Introduction

On November 23 2016 the European Commission published a legislative proposal amending the Bank Recovery and Resolution Directive (EU Directive 2014/59/EU) to modify creditor hierarchy in insolvency with a view to facilitating the resolution of EU credit institutions. The proposal, which was fast tracked, resulted in the adoption of EU Directive 2017/2399 (December 12 2017), which amends the Bank Recovery and Resolution Directive as regards the ranking of debt instruments in insolvency. EU Directive 2017/2399 must be implemented by the member states by December 29 2018.

EU Directive 2017/2399 introduces a new rank in insolvency for ordinary, long-term, unsecured debt instruments issued by credit institutions and financial institutions within their consolidation perimeter that are established in the European Union. These so-called 'senior non-preferred' instruments will rank as senior to regulatory capital, but as junior to other senior liabilities.

This proposal is designed to improve the resolvability of EU institutions. In particular, in line with the objectives of the Financial Stability Board's total loss absorption capacity (TLAC) standard and the Bank Recovery and Resolution Directive's minimum requirement for own funds and eligible liabilities (MREL), it will allow resolution authorities to bail-in senior ordinary bonds in priority to other senior liabilities, rather than being required (as is the case under the Bank Recovery and Resolution Directive) to bail-in all such bonds simultaneously and on a pari passu basis bail-in all senior liabilities, including operational liabilities, derivatives and deposits, which are difficult to bail-in.

EU Directive 2017/2399 builds on legislation recently enacted in certain members states (including France, Germany and Italy) and is closely aligned with the 2016 French Sapin 2 law.

Existing EU framework

The Bank Recovery and Resolution Directive framework requires the capital and debt instruments of an entity in resolution to be written down or converted in accordance with the following loss absorption waterfall:

  • common equity Tier 1 items;
  • additional Tier 1 instruments;
  • Tier 2 instruments;
  • subordinated debt that is neither Tier 1 nor Tier 2 capital, in accordance with the hierarchy of claims in insolvency under national law;
  • other eligible liabilities, in accordance with the hierarchy of claims in insolvency under national law;
  • deposits from natural persons and micro, small and medium-sized enterprises that exceed the amount of covered deposits; and
  • covered deposits and deposit guarantee schemes subrogated to their rights.

Claims within the same rank in the above waterfall must be reduced pari passu among themselves. In addition, the 'no creditor worse off' principle applies (ie, creditors must not suffer worse treatment in resolution than they would have suffered in insolvency and are entitled to compensation for the difference).

As an exception to the pari passu treatment, certain categories of eligible liability can be excluded from the resolution waterfall pursuant to Article 44(3) of the Bank Recovery and Resolution Directive in certain exceptional circumstances – for example, if:

  • the liability cannot be bailed-in within a reasonable time;
  • the exclusion is strictly necessary to ensure critical functions and core business lines;
  • the exclusion is strictly necessary to avoid widespread contagion, especially with respect to eligible deposits that would cause a serious disturbance to the economy of a member state or the European Union; or
  • the application of the bail-in tool to those liabilities would cause a destruction in value such that the losses borne by other creditors would be higher than if those liabilities were excluded from bail-in.

However, the Article 44(3) exclusions remain subject to the 'no creditor worse off' principle. Accordingly, where a resolution authority decides to exclude or partially exclude an eligible liability or class of eligible liabilities under this provision, the level of write down or conversion applied to other eligible liabilities may be increased to take account of such exclusions, to the extent that the holders of such eligible liabilities do not suffer a greater loss than they would have suffered in insolvency.

As a result, except under Article 44(3) (which may give rise to indemnity claims under the 'no creditor worse off' principle and is therefore not optimal from the standpoint of the resolution authority), the Bank Recovery and Resolution Directive framework does not allow resolution authorities to bail-in certain liabilities in priority to others if those liabilities have the same rank under national insolvency law.

Specifically, in situations where senior liabilities must be bailed-in (ie, where the entity's regulatory capital does not provide a sufficient cushion to absorb losses), the Bank Recovery and Resolution Directive does not allow resolution authorities to bail-in senior debt investors in priority to holders of other senior liabilities (eg, operational creditors, holders of derivative liabilities or depositors).

Under the framework, resolution authorities are therefore faced with the following alternatives in the most critical situations (ie, where an institution's regulatory capital is insufficient to absorb losses):

  • bailing in senior liabilities, in which case all senior liabilities must be bailed-in pro rata (including operational liabilities, derivatives and eligible depositors), which may result in political risk, financial contagion and litigation;
  • excluding certain liabilities (eg, derivatives, operational liabilities or retail depositors) from bail-in under Article 44(3), which may result in litigation and indemnification pursuant to the 'no creditor worse off' principle; or
  • seeking to avoid placement in resolution and bail-in altogether.

In most of the post-directive banking crises where a bail-in of senior liabilities would have been required to absorb losses, resolution authorities have, perhaps unsurprisingly, sought to avoid resolution and bail-in altogether and reverted to the pre-directive method of addressing banking crises (ie, taxpayer funded bailouts, with the holders of subordinated debt being subject to burden sharing under state aid rules, thereby calling into question the effectiveness, credibility and usefulness of the Bank Recovery and Resolution Directive framework).

