17 October 2016

Bail-In and Brexit

The Bail-In Clause has been causing lawyers to scratch their heads for some time. Will Brexit mean that English-law contracts have to include a Bail-in Clause? What happens if a counterparty refuses to incorporate the Bail-In wording?

Bail-In – a reminder

What does the clause do? - A Bail-In Clause requires counterparties to an agreement entered into with an EEA financial institution to acknowledge that a Regulator’s rescue plan may involve the cancellation, conversion or write-down of that institution’s liabilities. Broadly speaking, all EEA banks and major investment firms together with their branches, EEA parents and certain EEA subsidiaries must ensure that a Bail-In Clause is included in any agreement they enter into which is governed by non-EEA law and contains in-scope liabilities. The EEA consists of the EU, Iceland, Liechtenstein and Norway.

Article 55 - The requirement stems from Article 55 of the EU Bank Recovery and Resolution Directive. It affects all relevant agreements entered into after 1st January 2016 and certain pre-existing documents.

What type of liabilities? - Some types of liability are excluded, such as those to do with client money, but otherwise the range of contractual and non-contractual liabilities covered by the Bail-In requirement is extremely wide. A security agreement granted to a UK bank and governed by Jersey law is a classic example of the type of contract that could require Bail-In wording. Jersey is a non-EEA jurisdiction and, although they are probably not the type of liabilities that a Regulator would bother bailing-in, the bank has potential liabilities under the security agreement relating to the manner in which it enforces the security (amongst other things).

Impact of Brexit

The future - The LMA has recently produced a note discussing the impact of Brexit on LMA facility documentation. One of the issues the LMA looked at was what would happen to Bail-In requirements post Brexit. As law currently stands, there is no legal requirement for English law contracts, such as facility agreements, to contain a Bail-In Clause because the UK is a member of the EU. Whether or not that remains the case depends on what form Brexit takes.

Type of Brexit - If the UK exits the EU but remains a member of the EEA, then there will be no need for English-law agreements to contain a Bail-In Clause. Even if the UK rejects EEA membership, Article 55 provides that Bail-In wording need not be inserted if the remaining EU states are satisfied that their regulators will still be able to exercise conversion and write-off powers under English law.

As long as the UK exits on terms which tick one of the above boxes, there should be no requirement for Bail-In wording having to be routinely inserted in English law finance documents. However, the final legal form which Brexit will take is not yet clear so lawyers will continue to keep an eye on Bail-In compliance.

Stubborn counterparties?

PRA’s view - Some counterparties have refused to accept the insertion of Bail-In wording in contracts with UK financial institutions. They can be reluctant even when it’s explained that excluding the relevant wording won’t necessarily protect them.

The Prudential Regulatory Authority (PRA) has, however, recognised that compliance with Article 55 is sometimes impracticable. It has changed its rules so as to allow non-inclusion of Bail-In wording in some situations. This “modification by consent" was originally due to expire in August 2016 but has now been made permanent. The FCA has issued a similar consent, which has to be applied for by firms and which expires in June 2017.

Impracticability carve-out - The PRA has set out some examples of circumstances where the “impracticability carve-out” applies. They include situations where, for example, a non-EEA authority has stated that it will not allow inclusion of a Bail-In Clause or local laws will not permit it or the contract is on standard-form terms imposed by a non-EEA body which cannot be amended.

No slacking - The PRA has indicated that mere inconvenience or loss of profit are no reason for failing to include a Bail-in Clause. Market participants are expected to look at each contract on a case by case basis and to leave an audit-trail showing the steps they have taken regarding Bail-In compliance.

If all else fails, there may be other avenues that can be explored. It may be possible to persuade the counterparty to agree to a change of governing law, opting for the laws of an EEA state, although for security documents this may not be advisable. It remains to be seen whether financial institutions will turn down business with counterparties who will not play ball on Bail-In.

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