07/12127134_1 BANKING AND FINANCE ENTRY INTO FORCE OF ARTICLE 55 EU DIRECTIVE 2014/59 EU CONTRACTUAL RECOGNITION OF BAIL-IN Article 55 of Directive 2014/59/UE of the European Parliament and of the Council of 15 May 2014 establishing a framework for the recovery and resolution of credit institutions and investment firms (hereafter, the "BRRD") confers certain powers to European control and resolution authorities in relation to failing financial institutions within the European Union. These bail-in powers include in particular the regulation authorities' ability to write-down, cancel and/or convert into equity the liabilities of failing institutions. The BRRD has been transposed in France by Ordinance no. 2015- 1024 of 20 August 2015, codified in Articles L. 613-55 and seq. of the French Code monétaire et financier. These bail-in powers became effective on 1 January 2016 and are binding on European credit institutions and investment firms (together, the "European Financial Institutions") counterparties. In cases where a European Financial Institution is a party to a contract inducing obligations for such European Financial Institution against any other party to the contract, (i.e. a liability in case of non-compliance with such obligations, subject to some exceptions), and if this liability is governed by the law of an EU Member State, it is not necessary to state these bail-in powers in the contract1 . However, in cases where the contract inducing obligations for European Financial Institutions isn't governed by the law of a European Economic Area Member State2 , the BRRD3 requires European Financial Institutions to include a contractual recognition of bail-in clause so that European Financial Institutions' counterparties acknowledge that these bail-in resolution actions, which might be taken by European regulators against any European Financial Institution subject to resolution proceedings, are enforceable against them. Although Article 55 has a very limited material scope, its future implementation in an international context appears delicate. 1. When does it apply? Article 55 of the BRRD applies to any contract in the following circumstances: 1 However, parties may, if desired, mention the applicable law in order to, in particular, include reference to these resolution processes into the definition of Defaulting Lenders in a facility. See Paragraph 4 below. 2 All EU Member States have not implemented Article 55 provisions into their national law and some Member States are subject to temporary derogations (see Paragraph 3 below). In addition, see our comments on Iceland, Liechtenstein and Norway in Paragraph 6 below. 3 Obligation codified in Article L.613-55-13 of the French Code monétaire et financier for French credit institutions and investment firms. JANUARY 2016 Paris Table of Contents 1. When does it apply? 1 2. Which entities are in scope? 2 3. What are the exceptions to Article 55? 3 4. What must be stipulated in the bail-in clause? 5 5. What are the consequences of non-compliance? 5 6. Are there any other issues? 5 7. Contacts 6 BANKING AND FINANCE HERBERTSMITHFREEHILLS 2 07/12127134_1 (a) the contract is governed by the law of a non-EU country, potentially the law of a non-EEA country4 ; (b) an entity within the scope of this provision (hereafter, referred to as the general term "European Financial Institution") is a party to the contract in any capacity (e.g. borrower, lender, purchaser of receivables, facility agent, security agent or trustee, issuing bank, protection purchaser or seller hedging bank, or simple counterparty); (c) the European Financial Institution has a potential liability against its counterparties under this contract inducing obligations to pay, including of a compensatory nature, in cases of non-compliance with obligations to do or not do (whether contractual or non-contractual liability); and (d) either: (i) the European Financial Institution becomes a party to a new contract after 1 January 2016; (ii) new liabilities arise under a contract entered into before 1 January 20165 ; or (iii) a contract entered into before 1 January 2016 is materially amended6 . 2. Which entities are in scope? These requirements (together, hereafter referred as the general term "European Financial Institutions") apply to: (a) credit institutions and investment firms established in the European Union (potentially in the European Economic Area); (b) the relevant subsidiaries and financial institutions established in the European Union (potentially in the European Economic Area) which are subsidiaries of a credit institution, an investment firm or a company referred to in either or the two points below ((c) and (d)), and are covered by the supervision of the parent undertaking on a consolidated basis under Articles 6 to 17 of the CRR (Regulation (EU) No 575/2013); (c) financial companies, financial holding companies, mixed financial holding companies and mixedactivity holding companies established in the European Union (potentially in the European Economic Area); and (d) parent financial holding companies established in a European Union Member State, parent financial holding companies established in the European Union (potentially in the European Economic Area), parent mixed financial holding companies established in a European Union Member State, parent mixed financial holding companies established in the European Union (potentially in the European Economic Area) 7 . Non-European subsidiaries of European Financial Institutions are not affected by the new requirement whereas their branches are. Thus, if such bail-in clause isn't accepted by all contracting parties, including other financial parties, a French bank can no longer be a party to a facility governed by New York law, whether such French bank acts from Paris or its New York branch. Similarly, French banks will not be able to participate in loan syndications if the contract which they wish to access after 1 January 2016 has no contractual recognition of the bail-in clause, including cases where the contract has been entered into before 1 January 2016. Finally, this requirement may exclude non-European branches of European Financial 4 The European Economic Area or EEA comprises all European Union State Members, Iceland, Liechtenstein and Norway (see Paragraph 6 below). 