Legislation implementing the EU Bank Recovery and Resolution Directive ("BRRD") in Netherlands law and facilitating the application of the EU Single Resolution Mechanism Regulation ("SRM Regulation") was approved by the Upper Chamber of the Netherlands parliament on 10 November 2015 and is expected to enter into force before the end of this year. The new law – the "European Framework for the Recovery and Resolution of Credit Institutions and Investment Firms Implementation Act" – will be referred to below as the "Implementation Act".
In prior newsletters we discussed the consultation version of and the legislative proposal for the Implementation Act, as well as the BRRD and the SRM Regulation themselves. In this newsletter we will focus on the requirement under the Implementation Act that Netherlands banks, large investment firms and certain other institutions subject to the Implementation Act have to include a bail-in clause in certain agreements to which they are party if the agreements are governed by the law of a non-EU member state.
Background and scope
In short, the SRM Regulation and the BRRD have introduced a harmonised European framework for the recovery and resolution of banks and large investment firms which are failing or likely to fail. To enable the competent authorities to intervene in a timely manner, the BRRD (after implementation) and the SRM Regulation give them certain tools and powers. To ensure that these tools and powers are effective, the BRRD and the SRM Regulation require EU member states to impose various requirements on institutions or their counterparties. This newsletter discusses one of the requirements to be imposed: the requirement to include a bail-in clause in certain agreements.
The above requirement stems from the BRRD and, after implementation in the national legislation of the EU member states will apply, in short, to EU banks, large investment firms, and certain entities within a group such bank or investment firm forms part of. Where such institutions are established in the Netherlands, the requirement for a contractual bail-in clause applies pursuant to the Implementation Act. The requirement to include a bail-in clause in agreements pursuant to the Implementation Act appears however to differ in scope from the requirement reflected in the BRRD, because the requirement pursuant to the Implementation Act will also apply to certain EU branches of non-EU banks or large investment firms.
AFOMKI and bail-in
The contractual bail-in clause relates to the application of the following tools: (i) the write down or conversion of capital instruments (abbreviated in the explanatory memorandum to the Implementation Act as "AFOMKI" based on its Netherlands translation) and (ii) bail-in, and the accompanying write-down and conversion powers of the resolution authorities.
According to the BRRD, bail-in enables the competent resolution authority, if certain conditions are met, to write down, in whole or in part, some or all of the capital instruments and eligible liabilities of a failing institution or to convert them into shares or other instruments of ownership. Bail-in will usually be preceded by the application of AFOMKI, as a result of which a write-down or conversion in whole or in part of at least some of the institution's capital instruments will already have occurred. The Implementation Act even assumes that AFOMKI will always precede bail-in .
The national resolution authorities in the EU (in the Netherlands: the Netherlands Central Bank) will be awarded certain write-down and conversion powers in order to be able to apply the instruments of AFOMKI and bail-in (hereinafter together "bail-in") to such institutions. These powers will have to be exercised on the basis of national law implementing the BRRD.
With respect to liabilities which are governed by the law of an EU member state and which are not excluded from bail-in, the application of bail-in will be effective by operation of law. The legislation of each EU member state must provide that if liabilities governed by the law of that member state are written off or converted by the resolution authority of another member state, this will be recognised and enforced.
The effects of bail-in outside the EU
Institutions covered by the BRRD may, however, also incur liabilities (e.g. under capital instruments, bonds or other agreements) that are governed by the law of a country outside the EU (a "third country"), such as liabilities governed by the law of the State of New York or the law of Switzerland . It is uncertain whether bail-in will be effective with respect to such liabilities. This uncertainty is even greater if the agreement creating the liabilities designates the courts of a third country as the forum for the settlement of disputes in connection with such agreement. It cannot be ruled out that a third-country court will refuse to recognise and enforce bail-in. For example, such a court could recognise the exercise of set-off by an institution's counterparties in accordance with the law governing the agreement or, as the case may be, its national law in respect of all the institution's liabilities and not only those remaining after bail-in. This could be undesirable because, as a result of such set-off, the financial situation of the institution under resolution would in fact remain unchanged despite the application of bail-in, thereby adversely affecting the resolution process.
