On 7 October 2008, Parliament heard the first reading of the Banking Bill. The second reading started on 14 October. The Banking Bill will replace the Banking (Special Provisions) Act 2008, which will lapse in February 2009.
The Banking Bill applies to UK banks that have permission to take deposits. It does not apply to UK branches of EEA banks.
The Bill proposes several legal changes in response to the current banking crisis. These range from, on the one hand, giving the Bank of England a financial stability objective to, on the other, amending the law on issuance of bank notes by Scottish and Northern Irish commercial banks. But arguably the most important innovation in the Bill is the so called special resolution regime (SRR) set out in Part 1 to deal with failing banks. This article looks at the SRR and discusses the impact it is likely to have on counterparties of UK banks.
Stabilisation options and stabilisation powers, and the role of HM Treasury, the Bank of England and FSA
Under the SRR, the Bank of England and HM Treasury will have the power to exercise three stabilisation options. They can transfer a failing bank to:
- a private sector commercial purchaser;
- a bridge bank (a company wholly owned by the Bank of England); or
- the public sector.
The Bank of England would use the stabilisation powers to make a share or property transfer instrument for either of the first two options. HM Treasury would make a property transfer order for the third option and take a bank into temporary public ownership.
The instrument or order would effect the relevant transfer by law and in accordance with its terms. It may provide for a transferee to be treated as the same person as the transferor for any purpose connected with the transfer. It may also provide for agreements made or things done by the transferor to be treated as made or done by or in relation to the transferee.
Transfer orders or instruments may relate to the transfer of all or some of a specified bank’s securities or property. For the purposes of the SRR, securities and property have unusually wide definitions. “Securities” includes shares, debentures and warrants and also any other rights a deposit taker grants and which form part of its own funds for capital purposes. “Property” has a similarly wide definition and includes not just property in the usual sense, but also liabilities.
The Financial Services Authority’s (FSA) role in the SRR is one of scrutiny. The Bank of England and HM Treasury must consult with it and the other tripartite authority before exercising their stabilisation powers. Generally, FSA must be satisfied that (1) a bank fails to meet the threshold conditions and (2) (ignoring the stabilisation powers) it is reasonably likely that action will not be taken to meet those conditions. FSA must consult with HM Treasury and the Bank of England on condition (2). The threshold conditions (set out in Schedule 6 of the FSMA ) are high level and include requirements about a bank’s group ownership, fitness and propriety and the adequacy of its resources. But the requirements do not only relate to financial resources, so FSA could consent to the stabilisation power being exercised if, for example, it is not satisfied with other entities with which the failing bank has close links.
Special resolution objectives
In exercising any of the powers under the SRR, the tripartite authorities must have regard to the special resolution objectives set out in section 4 of the Bill. The objectives have no order of importance and the authorities must give them equal weight. They are:
- the financial stability of the banking system of the UK;
- public confidence in the stability of the banking system;
- the protection of depositors;
- the protection of public funds; and
- avoiding interference with the human right to property enshrined in the Human Rights Act.
Special resolution regime code of practice
HM Treasury must also issue a code of practice about the use of the SRR powers, and must consult on the code with FSA, the Bank of England and the scheme manager of the Financial Services Compensation Scheme (FSCS). It must lay the code before Parliament for information. The code of practice will cover among other things:
- management and control of bridge banks and transferees sold into public ownership;
- publication of share transfer orders and instruments (“as soon as is reasonably practicable after making a share transfer instrument”); and
- how to achieve the resolution objectives.
The Bill is not comprehensive about what the code of practice may contain, but presumably it will give guidance on how to decide which stabilisation option to use. Generally, a transfer to a commercial purchaser will be preferable to a transfer to a bridge bank or to public ownership. That said, the Bill contemplates onward transfers, so that some of these options may be merely temporary solutions.
Consequences of exercising stabilisation options
Making a share transfer instrument or order or a property transfer order could have a significant adverse impact on:
- directors of the affected bank;
- holders of shares and debentures of the affected bank;
- creditors; and
- group companies.
