Introduction of senior non-preferred debt in the Netherlands
3 April 2018
FCS Financial Law
A new EU Directive adopted in December 2017 will enable EU banks, large investments firms and relevant group companies (e.g. holding companies) to issue so-called 'senior non-preferred' debt instruments.
Such senior non-preferred debt will rank senior to regulatory capital instruments (CET1, AT1 and Tier 2) and other subordinated debt, but junior to the institution's senior debt (such as deposits and ordinary creditors).
The introduction of this instrument aims to facilitate the application of bail-in under BRRD and it allows institutions to maintain sufficient - subordinated - 'bail-inable' capital (also known as 'MREL' or 'TLAC').
The Netherlands proposed implementing Act was published on 9 March 2018.
The legislative proposal appears to allow institutions to already issue debt instruments prior to its entry into force that would automatically 'flip' to the senior non-preferred status upon entry into force. It is however questionable whether this is in line with the transitory regime under the EU Directive. Parties that intend to issue such instruments prior to the entry into force of the Act are advised to consider to include a manual 'flip' in the terms and conditions as a back-up measure.
On 9 March 2018, the Netherlands legislative proposal implementing Directive (EU) 2017/2399 as regards the ranking of unsecured debt instruments in insolvency hierarchy (the Amending Directive). The Amending Directive, which was published in the Official Journal on 27 December 2017, amends the Bank Recovery and Resolution Directive (BRRD), with a view to introducing the possibility for banks, large investment firms and certain group companies to issue so-called 'senior non-preferred' debt instruments. This newsletter discusses the Amending Directive and the Dutch draft legislation.
Bail-in under BRRD and SRM The BRRD, together with the Regulation (EU) No 806/2014 establishing the Single Resolution Mechanism (SRMR), provided for a uniform framework for the recovery and resolution of EU banks, large investment firms and certain group companies (together: institutions). The framework has provided the competent supervisory and resolution authorities with certain recovery and resolutions tools and the powers to implement these tools. One of these tools is the bail-in tool. The bail-in tool allows for the write-down or conversion (into equity) of capital instruments or eligible liabilities in a certain order, in order to absorb losses and to recapitalize an institution that is failing or likely to fail. The order that has to be followed by the competent authority is essentially the hierarchy of creditors in an insolvency of the institution, but in the reverse order.
Limitations: No creditor worse off An important principle of the BRRD and the SRMR is that no creditor should be worse off as a result of an institution being resolved than under normal insolvency proceedings (the NCWO-principle). This principle may affect the effectiveness of the bail-in tool in case liabilities of an institution cannot be written-down or converted, for instance because the liabilities are exempted from the scope of the bail-in tool or because a bail-in of such liabilities is not deemed possible or for other reasons excluded by the resolution authority. This may entail that creditors of similar or higher rank would have to absorb more losses, which could result in the NCWO-principle being breached.
MREL and TLAC To support the effectiveness of the bail-in tool, the BRRD and SRMR require institutions to maintain a minimum requirement for own funds and eligible liabilities (MREL). The liabilities that are eligible for MREL (and thus bail-in) include all liabilities of an institution, unless exempted (including deposits covered by Deposit Guarantee Schemes and secured liabilities). Currently, there is no statutory requirement for liabilities to be subordinated in order to be eligible for MREL. In other words, senior unsecured debt of an institution can be eligible, while the vast majority of categories of liabilities exempted from the bail-in tool also qualify as such senior debt, i.e. ranking pari passu with such debt. This increases the risk of the NCWO-principle obstructing the application of the bail-in tool.
Although resolution authorities have the possibility to on a case-by-case basis require a certain percentage of MREL to consist of subordinated debt and new legislation (also known as TLAC) is upcoming to subject certain of the largest institutions (including at least G-SIIs / G-SIBs) to a certain subordination requirement, this may leave many institutions for which impediments to applying the bail-in tool exist.
Measures in some Member States - diverging regimes In response to this, a number of Member States amended their insolvency hierarchy to allow institutions to comply with the subordinated requirement or to otherwise accommodate bail-in and prevent a breach of the NCWO-principle. This has however resulted in diverging regimes, creating uncertainty for issuing institutions and investors and making the application of bail-in for cross-border institutions (groups) more difficult. This in turn affects liquidity of issued instruments and increases the costs of issuing such instruments.
The Amending Directive
Introduction of senior non-preferred debt and eligibility criteria
With a view to the above developments, the EU has adopted the Amending Directive to provide for a harmonised framework for such amendments to the insolvency hierarchy. As part thereof, it has introduced a new category of debt: 'senior non-preferred' debt.
In insolvency, this level of debt will rank above (be paid earlier than / senior to) regulatory capital instruments and other subordinated debt and below (be paid later than / junior to) other senior liabilities. In bail-in, this level of debt will thus be subjected to bail-in after own funds and other subordinated debt, but before other senior liabilities. This order can be illustrated in a simplified manner (ignoring secured and other preferred
creditors) as follows, with covered DGS-deposits having the highest / best ranking and CET1 having the lowest ranking:
Criteria for senior non-preferred debt instruments The Amending Directive stipulates four criteria for institutions that wish to attract senior non-preferred debt:
I. The debt is attracted by an institution through issuing debt instruments within the meaning of the BRRD (notably bonds / notes);
II. the original contractual maturity of the debt instruments is at least one year;
III. the debt instruments do not contain embedded derivatives and are not derivatives themselves; and
IV. the relevant contractual documentation and, where applicable, the prospectus explicitly refers to the lower ranking under the relevant BRRD paragraph (i.e. Article 108, second paragraph, BRRD).
