Article 55 of the Bank Recovery and Resolution Directive (BRRD) (2014/59/EU) requires Member States to ensure that a bail-in clause is included in agreements containing liabilities of a regulated Member State financial institution which are governed by the law of a third country.

A bail-in clause provides that debt obligations of a distressed institution can, if necessary, be reduced or converted into equity by a Member State "resolution authority." Bail-in clauses are not required for agreements governed by the law of a Member State because in that scenario the write-down and conversion powers arise by virtue of the BRRD itself.

Although in the case of loan facilities, the most relevant situation is where the Member State financial institution is the borrower, certain obligations typically undertaken by lenders could also potentially constitute relevant liabilities for these purposes.

Article 55 contains an exception to the requirement to include a bail-in clause where "the resolution authority of [the relevant] Member State determines that the liabilities or instruments… can be subject to write down and conversion powers by [it] pursuant to the law of the third country or to a binding agreement concluded with that third country."

At the time of writing, a no deal Brexit remains a plausible scenario, notwithstanding the House of Commons voting on 13 March not to leave the EU without a deal. In the event of no deal, English law will become the law of a third country so it will be necessary as a matter of EU law for facility agreements governed by English law containing liabilities of regulated Member State financial institutions to include a bail-in clause unless the exception just referred to applies.

On this issue, the Loan Market Association (LMA) has commented[1] that "if the UK retains its current provisions implementing Articles 94 and 95 of the BRRD [which contain a regime for the recognition of third-country resolution proceedings], and as part of any withdrawal extends those provisions to recognise EEA resolution actions, the disapplication of the Article 55 Requirement is likely to be triggered."

The relevant EU Exit Statutory Instrument (The Bank Recovery and Resolution and Miscellaneous Provisions (Amendment) (EU Exit) Regulations 2018) (the "Exit SI") made in December 2018 is intended to give effect to the position described in the last paragraph in a no deal scenario, i.e. it guarantees recognition of resolution proceedings of EU27 countries on terms which comply with the requirements of Article 55 and the technical regulations made under the BRRD (Commission Delegated Regulation 2016/1075)).

However in order for the outcome described by the LMA to be fully achieved, and to avoid a risk of illegality, the resolution authority of each Member State would have to satisfy itself that the exception applies and make a determination accordingly before 29 March. Alternatively, if the exception does not apply, it is likely that Article 55 would require a bail-in clause to be inserted in all existing agreements/agreements relating to existing liabilities.

The recognition of write-down and conversion powers is also relevant to the prudential treatment of exposures to third parties for the purposes of meeting the minimum requirement for own funds and eligible liabilities (MREL) in Article 45 of BRRD. If the liabilities are governed by a Member State law then they automatically qualify as "eligible liabilities" because it is certain that they are subject to the write-down and conversion powers. By contrast, where the liabilities are governed by the law of third country, they do not automatically qualify and "resolution authorities may require the [relevant] institution to demonstrate that a decision of [the] resolution authority would be effective under the law of that third country" (Article 45(5)).

Although the Exit SI provides EU27 resolution authorities with a sufficient basis to determine that English law governed liabilities are not ineligible, it is not clear whether the present uncertainty will be resolved prior to 29 March. The European Banking Authority has suggested that this uncertainty could deter EU27 Member State financial institutions from selecting English governing law for instruments which need to qualify towards MREL[2]. Some commentators report that EU27 financial institutions have now taken to including bail-in clauses in their facilities as a mitigant[3].

The same uncertainty also affects the financial institutions' existing stock of instruments which were intended to qualify as eligible. As one commentator has stated: "If these instruments are determined to be ineligible, this could significantly reduce the level of eligible instruments, requiring existing instruments to be amended or the issuance of new existing arrangements, potentially causing market disruption."[4]

After several years under discussion, it was announced last month that the European Parliament and the Council have reached agreement on the content of an amending regulation, BRRD2. The impact of BRRD2 on the analysis above is uncertain because the European Commission, the Council and the European Parliament have each made different proposals. Under one formulation, the regime for eligibility of liabilities governed by the law of a third country would be simplified by making the inclusion of a contractual bail-in provision a precondition to eligibility. This would render most existing liabilities ineligible, but (unlike a no deal Brexit) would be manageable through a transitional regime.