Solution under the BRRD: mandatory contractual bail-in clause
In an attempt to ensure that bail-in is effective against liabilities governed by the law of a third country, the BRRD requires EU member states to require institutions to include a bail-in clause in agreements which create liabilities governed by the law of a third country that are eligible for bail-in, which bail-in clause must pertain to such liabilities. For Netherlands institutions this requirement follows from Section 3A:13 of the Implementation Act.
For the avoidance of doubt: in general the law applicable to an agreement will also apply to the liabilities arising from such agreement. Consequently, although the Implementation Act refers to the law applicable to the agreement, whereas the BRRD refers to the law applicable to the liabilities arising therefrom, in practice this is unlikely to lead to different outcomes as regards the scope of the requirement to include a bail-in clause.
Pursuant to the Implementation Act, a bail-in clause must provide that the institution's counterparty agrees with the application and consequences of bail-in. In principle the type of agreement is irrelevant. However, the clause need only apply to liabilities that:
- are not excluded from bail-in (examples of excluded liabilities are covered deposits, secured liabilities and liabilities to institutions, other than group companies, with an original maturity of less than seven days);
- are not deposits from natural persons and micro, small and medium-sized enterprises to the extent such deposits exceed the coverage level provided for under the relevant deposit guarantee scheme or deposits from natural persons, micro, small and medium–sized enterprises that would be protected under the relevant deposit guarantee schemes if these deposits would not have been held with non-EU branches of EU institutions;
- are governed by the law of a third country.
The clause need not be included by institutions with respect to liabilities governed by the law of a third country if the resolution authority having jurisdiction over the institution determines that bail-in will be recognised pursuant to the law of that third country or pursuant to a binding agreement concluded with that third country. The Implementation Act also requires that the resolution authority has granted dispensation to the relevant Netherlands institution involved.
Moreover, the Implementation Act stipulates that the contractual bail-in clause need not apply to agreements entered into before entry into force of the requirements, unless provided otherwise by delegated regulation of the European Commission.
Regulatory technical standards issued by European Banking Authority
The European Banking Authority ("EBA") has already published draft Regulatory Technical Standards to further specify the contents and scope of application of a contractual bail-in clause.
The EBA has elected not to propose a standard clause because of the possibility that such a clause may not be effective in all jurisdictions or not be suitable for all forms of liabilities that are supposed to be covered by the bail-in clause.
Contents of the bail-in clause
Instead, the EBA has proposed a number of elements that must be included in the clause and which must apply in relation to liabilities eligible for bail-in issued (e.g. in the case of capital instruments or debt instruments) or entered into (e.g. in the case of agreements) by the institution. These are:
- the acknowledgement and acceptance by the institution's counterparty that the liability may be subject to the exercise of write-down and conversion powers by a resolution authority;
- a description of those powers (a reference to the provisions of the Implementation Act or the BRRD will probably not suffice);
- the acknowledgement and acceptance by the institution's counterparty:
- that it is bound by the effect of the application of a resolution authority's write-down and conversion powers in respect of eligible liabilities, including (x) a reduction in the principal amount or outstanding amount due (including any accrued but unpaid interest), and (y) their conversion into shares or other instruments of ownership;
- that the terms of the agreement creating the eligible liabilities may be varied as necessary to give effect to the exercise by a resolution authority of its write-down and conversion powers and that such variations will be binding on the counterparty;
- that the institution's shares or other instruments of ownership may be issued to or conferred on the counterparty as a result of the exercise of the write-down and conversion powers;
- the acknowledgement and acceptance by the institution's counterparty that the clause is exhaustive on the matters described therein and cannot be altered by any other agreements, arrangements or understandings between the institution and the counterparty relating to the subject matter of the agreement containing the clause (an entire agreement-clause).
