Key Issues for Derivative Transactions under the BRRD | White & Case LLP International Law Firm, Global Law Practice
Key Issues for Derivative Transactions under the BRRD

Key Issues for Derivative Transactions under the BRRD

In this article, we outline the main resolution tools available to a resolution authority and consider the broad powers of resolution authorities that may impact existing derivative transactions in the event of a bail-in. Specific issues related to contractual recognition under Article 55 are also discussed.

 

Scope

The Directive 2014/59/EU of the European Parliament and of the Council establishing a framework for the recovery and resolution of credit institutions and investment firms ("BRRD")[1] introduced an EU-wide regime for recovery and resolution planning in respect of BRRD Entities (as defined below). Prior to the BRRD, there was no harmonisation of the procedures for resolving such institutions at the EU level. Resolution authorities are the authorities designated by each member state to exercise the powers, functions and tools laid out in the BRRD.

BRRD Entity

(a) credit institutions and investment firms that are established in the EU.

(b) financial institutions that are established in the EU when the institution is a subsidiary[2] of a credit institution or investment firm (or of a company referred to in (c) and (d) below) and is covered by the supervision of the parent undertaking on a consolidated basis.

(c) financial holding companies, mixed financial holding companies and mixed-activity holding companies that are established in the EU.

(d) parent financial holding companies in a Member State[3], EU parent financial holding companies[4], parent mixed financial holding companies in a Member State, EU parent mixed financial holding companies.

(e) EU branches of institutions that are established outside the EU in accordance with specific conditions laid out in the BRRD[5].

 

What are the four main resolution tools that a resolution authority may use?

Resolution authorities can apply the resolution tools individually or in any combination although the asset separation tool can only be used together with another resolution tool. The use of resolution tools and powers provided in the BRRD will replace senior management and disrupt the rights of shareholders and creditors.

Four resolution tools that a resolution authority may apply:

Sale of business

Sale of all or part of business without shareholder consent.

Bridge institution

Transfer of all or part of the business to an entity wholly or partially owned by the public authorities.

Asset separation

Transfer of 'bad' assets to a separate vehicle or 'bad bank'

Bail-in

Write down of equity debt

 

What is bail-in?

Bail-in is a process that may be utilised for either:

internal recapitalisation that may be triggered when a firm reaches the point of non-viability if the relevant resolution authority forms the view that the entity can be restored to solvency or long term viability; or

conversion to equity or reduction of the principal amount of claims or debt instruments that are transferred to a bridge institution (with a view to providing capital for that bridge institution) or through the sale of business tool or the asset separation tool.

Resolution authorities may only apply the bail-in tool for recapitalisation purposes if there is a reasonable prospect that the application of that tool will restore the relevant BRRD Entity to financial soundness and long-term viability.

Losses are imposed on certain of a firm's direct stakeholders according to a defined hierarchy (pursuant to Article 48 of the BRRD) by a process of "bailing-in", either by writing down their claims or by converting them to equity. The aim of a bail-in is that shareholders and creditors of the failing institution bear an appropriate part of losses arising from the failure of the institution. Bail-in may be applied to all liabilities of an institution (except certain excluded ones).

 

Which powers of a resolution authority may affect a derivative transaction?

Under the BRRD, resolution authorities have an extremely broad range of powers which can directly impact existing derivative transactions.

Powers that may impact derivative transactions

Article BRRD

If a resolution authority exercises its right to close-out, in the case that the non-defaulting counterparty does not enter into replacement trades, that counterparty would lose their hedges

63(1)(k))

The close-out amount may be calculated by the resolution authority

49(4)

Rights, assets or liabilities of an entity under resolution may be transferred to another entity, with the consent of that entity

63(1)(d)

Terms of contracts can be cancelled or modified in order to cancel, reduce or defer liabilities

64(1)(f)

Certain contractual terms (i.e. termination/enforcement rights) may be excluded

68

Counterparties' rights to terminate may be temporarily suspended

71

Counterparties' rights to enforce security may be temporarily suspended

70

Counterparties' payment and delivery obligations may be temporarily suspended

69

EU branches may also be subject to resolution

96

It is worth pointing out that in the context of a major restructuring, a resolution authority may decide to go far beyond its statutory powers or interpret them in a very broad fashion. The BRRD has not been put into practice yet and therefore the ultimate practical consequences remain unknown.