Transitory Regime The Amending Directive was published on 27 December 2017 and entered into force on 28 December 2017. Member States are required to implement the Amending Directive by 29 December 2018. The
Amending Directive does however provide for the following transitory regime:
Member States without similar legislation before 28 December 2017: The insolvency hierarchy of a Member State as adopted at 31 December 2016 applies to unsecured debt instruments issued prior to the date of entry into force of the legislation implementing the Amending Directive.
Member States with similar legislation adopted after 31 December 2016 and before 28 December 2017: If a Member State adopted legislation similar to the Amending Directive after 31 December 2016 and before 28 December 2017, unsecured debt instruments issued after the application of that national legislation shall be subject to such legislation and its lower ranking. Upon entry into force of the legislation implementing the Amending Directive, new senior nonpreferred debt instruments will have the same ranking as the aforementioned unsecured debt instruments.
Member States with comparable legislation adopted prior to 31 December 2016: Member States that prior to 31 December 2016 adopted national legislation which amended the rankings of unsecured debt of institutions may provide that debt instruments with the lowest priority among such unsecured debt have the same ranking as that of new senior nonpreferred debt instruments.
The Netherlands implementing legislation
The Netherlands proposal The legislative proposal implementing the Amending Directive (the Dutch Proposal) proposes to amend the Dutch Bankruptcy Code (Faillissementswet) to introduce the senior non-preferred ranking. It does so by making clear in a new Article 212rb that:
I. claims arising from debt instruments as referred to in the BRRD and
II. meeting the criteria in the Amending Directive (Article 108, second paragraph, BRRD) can be recovered from the insolvency estate "immediately" after claims of senior creditors and before claims which have on any basis been subordinated to the senior creditors (we read this as: the claims of the senior creditors).
The use of "immediately" is apparently intended to prevent parties from providing for a contractual arrangement which would introduce a new category between senior non-preferred and senior debt. This is made clear further by the Dutch Proposal stipulating that the senior nonpreferred instruments have a similar rank among other senior nonpreferred instruments. Finally, the Dutch Proposal provides that the new Article 212rb applies to any insolvent party that was an institution (i.e. a bank, large investment firm or certain group company) at the time of issuing the senior non-preferred debt instruments, irrespective of its status at the time of insolvency.
A gap in the Dutch Proposal for the transitory regime? It is noteworthy that the explanatory notes to the Dutch Proposal state that debt instruments meeting the relevant criteria issued prior to entry
into force of the Dutch Proposal (e.g. by referring to the lower ranking in the contractual documentation / prospectus) will upon entry into force of the Dutch Proposal 'flip' in ranking (van rang wisselen) from senior debt to senior non-preferred debt. Although the Dutch Proposal is not intended to impact the ranking of existing debt instruments, it is apparently possible to anticipate the entry into force of the Dutch Proposal in issuing new instruments by referring to the lower, senior nonpreferred ranking (and meeting the other relevant criteria). In itself, this can be encouraged.
Although certain market parties have during the consultation phase asked the legislature to provide for explicit transitory rules, the legislature has not found this to be necessary. Looking at the transitory regime prescribed by the Amending Directive, it is questionable whether the Netherlands legislature is correct in this respect.
The Amending Directive clearly leaves room for existing debt instruments to anticipate the new senior non-preferred ranking where these have been issued under similar / comparable national legislation (i) that was adopted prior to 31 December 2016 or (ii) that entered into force after 31 December 2016 and before 28 December 2017. In the absence of such similar / comparable legislation (as is the case for the Netherlands), the Amending Directive explicitly provides that Member States have to ensure that the insolvency hierarchy as adopted at 31 December 2016 will apply to any instruments issued prior to the date of entry into force of the legislation implementing the Amending Directive. In other words, contrary to the Dutch legislature's intentions, the Amending Directive does not appear to allow for the issuing of instruments that anticipate the new ranking and that rely on an 'automatic' flip in ranking from senior debt to the senior non-preferred debt after such legislation enters into force.
Advice to market parties that wish to issue instruments during the transition period
Without prejudice to the above, the Dutch Proposal in its current form indeed seems to allow for the issuance of debt instruments that would 'flip' to the new senior non-preferred ranking upon entry into force of the Dutch Proposal. Nonetheless, as this is not provided for in the Amending Directive and the Dutch Proposal may be in breach thereof, market parties that wish to issue senior-non preferred debt instruments prior to the entry into force of the Dutch Proposal are advised to consider whether to include back-up contractual provisions in the terms and conditions of the instruments. This could for instance take the form of a manual 'flip' to the senior non-preferred ranking by making use of a substitution / variation right in respect of the existing debt instruments upon entry into force of the Dutch Proposal.
Entry into force Finally, the Dutch Proposal is subject to parliamentary debate and thus change. An expected date of entry into force has unfortunately not yet been announced, but is any case expected to be before the end of 2018.
Larissa Silverentand Partner T +31 20 71 71 716 M +31 6 53 95 93 61 E Larissa.Silverentand@nautadutilh.com Frans van der Eerden Partner T +31 20 71 71 697 M +31 6 51 86 97 12 E Frans.vanderEerden@nautadutilh.com Sven Uiterwijk Senior Associate T +31 20 71 71 595 M +31 6 20 21 05 70 E Sven.Uiterwijk@nautadutilh.com