THE DELTA REPORT
The "ISDA 2016 Bail-In Article 55 BRRD Protocol (Dutch / French / German / Irish / Italian / Luxembourg / Spanish / UK entity-in-resolution version)" (the "Protocol") was published by the International Swaps and Derivatives Association, Inc. ("ISDA") on 14 July 2016. The Protocol is aimed at helping market participants meet a requirement under the European Union Bank Recovery and Resolution Directive ("BRRD").104
What does the Protocol do?
Under the BRRD regime, resolution authorities in EU member states ("Member States") are given a wide range of tools including bail-in powers ("bail-in") to write-down and/or convert into equity certain liabilities of failing financial institutions. Entities within the scope of the BRRD (the "In-scope Entities") are required under its Article 55 to include a new contractual term (an "Article 55 Provision") in any agreement agreed on or after 1 January 2016 that is governed by the laws of a non-EU member state (a "Third Country Agreement") with limited exceptions.
The purpose of this requirement is to address a specific concern, namely the enforceability of the exercise of bail-in powers by a resolution authority against counterparties in cross-border transactions where the contract governing the relevant in-scope liabilities is not governed by the laws of a Member State. Within the EEA, the effectiveness of statutory bail-in powers is ensured by the mutual recognition requirements under the BRRD. Beyond the borders of the EEA where mutual recognition does not apply, Article 55 purports to fill the gap by offering a contractual solution whereby the counterparty is held to the agreed contractual terms, thus preventing court challenges in the relevant non-EEA jurisdiction. On the other hand, absent an Article 55 Provision, whether or not the exercise of bail-in powers is effective would need to be assessed under the relevant governing law and the applicable conflict of law principles.
The Protocol only covers the Dutch, French, German, Irish, Italian, Luxembourg, Spanish, and UK bail-in regimes as these were the only Member States which had published final relevant implementation rules at the time of drafting Article 55. By now EU financial institutions will have a clear view as to whether they are In-scope Entities under the BRRD. For In-scope Entities in the applicable jurisdictions, the Protocol offers an efficient way to comply with Article 55 and the related regulatory technical standards. This is achieved by way of the adhering parties ("Adhering Parties") amending their existing ISDA Master Agreements and certain other ISDA-sponsored agreements as described in the Protocol ("Other Agreements") through deemed incorporation of an Article 55 Provision in the form set out in the Attachment to the Protocol. Other Agreements include for example, other master agreements, framework agreements, securities lending agreements, repurchase agreements, futures agreements and clearing and execution agreements.
What should be included in an Article 55 Provision?
The European Banking Association ("EBA") is mandated under Article 55(3) of the BRRD to develop draft regulatory technical standards in order to further determine the contents of an Article 55 Provision ("Article 55 RTS"). The Article 55 RTS was published in the Official Journal of the European Union on 8 July 2016 and has been directly applicable in Member States since 28 July 2016. Among other things, the Article 55 RTS sets out certain mandatory requirements for inclusion in an Article 55 Provision.105
The Protocol language incorporates these mandatory elements. It (1) provides an acknowledgement and acceptance by the parties to an agreement that certain liabilities created by such an agreement may be subject to bail-in, and (2) evidences agreement by the parties that they will be bound by the exercise of any bail-in powers by the relevant resolution authority in respect of all transactions under such an agreement.
What agreements are covered under the Protocol?
The Protocol amends existing ISDA Master Agreements and Other Agreements between Adhering Parties except in the following circumstances: (1) the parties agree bilaterally that the Protocol does not apply; (2) there are already alternative written agreements existing between the parties which cover the issues and substance of the Attachment to the Protocol; (3) the relevant resolution authority determines that the relevant liabilities may be subject to bail-in pursuant to the laws of the third country governing such liabilities or a binding agreement concluded that such third country laws together with the relevant implementation legislation has been amended to reflect such determination; or (4) the relevant implementation legislation has been repealed or amended in a manner that the requirement for contractual recognition of bail-in is removed.
All Adhering Parties must adhere to the Protocol in its entirety. Partial adherence is not permitted. The Protocol will apply to all ISDA Master Agreements and Other Agreements between any two Adhering Parties that are entered into on or prior to the Implementation Date provided that the law governing such agreement is that of a non-EU member state. "Implementation Date" is broadly defined in the Protocol as the later date upon which either of the two relevant Adhering Parties delivers an Adherence Letter in the form prescribed under the Protocol. Any new documentation entered into after the Implementation Date will need to expressly incorporate the Protocol terms in the documentation.