 

Contractual recognition under Article 55 and its scope

From 1 January 2016, BRRD Entities are required under Article 55 to include certain contractual terms in any agreements governed by the laws of non-EU Member States to recognise the bail-in tool under the BRRD, subject to certain exclusions. This contractual recognition requirement is designed to ensure the effectiveness of the bail-in tool in a cross-border resolution and to promote equal treatment between EU and third-country liability holders.

Article 55 – Which liabilities are included?

not excluded under Article 44(2)

not a deposit

governed by the law of a third country

issued or entered into after the date on which a Member State transposes into national law the provisions of the BRRD (1 January 2016 at the latest or earlier)

Non-EU incorporated firms and their EU branches are out of scope for the purposes of Article 55. In respect of "excluded liabilities" please see further discussion below.

The contractual recognition requirement will not apply where the resolution authority determines that the law of a third country or a binding agreement concluded with that third country allows the resolution authority to exercise its write down or conversion powers.

 

Can the contractual obligation under Article 55 be disapplied in respect of third country agreements?

The contractual recognition requirement will not apply where the resolution authority determines that the law of a third country or a binding agreement concluded with that third country allows the resolution authority to exercise its write down or conversion powers. For example, if a third country implemented a law or entered into an agreement with the relevant resolution authority, which recognized and gave effect to the exercise of write-down and conversion powers by such resolution authority, entities of such third country would not be affected by this contractual recognition.

Article 55 contemplates also those situations where an institution fails to include the Article 55 contractual provisions, in which case such failure will not prevent the resolution authority from exercising the write down and conversion powers in relation to that liability.

Separately, at the UK level, on 25 November 2015, the Prudential Regulatory Authority ("PRA") published a modification by consent[6] which disapplies Contractual Recognition of Bail-In Rules 1.2 and 2.1[7] in circumstances where compliance with them in respect of an unsecured liability that is not a debt instrument is impracticable. The PRA expects BRRD Entities to make their own reasoned assessment with regard to impracticability in relation to an unsecured liability that is not a debt instrument.

The exceptions that the PRA may consider include but are not limited to

Not permitted

Relevant third-country authorities have informed the BRRD Entity in writing they will not allow it to include contractual recognition language in agreements or instruments creating liabilities governed by the law of that third country

Illegality

It is illegal in the third country for the BRRD Entity to include contractual recognition language in agreements or instruments creating liabilities governed by the laws of that third country

Impossibility

The creation of liabilities is governed by international protocols which the BRRD Entity has in practice no power to amend

Impracticability

Contractual terms are imposed on the BRRD Entity by virtue of its membership and participation terms in non-EU bodies, whose use is necessarily on standard terms for all members and impracticable to amend bilaterally

Contingency

The liability which would be subject to the contractual recognition requirement is contingent on a breach of the contract

It is clear that the above "exceptions" are of legal nature so entities will unlikely be able to rely on any "impracticalities" of "operational" nature. In addition, the PRA has confirmed that it does not consider loss of competitiveness or profitability to be grounds for an impracticability judgement.

 

Which instruments, contracts or products are covered by the bail-in tool?

The BRRD is a piece of legislation that lays down rules and procedures relating to the recovery and resolution of financial entities such that the scope of powers given to resolution authorities is extremely broad as they have to deal with significant liabilities that arise from numerous and often complex contracts. The relevant concept is therefore not expressed in terms of products or contracts but rights and liabilities.

Article 44(1) of the BRRD, which describes the scope of bail-in, clearly states that it applies to "all liabilities" which are not excluded. Capital instruments, bonds and other instruments creating indebtedness, fall within the scope.

The BRRD does not provide a list of contracts that are impacted but gives resolution authorities general and ancillary powers to apply the resolution tools. These powers can impact directly on products and contracts.

 

What constitutes secured liabilities?

Article 44(2)(b) of the BRRD excludes "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".

The actual meaning of "secured liability" is clarified in Article 1(67) of the BRRD which defines it as "a liability where the right of the creditor to payment or other form of performance is secured by a charge, pledge or lien, or collateral arrangements including liabilities arising from repurchase transactions and other title transfer collateral arrangements".

 

Which conditions are necessary to qualify as a secured liability?