This was the case in particular with respect to:

  • the Greek banks recapitalised by the state-owned Hellenic Financial Stability Fund in November 2015 under the precautionary recapitalisation exception provided in Article 32(4) of Bank Recovery and Resolution Directive;
  • Banca Monte dei Paschi di Siena, recapitalised by the Italian state in July 2017 under the precautionary recapitalisation exception provided in Article 18 of EU Regulation 806/2014; and
  • Veneto Banca and Banca Popolare di Vicenza, placed in liquidation in June 2017 under the national insolvency rule (Article 18 of EU Regulation 806/2014).

The cases in which placement in resolution occurred did not require a bail-in of senior liabilities and resulted in protracted litigation.

The Financial Stability Board anticipated the potential impediment to resolvability resulting from the pari passu principle illustrated by these cases. It put forward the TLAC standard in November 2015. The standard requires global systemically important banks (G-SIBs) to hold a minimum amount of "minimum external loss-absorbing capacity" in the form of resources that are either regulatory capital or loss-absorbing liabilities that:

  • have a remaining maturity of at least one year;
  • do not consist of certain excluded liabilities (covered or short-term deposits, derivatives, structured notes, preferred or secured liabilities, liabilities that are legally excluded from bail-in or cannot be bailed-in without giving rise to material risk of successful legal challenge or indemnity claims); and
  • are subordinated (including through a junior rank under insolvency law) to such excluded liabilities.

Directive

EU Directive 2017/2399 implements the TLAC principles in the EU framework by requiring member states to introduce a new statutory senior non-preferred rank in insolvency for credit institutions and financial institutions within their consolidation perimeter that are established in the European Union.

In order to be eligible for senior non-preferred rank, liabilities must have the following characteristics:

  • they must be unsecured claims arising out of debt instruments (ie, bonds and other forms of transferrable debt and instruments creating or acknowledging a debt);
  • their contractual documentation must expressly refer to this ranking;
  • their initial contractual maturity must be at least one year; and
  • they must neither be derivatives nor contain embedded derivatives – in particular, debt instruments with variable interest derived from a broadly used reference rate such as Libor or Euribor (ie, floating rate debt instruments) and debt instruments not denominated in the domestic currency of the issuer (provided that principal, repayment and interest are denominated in the same currency), will not be considered to be debt instruments containing embedded derivatives solely because of those features.

The new rank will be eligible for instruments issued after the entry into force of national measures implementing EU Directive 2017/2399, subject to grandfathering provisions taking into account regimes implemented in certain member states before December 31 2016 in order to implement the TLAC standard, as well as measures adopted by member states after December 31 2016 to anticipate the adoption of the directive.

Given that senior non-preferred instruments are designed to absorb losses in priority to other senior liabilities, the European Parliament's Committee on Economic and Monetary Affairs (ECON) proposed several amendments driven by the wish to protect investors buying those instruments, ranging from specifying that senior non-preferred instruments will qualify as complex under Article 25 of EU Directive 2014/65/EU to proposing that "only professional clients should be allowed to purchase" such instruments. These principles, while not incorporated in the directive, are in any event – at least, in part – reflected in the European Securities and Markets Authority guidelines on complex debt instruments and structured deposits, which provide that all "debt instruments eligible for bail-in tool purposes" are to be deemed complex.

The ECON draft report (September 8 2017) also proposed adding an additional rank consisting of debt instruments, which would rank senior to senior non-preferred debt, but junior to all other ordinary unsecured claims. This proposal was in line with the European Central Bank recommendation to introduce "a general depositor preference, based on a tiered approach". However, it was not reflected in the directive, which maintains a preference for covered deposits, as well as deposits from natural persons and micro, small and medium-sized enterprises, but does not introduce a general preference covering depositors such as corporate depositors. EU Directive 2017/2399 nevertheless leaves member states free to adopt a general deposit preference under their national laws:

  • The new ranking will allow EU G-SIBs to issue instruments with a lower cost than regulatory capital, which still count towards their minimum TLAC requirements. Senior non-preferred instruments will also allow institutions to meet their institution-specific MREL, which applies to all EU institutions, not only G-SIBs (where competent authorities require MREL to be met with instruments that are subordinated to ordinary unsecured liabilities).
  • Due to the fact that senior non-preferred instruments will rank senior to regulatory capital, they will be subject to bail-in only if the institution is placed in resolution and will not be subject to mandatory write-down and conversion at the point of non-viability under Article 59 of the Bank Recovery and Resolution Directive (which applies to regulatory capital instruments only).
  • The new rank ensures that that claims resulting from ordinary commercial relationships with the banks (eg, operational liabilities and deposits, including non-retail) are subject to a lower risk of bail-in than bonds, which are subscribed on the basis of a deliberate investment decision.
  • EU Directive 2017/2399 should not affect the rank in insolvency of existing senior instruments, which should continue to rank senior to senior non-preferred instruments.
  • EU Directive 2017/2399 reduces the disparity between national bank insolvency regimes, which had created uncertainty for investors and potential difficulties when applying resolution tools in a cross-border context. However, it does not fully eliminate such disparities, since member states remain entitled to create several classes within senior liabilities (as well as a general or tiered depositor preference).

This article was first published by the International Law Office, a premium online legal update service for major companies and law firms worldwide. Register for a free subscription.

For further information on this topic please contact Amélie Champsaur, Bernardo Massella Ducci Teri or Michael Kern at Cleary Gottlieb Steen & Hamilton LLP by telephone (+33 1 40 74 68 00) or email (achampsaur@cgsh.com, bmassella@cgsh.com or mkern@cgsh.com). The Cleary Gottlieb Steen & Hamilton LLP website can be accessed at www.clearygottlieb.com.