The types of agreements covered under the Protocol ("Protocol Covered Agreements") are wide in scope and broadly include:
(a) ISDA Master Agreements (including any deemed ISDA Master Agreement arising pursuant to the execution of a confirmation), any outstanding Transactions thereunder and any outstanding Credit Support Documents entered into by such Adhering Parties in connection therewith; and
(b) other master agreements, framework agreements, master netting or set-off agreements or agreements incorporating master trading terms by reference where such terms may cause all transactions relating to one or more netting sets to terminate (including where such agreement has been amended or is designed to provide for client clearing, any compensation agreement or execution agreement), in each case may be in writing, electronic format for other agreed official record.
Where there is an express requirement that any amendment or modification to such ISDA Master Agreements and Other Agreements is subject to any consent, approval, agreement, authorisation or other action of any third party, such ISDA Master Agreements and other Agreements shall not be Protocol Covered Agreements unless such consent, approval, agreement, authorisation or other action has been duly obtained.
The Protocol may extend to agreements signed by an investment manager or asset manager as principal and as agent on behalf of its clients. In such circumstances a separate Adherence Letter must be submitted for the principal and for the agent.
The text of the Adherence Letter cannot be altered. Therefore, in cases where an adhering party wishes to amend the Protocol it must revert to bilaterally negotiating and amending the relevant agreements.
When does Article 55 apply?
Any In-scope Entity that is a party to any Third Country Agreement is required to include an Article 55 Provision in the Third Country Agreement, except in the limited circumstances where such Third Country Agreements only create liabilities that are excluded from bail-in ("Excluded Liabilities").
The term "liability" is not defined in the BRRD but may be defined in the relevant Member State implementation rules. Article 44(2) of the BRRD sets out the list of Excluded Liabilities, of which "secured liabilities" is probably the most relevant to derivative transactions.
"Secured liabilities" is defined in the BRRD as liabilities "secured by a charge, pledge or lien or collateral arrangements including liabilities arising from repurchase transactions and other title transfer collateral arrangements".106 However, Article 55 RTS states that "a secured liability shall not be considered as an excluded liability where, at the time at which it is created, it is (a) not fully secured; or (b) fully secured but governed by contractual terms that do not oblige the debtor to maintain the liability fully collateralised on a continuous basis in compliance with regulatory requirements of Union law or of a third country law achieving effects that can be deemed equivalent to Union law". This creates ambiguity around the precise scope of "secured liabilities", and in light of this, ISDA has advised parties to consider signing the Protocol even if the relevant liability is secured/collateralised. The national rules implementing Article 55 in the relevant Member State will also be relevant, and any party seeking to rely on any exclusion should exercise caution.
What are the implementation measures in the United Kingdom?
There is much uncertainty surrounding the precise scope of the application of the Article 55 requirements, with the details left to each implementing regulator. Within the UK the final version of the amended Prudential Regulation Authority ("PRA") rules relating to the requirement for contractual recognition of bail-in came into force on 1 August 2016. The published policy statement (PS17/16)107 contains the final rules on contractual recognition of bail-in (PRA 2016/28)108 and the final supervisory statement on impracticability (SS7/16).109 These allow a UK In-scope Entity not to include an Article 55 Provision in a Third Country Agreement where such entity concludes that to do so would be "impracticable". Impracticability is narrowly defined and therefore is unlikely to apply in relation to most derivative transactions.
How may Brexit affect this?
Although still speculative at the current stage, if and when the UK leaves the EU English law will cease to be the law of a Member State. This remains contingent on the outcome of the Brexit negotiations but the UK might fall within the scope of the Article 55 requirement with the result that UK counterparties would need to include an Article 55 Provision when dealing with an In-scope Entity other than in respect of Excluded Liabilities.
What happens to derivative transactions upon bail-in?
Article 49(2) of the BRRD provides that write-down or conversion powers apply only upon or after relevant derivatives have been closed-out. Additionally, Article 49(3) of the BRRD requires that the liability arising from derivative transactions subject to a netting agreement must be determined on a net basis in accordance with the underlying netting agreement.