It is important to highlight that pursuant to Article 43(1) of the Commission Delegated Regulation (EU) 2016/1075 ("Contractual Recognition RTS")[8], for the purposes of Article 55, a secured liability will not be considered as an excluded liability where, at the time at which it is created, it is:

(a) not fully secured;

(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 EU law or of a third country law achieving effects that can be deemed equivalent to EU law.

It is should be pointed out that there is no legal definition of what exactly constitutes "fully secured" and "fully collateralised on a continuous basis". We are of the opinion that provided there is a security or title transfer collateral arrangement under which collateral has been posted or delivered as of the date of entering into the relevant contract and remains outstanding and provided further that appropriate enforcement legal opinions (e.g. the ISDA collateral and netting opinions) have been issued, derivative transactions should be "secured liabilities".

As explained above, the relevant liabilities will have to comply with the requirements laid out in Article 43(2) of the Contractual Recognition RTS (and the relevant implementation rules of each Member State).

It is important to note that even though derivative liabilities may fall under the general exclusions from the scope of the bail-in power under Article 44(2) this will apply only to the extent that the value of the liability does not exceed the value of the collateral.[9]

At the UK level and in light of the Contractual Recognition RTS, the PRA has clarified the concept of "unsecured liability" and "fully secured liability" as follows:

"unsecured liability"

"fully secured liability"

in respect of liabilities created on or before 31 July 2016, a liability under which the right of the creditor to payment or other form of performance is not (i) secured by a charge, pledge, lien or mortgage, or (ii) subject to other collateral arrangements, including liabilities arising from repurchase transactions and other title transfer collateral arrangements; and in respect of liabilities created after 31 July 2016, a liability that is not a fully secured liability

a liability which, at the time it is created, is fully secured and governed by contractual terms that oblige the debtor to maintain the liability fully collateralised on a continuous basis in compliance with regulatory requirements of EU law[10] or of the law of a third country achieving effects that can be deemed equivalent to EU law

 

Can liabilities be excluded on exceptional circumstances?

Article 44(3) of the Contractual Recognition RTS permits the resolution authority to exclude liabilities, including those in respect of derivatives, from bail-in in exceptional circumstances where:

(a) it is not possible to bail-in that liability within a reasonable time;

(b) the exclusion is strictly necessary to ensure the continuity of critical functions and core business of the entity;

(c) the exclusion is strictly necessary to avoid giving rise to widespread contagion; and

(d) the application of the bail-in to those liabilities would cause a destruction in value such that the losses borne by other creditors would be higher than if those liabilities were excluded from bail-in.

 

How are derivatives valued in the context of a bail-in?

In the case that the resolution authority exercises its right to close-out a contract which has not already been terminated by the counterparty, the counterparty is entitled to submit evidence of an actual transaction on economic terms equivalent to the closed-out transaction entered into on or after the close-out date of such transaction to re-establish on a net risk exposure basis, any hedge or related trading position that was constituted by the closed-out transaction. The valuation process is set out in the Commission Delegated Regulation (EU) 2016/1401 (the "Valuation RTS")[11].

The valuer will evaluate the proposed replacements trades to ensure they are commercially reasonable. If it concludes that the criteria are satisfied, it will determine the close-out amount at the price of those replacement trades.

This approach is similar in some ways to the 1992 ISDA Master Agreement (Multicurrency – Cross-Border) market quotation methodology although actual executed transactions instead of quotations are required.

The Valuation RTS defines a "commercially reasonable replacement trade" as a replacement trade entered into on a netted risk exposure basis, on terms consistent with common market practice and by making reasonable efforts to obtain best value for money. Therefore, the notion of "commercially reasonable replacement trade" is broadly defined in order to enable the valuer to conduct the required assessment in all market contexts.[12]

 

What happens if no replacement trades are submitted?

If a valuer determines that the replacement trades submitted were not concluded on commercially reasonably terms or if a counterparty has not provided evidence of any replacement trades within the deadline set in the communication, the valuer will determine the close-out amount on the basis of the following:

(a) the mid-market end-of-day prices in line with the business-as-usual processes within the institution under resolution at the date determined pursuant to Article 8 of the Valuation RTS;

(b) the mid-to-bid spread or mid-to-offer spread, depending on the direction of the netted risk position;

(c) adjustments to the prices and spreads mentioned in points (i) and (ii) where necessary to reflect the liquidity of the market for the underlying risks or instruments and the size.