5 The contract and/or liability renewal should, in all likelihood, induce new obligations to pay (including of a compensatory nature), thereby falling within the scope of Article 55 of the BRRD. 6 The interpretation to be given to the 'agreements' falling under the scope of article 55 §1(d) has caused a lot of questions, in particular as to whether an agreement creating the liability is entered into after the 1st January 2016 in the case of amendments or minor changes to the contract. EBA has developed draft regulatory technical standards in order to determine the list of liabilities which are excluded from the scope of article 55 including a materiality threshold such that non-material amendments to a relevant agreement created before the 1st January 2016 but amended after that date would not trigger the obligation for European Financial Institutions to include the contractual bailin term (art. 2(2) of the draft RTS). Under the proposed approach by EBA, when the amendments introduced constitute non-material amendments, i.e. which do not affect the substantive rights and obligations of a party to an agreement, it is not necessary to include a bail-in clause. Unfortunately, EBA has limited these "substantive rights and obligations" to any changes, including any automatic amendment, to the contact details of a signatory or the addressee for the service of documents, typographical changes to correct drafting errors or automatic adjustments of interest rates. This concept, that is more than just technical change rather a substantive change, seems too restrictive. The safer view is therefore to apply the bail-in clause for European Financial Institutions for any amendment entered into after the 1st January 2016. Similarly, we are of the view that any further renewal of a commitment shall be affected by the bail-in clause. 7 In mixed-activity groups, where all the regulated entries are held in a discrete subgroup, the requirement should not extend to holding companies above the immediate mixed activity financial holding company of that subgroup. BANKING AND FINANCE HERBERTSMITHFREEHILLS 3 07/12127134_1 Institutions from some functions or roles of loans, such as the role of facility agent, due to the consequences of resolution proceedings they have to accept and the incompatibilities of such resolution proceedings with the relevant role8 . However, European Financial Institutions (including European branches of non-European banks) may modify the law applicable to their contracts when such law isn't a European law, to submit these contracts to a European law in order to automatically impose the bail-in process and comply with their regulatory requirements, without lengthy discussions with their counterparties about the insertion of bail-in clauses. This European requirement for all European Financial Institutions may generate a distortion of competition to the detriment of such European Financial Institutions. 3. What are the exceptions to Article 55? 3.1 Exceptions listed by reference to Article 44.2 of the BRRD Resolution authorities shall not exercise their write-down or conversion powers in relation to certain liabilities, in particular: - deposits not exceeding the guarantee cap secured by the "Fonds de Garantie des Dépôts et de Résolution". In France, the amount of secured deposits has been set to 100,000 EUR per person and per institution9 ; - secured liabilities (including covered bonds and liabilities in the form of financial instruments used for hedging purposes, which form an integral part of the cover pool and which according to national law, are secured in a way similar to covered bonds) whether governed by the law of a EU State Member or a nonEU State Member. The European Banking Authority has specified in its recommended technical standards to the EU Commission that the obligation to include a bail-in clause arises wherever the secured obligation isn't fully collateralised; - any liability that arises by virtue of the holding of assets or money held on behalf of UCITS or AIFs; - certain liabilities with an original maturity of less than seven days; - any liability that arises by virtue of a fiduciary relationship between an institution or entity (as fiduciary), subject to resolution proceedings, and another person (as beneficiary) provided that such a beneficiary is protected under the applicable insolvency or civil law; - any liability to a commercial creditor arising from the provision to a European Financial Institution, subject to resolution proceedings, of goods or services that are critical to the daily functioning of its operations. Thus, in collateralised facilities, repos or securities lending and derivatives governed by a non-European law entered into between two banks, no clause will be required if the European Financial Institution's obligations are fully collateralised10. However, if the European Financial Institution is a lender or a hedging bank, the bailin clause may need to be included. 