The regulatory technical standards (C(2016) 2967 final) on the valuations of derivatives for the purpose of bail-in (the "Derivative Valuation RTS") were adopted by the European Commission on 23 May 2016 pursuant to Article 49(4) of the BRRD.110 Broadly speaking, counterparties of In-scope Entities are expected to have limited control over the termination and valuation process and methodology of derivative contracts on any default by the relevant In-scope Entities arising from application of the bail-in tool or other resolution measures. Under Article 3 of the Derivative Valuation RTS, if the bail-in tool is applied to derivative contracts, a resolution authority may specify the criteria it intends to apply when assessing whether replacement trades are commercially reasonable and can force close-out all affected derivative contracts and set a date for valuation.
Derivative counterparties should also be alert to the consequences of the ISDA 2015 Universal Resolution Stay Protocol,111 the ISDA 2014 Resolution Stay Protocol112 (together, the "Resolution Stay Protocols") and the ISDA Resolution Stay Jurisdictional Modular Protocol113 (the "Modular Protocol") where applicable. The Resolution Stay Protocols and the Modular Protocol, which differ from the BRRD regime in terms of jurisdictional scope and applicability, also have the effect of restricting counterparties" rights by placing a temporary stay on the non-defaulting party"s exercise of termination rights in an insolvency situation.
What are the practical implications and challenges of the Article 55 requirement?
Bail-in was developed as a response to the financial crisis and it is intended to, particularly in the event of an EU bank rescue situation, shift the burden and risk of potentially having to write-down, convert or reduce in value certain liabilities from governments and the general public to the creditors and parties to the agreements which created such liabilities in the first place.
The rationale underpinning Article 55 BRRD is sound, and contractual recognition of bail-in as a method of addressing cross-border recognition issues is also generally regarded as necessary by financial regulators in order to bridge enforceability gaps where comprehensive national statutory regimes are not yet in place.
The main difficulty with the Article 55 requirement is that it is extremely broad in scope. The fact that BRRD does not set out any definition as to what types of liabilities are subject to contractual bail-in requirements poses significant challenges from an implementation perspective. Furthermore, the BRRD does not mention any specific sanction for breach of bail-in requirements, meaning it may be up to individual member states to set up the relevant frameworks. This uncertainty in scope, the differing legal interpretations of Article 55 within Member States and the layers of legislation at national and EU-levels all contribute to potentially testing times ahead for the BRRD regime. The worst case scenario would be entities having to withdraw trading lines with a reluctant counterparty should negotiations fail.
It is against this backdrop that sector specific bodies such as the ISDA have stepped in to create standard implementation measures or model provisions for specific asset classes. Beyond derivatives, the Association for Financial Markets in Europe, for example, recently released its finalised version of the model clauses for debt and equity instruments. Nevertheless, these initiatives are still seen as interim measures by those who advocate the continuing pursuit of comprehensive statutory recognition, fearing that Article 55 could have an adverse impact on the ability of financial institutions to compete beyond EU borders.
Further developments on the topic of Article 55 BRRD are expected, with some proposing that its scope be revised as part of the review of the minimum requirement for eligible liabilities and own funds under BRRD in order to align it with the guidance of the Financial Stability Board. Others are calling for proportionality requirements to be detailed and for a substantive impact assessment to be carried out. We will continue to watch this space.
104 Directive 2014/59/EU 15 May 2014.
105 Article 55 RTS, Article 44: "Contents of the contractual term required by Article 55(1) of Directive 2014/59/EU".
106 Article 2(1)(67), BRRD.
107 PRA Policy Statement (PS17/16) June 2016: "The Contractual Recognition of Bail-In: Amendments to Prudential Regulation Authority Rules".
108 PRA Rulebook, 27 June 2016: "CRR Firms and Non-Authorised Persons: Contractual Recognition of Bail-In Amendment Instrument 2016".
109 PRA Supervisory Statement (SS7/16) June 2016, "The Contractual Recognition of Bail-In: Impracticality".
110 "Commission Delegated Regulation supplementing Directive 2014/59/EU of the European Parliament and of the Council establishing a framework for recovery and resolution of credit institutions and investment firms with regard to regulatory technical standards for methodologies and principles on the valuation of liabilities arising from derivatives."
111 The ISDA 2015 Universal Resolution Stay Protocol published on 4 November 2015.
112 The ISDA 2014 Universal Resolution Stay Protocol published on 4 November 2014.
113 The ISDA Resolution Stay Jurisdictional Modular Protocol published on 3 May 2016.
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