 

On what date can the valuer rely to make its valuation?

For determining a value of the close-out amount, the valuer may consider a full range of available and reliable data sources. It may rely on observable market data or theoretical prices generated by valuation models aimed at estimating values, including the following sources of data:

(a) data provided by third parties, such as observable market data or valuation parameters data and quotes from market-makers or, where a contract is centrally cleared, values or estimates obtained from central counterparties;

(b) for standardised products, valuations generated by the valuer's own systems;

(c) data available within the institution under resolution, such as internal models and valuations;

(d) data provided by counterparties other than evidence of replacement trades communicated pursuant to the Valuation RTS, including data on current or previous valuation disputes with regard to similar or related transactions and quotes; and

(e) any other relevant data.

 

THE DELTA REPORT
Derivatives Newsletter
January 2017

Read other articles in this issue

Search for more Derivatives Insights

 

[1] Available at: eur-lex.europa.eu/legal-content/EN/TXT/PDF/?uri=CELEX:32014L0059&from=en
[2] Non-EU subsidiaries of EU companies will not be in scope.
[3] Pursuant to point (30) of Article 4(1) of Regulation (EU) 575/2017 this means: a parent financial company in a Member State: a financial holding company which is not itself a subsidiary of an institution authorised in the same Member State, or of a financial holding company or mixed financial holding company set up in the same Member State.
[4] Pursuant to point (31) of Article 4(1) of Regulation (EU) 575/2017 this means: a parent financial holding company in a Member State which is not a subsidiary of an institution authorised in any Member State or of another financial holding company or mixed financial holding company set up in any Member State.
[5] Article 1 defines the scope of the BRRD as including "branches of institutions that are established outside the Union in accordance with the specific conditions laid down in this Directive" (EU branches).
The requirement as to the actions that a resolution authority should be able to take as regards these branches is defined in a broad manner. Articles 94(4)(a) (i) and (ii) of the BRRD request that EU Member States equip their authorities with powers to enforce third country resolution proceedings by being able to exercise resolution tools over, respectively, assets of a third country institution or parent undertaking that is located in their jurisdiction or governed by the law of that Member State and rights or liabilities of a third-country institution that are booked by the EU branch in their Member State or governed by the law of their Member State, or where claims in relation to such rights and liabilities are enforceable in their Member State. For EU branches that are not subject to third-country resolution proceedings (or where the third-country resolution proceeding cannot be recognised), Article 96(3) applies, which sets out principles and requirements that the authority should have regard to when taking action (in so far as they are relevant).
[6] Available at: bankofengland.co.uk/pra/Documents/publications/cp/2016/cp816.pdf
[7] Available at: prarulebook.co.uk/rulebook/Content/Part/211722/05-01-2017#211722
[8] Available at: eur-lex.europa.eu/legal-content/EN/TXT/PDF/?uri=CELEX:32016R1075&from=EN
[9] This could arise in a situation where the collateral held by a counterparty does not fully cover its exposure (e.g. due to a threshold amount in the documentation or the time gap in between the last margin call and close-out occurring). However, this would not make the entire claim subject to bail-in; only the difference between the collateral value and the sum due on close-out would not constitute an "excluded liability".
[10] Article 11(3) of Regulation (EU) No 648/2012 of the European Parliament and of the Council of 4 July 2012 on OTC derivatives, central counterparties and trade repositories ("EMIR") sets out the general obligation. EMIR margin requirements are developed more specifically by the Commission Delegated Regulation (EU) 2016/2251 of 4 October 2016 supplementing Regulation (EU) No 648/2012 of the European Parliament and of the Council on OTC derivatives, central counterparties and trade repositories with regard to regulatory technical standards for risk-mitigation techniques for OTC derivative contracts not cleared by a central counterparty. Available at: eur-lex.europa.eu/legal-content/EN/TXT/PDF/?uri=CELEX:32016R2251&from=EN
[11] Available at: eur-lex.europa.eu/legal-content/EN/TXT/PDF/?uri=CELEX:32016R1401&from=EN
[12] Note that the obligation will be on the counterparty to actually replace the trade. The valuation process simply looks to provide compensation for doing so.

 

This publication is provided for your convenience and does not constitute legal advice. This publication is protected by copyright.
© 2017 White & Case LLP