Banking & Finance Brexit Blog: Bail-in clauses and Brexit

What is a ‘bail-in’ clause?

The inclusion of ‘bail-in’ clauses in certain contracts, such as loan agreements or the issuance of bonds are the result of requirements set out in Article 55 of the EU Bank Recovery and Resolution Directive (BRRD). The BRRD is an EU directive that was conceived following the 2008 financial crisis with the aim of establishing a common framework for the European Economic Area (EEA) states (i.e. any EU member state plus Iceland, Liechtenstein and Norway) to employ in resolving distressed financial institutions and ensuring co-operation between EEA states in managing those situations when they involved cross-border financial institutions. Provisions within the BRRD include the grant of recovery and resolution powers to EEA regulators to ‘bail-in’ certain liabilities of any failing EEA financial institutions by instigating actions such as write-downs or conversions into equity of the failing financial institutions liabilities. These rights are automatically effective in respect of liabilities in contracts that are governed by the law of an EEA country. Article 55 extends these powers by specifically requiring that any EEA financial institution with liabilities under a contract governed by the law of a non-EEA state must include in that contract a clause that contractually recognises the powers of the EEA regulators pursuant to Article 55 – known as a ‘bail-in’ clause.

In response to this requirement certain market associations, in particular the UK based Loan Market Association (LMA) and the International Capital Markets Association (ICMA), have each devised their own form of bail-in clause that have been widely accepted in applicable contracts in the relevant markets.

Why have ‘bail-in’ clauses started to appear in English law governed finance contracts?

In anticipation of the UK formally and fully exiting its EU/EEA membership following the end of the transition period on the 31 December 2020, it has become increasingly standard practice to include a form of bail-in clause in contracts that are governed by English law and have an EEA financial institution party to them or potentially party to them (e.g. with respect to loan agreements where the subsequent syndication of a loan or transfer of a loan in the secondary market may occur bringing an EEA member state financial institution into the scope of the contract) in order for those EEA financial institutions to be in compliance with Article 55 of the BRRD post the transition period.

The BRRD does permit the EU to agree exemptions with third states (e.g. post transition the UK) so that contractual recognition of bail-in clauses need not be included in contracts that would otherwise be covered by Article 55. However, thus far no such exemption has been forthcoming for the UK and no wider comprehensive long term ‘Brexit’ agreement between the EU and UK that might scoop up and grant waivers or equivalence recognition for such requirements look likely as we now race quickly towards the end of the transition period.

What is the future of bail-in clauses?

The inclusion of bail-in clauses in contracts governed by English law and involving (or potentially involving) EEA member state financial institutions continue to be prudent in anticipation of the UK becoming a non-EEA state and given the current trajectory of the negotiations between the EU and UK.

The BRRD will also be ‘on-shored’ (i.e. made domestic UK law pursuant to a statutory instrument – the BRRD SI[1]) with amendments, meaning that UK financial institutions will also need to consider the inclusion of bail-in clauses into financial contracts governed by an EEA law. This should not be something entirely new to UK financial institutions as pursuant to rules already set out in the Financial Conduct Authority Handbook and the Prudential Regulatory Authority Rulebook UK financial institutions are already required to include bail-in clauses in relevant contracts governed by a non-EEA law. The BRRD SI will amend the Handbook and Rulebook to also include those contracts governed by EEA law.

However, interestingly in July of this year the European Banking Authority’s (EBA) launched a consultation paper on the Draft Regulatory Technical Standards (RTS) on impracticability of contractual recognition of bail-in clause under Article 55(6) of the BRRD and the Draft Implementation Standards (ITS) for the notification of impracticability of contractual recognition under Article 55(8) of BRRD (the Consultation Paper) to canvas views from the market on its proposed draft regulatory technical standards that include conditions of impracticability for parties to include a bail-in clause in finance contracts.

There are of course some obvious conditions that make inclusion of a bail-in clause impracticable, such as illegality by virtue of the laws of a third state. Respondents to the consultation were also provided though with a list of circumstances or criteria that could potentially be considered conditions of impracticability but were not actually deemed to be by the EBA and asked to confirm their agreement with that list. Of particular interest was the situation where a liability is contingent on a breach of contract. Usually a financial institution that is party to a loan agreement, for example, is providing credit or fulfilling an administrative role (e.g. facility agent) and its obligations in these capacities would only, generally speaking, give rise to liabilities should they breach those obligations – fitting perfectly into the situation outlined by the EBA.

The EBA stated their case that:

“Since the liabilities subject to Article 55 have to arise out of a contract in any event, the fact that an underlying liability may be contingent at the time of formation of the contract, does not of itself prevent the inclusion of Article 55 wording in the contract.”

The LMA submitted its responses to the Consultation Paper setting out its reasons for disagreeing with this position. The strongest strand of its argument is probably that this position is inconsistent with guidance previously issued by the European Commission[2] (EC) that:

“Under certain circumstances, it could be considered impracticable to include contractual recognition clauses in liability contracts in cases where […] the liability which would be subject to the contractual recognition requirement is contingent on a breach of contract […]”

Supporting this position is the LMA’s arguments that in any event it is unlikely that the ability to bail- in a liability arising from a breach of contract will arise because the value of such liability is most likely to be either settled between the parties or by a court following litigation. The liability cannot be bailed-in until it is quantified and, in such circumstances, it is being quantified outside of the original contract, i.e. in an agreement or judgement that does not include the Article 55 required bail-in clause. By accepting and confirming this situation as impracticable under the RTS the EBA would be taking a position not only consistent with the EC views but also with the approach taken in other jurisdictions.

In fact the UK Prudential Regulation Authority published guidance[3] to the effect that impracticability grounds could be invoked for not including bail-in clauses in contracts where the relevant liabilities are contingent on a breach of contract. This means that strictly speaking in the UK, for example, contracts governed by third state law (e.g. New York law or post transition period that of an EEA member state) involving UK financial institutions alone are not required as a matter of UK law to include bail-in clauses. However, in practice in respect of, for example, a syndicated or syndicatable loan or a loan permitting transfers it is likely that even in the scenario where you have UK financial institutions entering into third state governed law contracts you would still include a bail-in clause to ensure that any European banks entering into the documentation at a later date do not fall foul of Article 55. We await the outcome of the consultation process and for the EBA to deliver the final draft RTS and final draft ITS to the European Commission before their position on this issue will become clearer.

 

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