3.2 Lack of clarity of these exceptions (a) The above-mentioned exceptions are often limited to some of the liabilities under a contract. For instance, amounts payable to European Financial Institutions employees are exempt, whereas performance related bonuses are not; European Financial Institutions secured liabilities are exempt, whereas any portion of the liability which is in excess of the value of the security at the date of bail-in is not; liabilities in relation to the supply of essential services (e.g. IT services, specifically referred to by the BRRD as non-subject to any write-down or conversion11) are exempt, whereas non-essential services which may be referred in the contract are not. (b) Article 44 does recognise that it may be impractical to bail-in certain liabilities, but this is to be decided on a case-by-case basis in the bail-in process; there is no ex ante exception. 8 It seems difficult for financial parties to accept the conversion or annulation of their debt against an agent which would have received amounts on their behalf. 9 Note that French "Livrets A", to which some legal entities have access, are subject to specific provisions insofar as they are secured by a State Guarantee for their entire amount. 10 Resolution authorities shall always be entitled to use their conversion and/or cancellation powers towards a secured liability or a collateralised liability which exceeds the value of assets, pledges, liens or securities used to secure the liability. 11 The Directive includes an exception to Article 55 for goods or services that are critical to the daily functioning of in-scope institutions or entities' operations. It is questionable whether these exceptions might be extended to many services. BANKING AND FINANCE HERBERTSMITHFREEHILLS 4 07/12127134_1 (c) Thus, the provisions of Article 55 of the BRRD are intended to apply to the following-non exhaustive circumstances: Loan agreements; receivables purchase agreements; securities lending agreements or repos; subscription agreements; derivatives / swaps; intercreditor agreements; security documents; letters of credit; guarantees and indemnities; debt securities12; and secondary loan trading documents. 3.3 Absence of restriction of Article 55 provisions' scope for French Financial Institutions: The French Government introduced a draft bill to Parliament on 13 January 2016 which would empower the ACPR Resolution College to classify the liabilities of the French Financial Institutions by category, by introducing a calendar for implementation of the bail-in clause for certain liabilities13. The date of the vote is not yet known; this creates an uncertainty as to the current French substantive law. The impact assessment published with the draft bill stresses that Article 55 should be applied proportionately. The ACPR Resolution College would have ability to foresee, on a case-by-case basis, that this obligation applies in a way differentiated according to categories of contracts, according to the challenges which they represent for the resolution of the French Financial Institutions concerned. The obligation could thus be differed in time for the least significant contracts or certain contracts exempted from bail-in clause. If the bill is voted as such, the ACPR will have to promptly demonstrate its willingness to introduce or not a calendar and to determine if some categories of liabilities are concerned by such time-shift (this seems to be the position declared by the Government)14. Pending the vote of this bill - that we hope will occur soon - and then the intervention of the ACPR in relation to the exceptions of Article 55 of the BRRD/Article L.613-55-13 of the French Code monétaire et financier, the safest approach is to assume that the bail-in recognition clause should be included in all contracts which satisfy the above-mentioned criteria to which a French Financial Institution would be a party. It may be noted that the Prudential Regulation Authority (hereafter, the "PRA") and the Financial Conduct Authority (hereafter, the "FCA") modified their implementation of Article 55 of the BRRD in the UK. This modification provides that the requirement to include a bail-in recognition clause does not apply where inclusion of the clause is "impracticable". This modification is valid until the earlier of (i) 30 June 2016; or (ii) the relevant contractual recognition of bail-in rules applicable in the UK are amended or revoked. Both the PRA and the FCA intend to consult on amending the contractual recognition of bail-in rules. The term "impracticable" being ambiguous, the modification introduced by both the PRA and the FCA is probably designed to protect non-compliant English credit institutions and investment firms. These discussions should be closely monitored to ensure European Financial Institutions are not treated differently. In addition, this temporary limitation introduced by the UK would not exempt European Financial Institutions established in other European Union Member States to include the aforesaid bail-in recognition clause in order to comply with their own requirements. The safest way in any operation – such as syndication – involving 12 We might limit debt securities to those issued by European Financial Institutions but the issue is discussed. The AFME does not seem, for instance, to make a distinction. 13 Proposed insertion to article L. 613-55-13 of the French Code monétaire et financier: "the resolution college can provide that the provisions above are applied according to a calendar which it determines by category of liability" – article 2-13° of the draft bill of ratification of the Ordinance no. 2015-1024 of 20 August 2015 (Draft bill n°3393 registered to Parliament on 13 January 2016). 