Either HM Treasury or the Bank of England may under a share transfer arrangement:
- vary the service contract of; or
- end the service contract of
a director of an affected bank and appoint a director of that bank. Appointments of new directors will be on the terms and conditions agreed with the Bank of England or HM Treasury.
Holders of securities
The Banking Bill provides for compensation to be paid to shareholders and other transferors affected by the transfer. If the Bank of England transfers shares or property to a private sector purchaser, HM Treasury must make a compensation scheme order. The compensation scheme order may include a third party compensation order. This does not mean that shareholders will necessarily get compensation, indeed the order is to set up a scheme to decide whether compensation should be paid.
Under Clause 16 of the Bill anyone with a lesser interest in shares and debentures such as security rights or rights under a trust or an option to buy securities may lose those rights altogether. HM Treasury only has to include a third party compensation order if the transfer is a partial property transfer; a third party compensation order is not mandatory if all the property is transferred. Third parties whose rights were extinguished may not receive any compensation whatever.
With a property transfer to a bridge bank, HM Treasury must make a resolution fund order. This is an order which will set up a scheme under which transferors will become entitled to the proceeds of the sale of the things transferred to the extent and in the circumstances set out in the order.
If there is a transfer to temporary public ownership, HM Treasury must make either a compensation scheme or a resolution fund order and these may include a third party compensation order.
The Banking Bill effectively prevents creditors of banks from calling a share transfer or a property transfer made under the special resolution regime an event of default. Anticipating clever drafting around this provision, the Bill also provides that actions or decisions leading to a transfer must be disregarded for calling a default. So, for example, existing master agreements under which derivatives are traded or shares are lent and borrowed cannot be terminated on this basis.
If adopted, this provision is likely to make it hard for UK lawyers to give opinions (which some institutions require under capital rules) that netting works. This could increase the credit risk which banks take against each other and as a result, the amounts of capital which financial institutions are required to hold to cover their exposures to other banks. Doubtless if this were the result, it would be perceived as something of an own goal by the Government.
It is also conceivable that assets may be cherry picked so that good assets go to a bridge bank or into public ownership leaving the counterparty with a claim on the residual and much weakened bank. The Bank of England can decide which “property” (i.e. including assets and liabilities) to transfer, and although the Treasury has the power to restrict the making of such an order if it affects security interests or set-off and netting, there is no duty on HM Treasury to make such an order.
Following a partial property transfer, the residual bank and any group companies of the residual bank must continue to provide services and facilities to make it possible for the transferred bank to run effectively. The Bank of England may tell a residual bank or group company what is needed. In addition, the Bank may interfere in contracts between a residual bank, transferee bank and/or group company. This could have an adverse effect on international relations if exercised against a UK subsidiary of a foreign bank.
Other contentious provisions
A property transfer instrument may include foreign property, and if it does, the transferee and transferor must do what is necessary to make sure the transfer is effective as a matter of foreign law. The Bill does not say what will happen if, when the order was made, the property was sold (or encumbered) in that foreign country to an innocent third party.
Power to amend the law
Under Clause 65 of the Bill, the Treasury is given the power to amend the law for the purpose of enabling the special resolution regime powers to be used effectively. This can include changing any legislation or any provision or common law and, at least in relation to a particular exercise of power under the Banking Bill, it may do so retrospectively. Although this power will be subject to Parliamentary scrutiny, anything done under an order before Parliament approves it will stand.
The Banking Bill contains extremely wide powers which may have unintended consequences. Draconian powers given to Government agencies may make sense in the face of adversity (witness the terrorism legislation in the context of the war on terror). But they could be used in all sorts of ways which may not be foreseen at the time. The recent use of widely-drawn anti-terrorism legislation to achieve the freezing of the assets of Landsbanki UK branch is a case in point.
It may be difficult to argue for the rule of law in this context when the Government is bailing out the finance industry. But it would be a pity if legislation adopted in extraordinary times unnecessarily undermines one of the fundamental planks of the UK’s unwritten constitution.