EU Requirements for Contractual Bail-In Clauses
“Bail-in” clauses, which have become a standard feature of contracts between European financial institutions and non-European parties, stipulate that European financial regulators have the power to write down, cancel or convert to equity the obligations of the financial institution.
The bail-in rules form part of a comprehensive package of measures under EU law designed to permit orderly rescue or wind-down of distressed banks. The power of European regulators to invoke the bail-in option is recognized by the law of all EU member states and should be respected by any court in those countries, whether or not the relevant contract includes bail-in language. However, courts in other countries (“third countries”) might rule differently.
For that reason, EU bail-in legislation requires certain regulated financial institutions to include bail-in language in certain obligations subject to the law of a third country (such as those subject to New York law) entered into after Jan. 1, 2016, including new contracts or material amendments of older contracts.
The bail-in mechanism is one of several measures created by the EU “Bank Resolution and Recovery Directive” (BRRD) of May 15, 2014,1 establishing “a framework for the recovery and resolution of credit institutions and investment firms.” The BRRD sets out requirements for legislation to be adopted by countries in the European Economic Area, i.e., the 28 EU Member States (all of which have enacted corresponding legislation), plus Iceland, Liechtenstein and Norway.2
Along with other measures, the BRRD established four “tools” that regulators can use in a “resolution” proceeding to deal with financial institutions in distress:
- The “sale of business” tool, allowing authorities to sell the distressed institution.
- The “bridge institution” tool, allowing them to ring-fence compromised assets in a new institution — typically, a “bad bank” — while permitting the distressed institution to continue operations with its remaining assets.
- The “asset separation” tool, which allows spinning off certain assets, typically in an asset-management vehicle.
- The “bail-in” tool, used in conjunction with one or more of the other tools, and that allows reducing, canceling or converting the rights of creditors.
How A Bail-in Is Supposed to Operate
In theory, if a bail-in occurs, the extent to which rights of creditors (and shareholders) will be compromised is limited by operation of the “No Creditor Worse off Than Under Liquidation” (NCWOL) test, pursuant to which public authorities are supposed to treat creditors and shareholders no worse than they would be treated in a normal bankruptcy proceeding. Indeed, some studies conclude that under a resolution procedure, losses of stakeholders should be substantively lower than under a full-blown liquidation, so that there is supposed to be a win-win result for creditors and for the public.
The resolution procedure for a distressed financial institution is designed to be implemented very quickly — the image of public authorities acting over a weekend comes to mind — and to involve exercise of discretion as to which liabilities will be reduced or converted. However, post-implementation, creditors and shareholders are entitled to have their rights valued independently and to appeal that determination, with extra compensation to be received to the extent that the NCWOL test is not met.
As a policy measure, the bail-in rules are expected to be both dissuasive, presumably fostering balance sheet discipline by financial institutions, and operational, in case of the debtor’s financial distress and the need for “resolution” via restructuring or liquidation.
It remains to be seen whether or not this mechanism will put a damper on the next speculative bubble or work smoothly if called on in any given case. But the measure has now become a mandatory feature of European financial market practice — and has generated a lot of paperwork.
Which Liabilities Must Contain Bail-in Clauses
Although bail-in rules will be enforceable in courts of EU Member States (and in other EEA member states), they may not automatically apply in third countries, such as the United States, unless the creditor has so agreed. Such an agreement by the creditor, to allow compromise by public authorities of the creditor’s rights, is exactly what the bail-in rules require.
Under article 55 of the BRRD, implementing legislation passed at the national level must require financial institutions to include, in agreements “creating” an unsecured liability that are “governed by the law of a third country,” a clause by which the “creditor or party to the agreement” recognizes that this liability may be subject to public authorities’ write-down and conversion powers. Consequently, the scope of article 55 is broad, including not only debt instruments issued by the institution, but also liabilities such as those arising under letters of credit (and other contingent liabilities), liabilities arising out of derivatives transactions, operational liabilities and even some liabilities arising under credit facilities extended by the financial institution (for example, as a result of inter-creditor or syndication agreements).
Several types of creditors are excluded from this requirement, including creditors of covered deposits or bonds and certain other creditors whose debts are fully secured; client assets including assets held for certain funds and other liabilities that arise “by virtue of a fiduciary relationship,” provided that these creditors are protected under applicable insolvency or civil law; liabilities to unrelated institutions with an original maturity of less than seven days; liabilities arising under payment and settlement systems; liabilities to employees, other than for certain variable consideration; liabilities to certain trade creditors (including for IT services and rent and upkeep of premises); preferred claims of tax and Social Security authorities; claims of deposit guarantee schemes; and certain unsecured priority creditors including uninsured deposits by individuals and small and midsize enterprises. Certain other liabilities can be exempted by national authorities, including when requiring bail-in language is “impracticable.”
The requirement under BRRD article 55 to include bail-in language applies generally to liabilities created on or after Jan. 1, 2016. This includes new agreements entered into after that date and also liabilities created after that date under pre-existing agreements, which are generally considered to include “material amendments” to pre-existing agreements and pre-2016 transactions subject to a netting arrangement which includes post-2015 transactions (such as an ISDA or revolving facility).
Model Bail-in Language
Model language designed to comply with BRRD article 55 has been developed by several groups, including the Loan Market Association (LMA), the Loan Syndications and Trading Association (LSTA), the Association for Financial Markets in Europe (AFME) and the International Capital Markets Association (ICMA). The International Swaps and Derivatives Association (ISDA) has published a protocol intended to allow amendment of derivatives agreements of Dutch, French, German, Irish, Italian, Luxembourg, Spanish and UK entities to comply with BRRD article 55. These model documents and the protocol take account of the fact that implementing legislation at the national level may vary from country to country.
Since financial institutions subject to BRRD are subject to sanctions if their relevant liabilities do not contain bail-in language, they not only systematically include bail-in language in new agreements governed by third-country law but have also systematically requested that creditors under pre-2016 agreements agree to bail-in language.
Questions for Creditors
Creditors may be faced with several decisions as a result of the bail-in legislation.
A threshold issue may be whether or not refusal to agree to add bail-in language will actually prevent relevant public authorities from forcing a bail-in. This question has to be evaluated on a case-by-case basis, taking account of where the creditors’ claims would be enforced and whether courts in those jurisdictions would recognize bail-in powers. Commercial considerations should also be taken into account.
A further issue is how to evaluate the impact of the bail-in tool, and the other resolution tools set out in the BRRD, on any particular debt of a European financial institution. This review will take into account the institution’s general debt/asset structure and many other factors.
Analysis of these questions will of course take account of the legal measures on the books today, including those resulting from the BRRD, and the history of what steps were taken in past crises. The most difficult piece in the puzzle, however, will be predicting the new features likely to spring up.