information on their financial contracts.
Timing and transitionals
In order to maintain the benefits of cross product netting and overall portfolio margining, the PRA proposes to introduce the rule on a counterparty-by-counterparty basis rather than a product-by-product basis. As a result, there will be staggered implementation dates as follows:
- 1 January 2016: credit institutions and investment firms;
- 1 July 2016: asset managers (and the funds they manage), insurers and other counterparties that act on an agency basis;
- 1 January 2017: all other counterparties.
An uphill challenge
Implementation of the proposed rule appears challenging for UK headquartered internationally active banks – exacerbated by the unnecessary breadth of scope of the proposed rule and the obscurity of the requirement, which will be hard for counterparties to understand. Given the substantial overlap with Article 55 of the BRRD in terms of scope, application and timing, firms will need to manage implementation of the two sets of requirements together – rendering the staggered implementation proposal unrealistic.
The ISDA Protocol is mentioned in the consultation paper and the PRA have made clear that they expect a similar solution to be developed this year for standardised documentation in relation to securities financing and repo transactions – such an approach is also supported by FSB member authorities. Given the length and complexity of the ISDA Protocol, it is not clear if this approach would be optimal and despite substantial learning during that process, an extension of the ISDA Protocol is unlikely to be straightforward.