When must a bail-in clause be included?
The EBA also gives more information on when a bail-in clause must be included.
The basic rule is that the clause must apply to liabilities eligible for bail-in issued or entered into after the date of application of the requirement to include the clause in the relevant member state. According to the EBA, these liabilities comprise:
- liabilities created after the above date, regardless of whether they are created under agreements (including the terms of a capital instrument) entered into before that date;
- liabilities created before or after the above date under agreements (including the terms of a capital instrument) entered into before that date which undergo a "material amendment";
- liabilities under debt instruments issued after the above date;
- liabilities under debt instruments issued before or after the above date under agreements entered into before that date which undergo a "material amendment".
According to the EBA, a material amendment is an amendment that is not a non-material amendment. A non-material amendment is an amendment, including an automatic amendment, which does not affect the substantive rights and obligations of a party to an agreement or issuance, such as a change to the contact details, changes to correct grammatical errors or automatic adjustments of interest rates.
To summarize, a contractual bail-in clause must according to EBA be included in respect of liabilities eligible for bail-in created after the entry into force of the requirement to include the clause in the EU member state in which the institution is established, and in respect of such liabilities created before the entry into force of that requirement if the agreement undergoes a material amendment after the entry into force of that requirement.
The EBA does not explain when, in its view, liabilities "are created". In our opinion it is logical to treat e.g. certain delivery and payment obligations laid down in an agreement as being created on the date the agreement is entered into, irrespective of when these obligations must actually be performed and are enforceable. However in the case of, in particular, master agreements – pursuant to which multiple transactions are entered into – the decisive date will generally be the date of the relevant transaction and not the date of the master agreement. It is interesting to consider whether this approach is compatible with the single agreement principle, under which the master agreement and all transactions together form one agreement. See, for example, Section 1(c) of the ISDA Master Agreement. This is a question which must in the first instance be answered under the law applicable to the relevant master agreement.
As indicated above, the BRRD excludes secured liabilities from bail-in. The EBA elaborates on this by stating that the exclusion does not apply to the extent that (i) the liability is not fully secured (this already follows from the BRRD) or (ii) the liability is fully secured but governed by contractual terms that do not oblige the institution in question to maintain the liability fully collateralised on a continuous basis in accordance with regulatory requirements of EU law (such as the Capital Requirements Regulation) or comparable requirements under the law of a third country.
Foreign courts and contractual bail-in clauses
When a dispute with respect to a contractual bail-in clause is brought before the competent (foreign) court, such court shall generally first assess the law applicable to such clause pursuant to its own conflict of laws rules. It is likely that such applicable law shall be the law applicable to the agreement in which the clause is included. The court shall subsequently have to decide whether to recognise and enforce the clause on the basis of the applicable law. To increase the likelihood of enforceability of the bail-in clause under the law of the third country that is applicable to the agreement in which the clause is included, the clause should be drafted and agreed to in accordance with the law of that third country. In this connection the Implementation Act provides that the competent resolution authority may require the institution to provide a statement by an independent expert (often in the form of a legal opinion) confirming that the clause is enforceable under the law of the relevant third country.
As indicated above, it is expected that the Implementation Act will enter into force this year. The requirement to include a contractual bail-in clause will probably apply immediately. Netherlands banks and other institutions covered by the Implementation Act should determine which of their agreements (including agreements relating to capital instruments and debt instruments issued by them) must include such a clause. The clause should then be drafted and agreed to in accordance with the law of the relevant third country.
The full details of the rules applicable to contractual bail-in clauses will, however, probably not yet be available on the date the Implementation Act enters into force. The EBA's proposed regulatory technical standards must still proceed through the European legislative process and are, unfortunately, still subject to change. Nevertheless, in our opinion the standards in their current form provide a good basis for taking preparatory action.