14 According to the preamble of the draft bill, it is a “technical adjustment of the articles of the French Code monétaire et financier which have implemented the Ordinance no. 2015-1024 of 20 August 2015. It clarifies in particular the conditions under which certain contracts can be concerned by some resolution measures and shall include bail-in clause”. This suggests that only certain liabilities will be concerned. BANKING AND FINANCE HERBERTSMITHFREEHILLS 5 07/12127134_1 European Financial Institutions, English Financial Institutions and others located in our outside the UE, should be to require the bail-in recognition clause application. 4. What must be stipulated in the bail-in clause? European Financial Institutions can't make a commitment under a contract governed by the law of a non-EU country, unless the contract includes a bail-in recognition clause which stipulates that the creditor acknowledges that the liability is subject to write-down and conversion and accepts to be bound by any reduction of principal or outstanding amount due, conversion or cancellation exercised by the ACPR Resolution College ("Le Collège de Résolution) by the exercise of its powers. In practice, the in-scope European Financial Institutions' counterparties shall accept that from the bail-in exercise by the competent regulation authority, (i) no early prepayment, no cancellation, no repayment will be issued against the European Financial Institution or carried out by such European Financial Institution; or (ii) the outstanding amount due may be subject to write-down, cancellation and/or conversion into equity. Various industry bodies such as the Loan Market Association (LMA), the Asia Pacific Loan Market Association (APLMA), the Loan Syndications & Trading Association (LSTA - New York), the Association for Financial Markets in Europe (AFME) and the International Capital Market Association (ICMA) have released suggested forms of bail-in recognition clause. Other amendments to the documentation may also be made such as including in a loan, the European Financial Institution which has been subjected to resolution proceedings into the "Defaulting Lender" definition. Furthermore, the ACPR Resolution College may require from European Financial Institutions to provide authorities with a legal opinion to the legal enforceability and effectiveness of such a term. Legal opinions issued by non-European Financial Institutions' counsels in relation to an operation shall probably expressly cover the validity of these bail-in recognition clauses or at least have no reservation about the validity or the enforceability in local law of such clauses. It should also be possible to obtain a unique legal opinion based on standard clauses, which might then be renewed/confirmed on a regular basis. 5. What are the consequences of non-compliance? Consequences of non-compliance by European Financial Institutions with Article 55 may result in fines, regulatory actions and a potential illegality of the transaction, although this varies with national transposition of Article 55. Non-compliance with Article 55 also exposes the counterparty to legal uncertainty because it does not know whether bail-in proceedings might be applied in the event of the European Financial Institution going into resolution measures. The scheme of the BRRD doesn't allow EU Member States to refuse the enforceability of such clause against a bank or an investment firm that had not entered resolution (although there would be a breach of a mandatory law of the forum). Furthermore, enforceability of Article 55 has to be decided on a case-by-case basis based on the implementation by each EU Member State. In particular, the bail-in implementation beyond European borders creates a risk of distortion of competition between European Financial Institutions and their non-European competitors. In cases of failure to introduce the aforesaid clause or a possibility to require the contract to be governed by a European law (English or France for instance), the responsibility of European Financial Institutions is incurred. The international market may set aside European Financial Institutions or force them to only act through their international subsidiaries in order to avoid these constraints. 6. Are there any other issues? Although it is intended that the Directive should apply across the EEA, it has not yet been incorporated into the EEA Agreement and the three EEA States outside the EU (Norway, Iceland and Liechtenstein) have not yet implemented the BRRD. Advice should therefore be taken on whether these EEA Member States should be treated as third countries when contracting under their laws. The safest approach is to consider, unless confirmed otherwise by suitable local lawyers, that the bail-in clause shall apply when the contract to which the European Financial Institution is party is governed by the law of one of these three countries. It is also quite likely that Switzerland will adopt a similar national law. BANKING AND FINANCE HERBERTSMITHFREEHILLS 6 07/12127134_1 7. Contacts Vincent Hatton, Partner T +33 1 53 57 70 85 [email protected] Virginie Barbier, Professional Support Lawyer T +33 153 57 65 34 [email protected] The contents of this publication, current at the date of publication set out above, are for reference purposes only. They do not constitute legal advice and should not be relied upon as such. Specific legal advice about your specific circumstances should always be sought separately before taking any action based on the information provided herein. © Herbert Smith Freehills LLP 2016 07/12127134_1 7