The history of Recovery and Resolution Plans (“RRPs” aka “Living Wills”) for systemically important financial institutions (“SIFIs”) can be traced back to the final communiqué of the G20 group of nations following the Pittsburgh Summit of September 2009, wherein it was concluded that:
“major failures of regulation and supervision, plus reckless and irresponsible risk taking by banks and other financial institutions, created dangerous financial fragilities that contributed significantly to the current crisis. A return to the excessive risk taking prevalent in some countries before the crisis is not an option.”
The G20 resolved to take action, by the end of 2010, to address the cross-border resolution of SIFIs. SIFIs would be required to develop internationally-consistent firm-specific contingency and resolution plans. Moreover, authorities would be required to establish crisis management groups for major cross-border financial firms, a legal framework for crisis intervention, improve information sharing in times of stress and develop resolution tools and frameworks for the effective resolution of financial groups.
Whilst the implementation timeline of the original G20 initiative has slipped, the pace of regulation is now beginning to increase. A number of FDIC rules passed pursuant to the Dodd-Frank Act were finalised over the past months. During the course of 2012, the EU Commission is also due to publish a draft directive regarding an EU framework for bank RRPs and the FSA is to publish a policy statement on proposals for RRP, following its 2011 consultation exercise.
Although no two sets of regulations are identical, it seems clear that resolution authorities will have a basic set of powers to:
- sell a failing business to a private purchaser;
- set up a bridge institution to which the business of a failing firm can be transferred pending sale or winding up;
- take control of an institution under resolution and exercise all the rights conferred upon the shareholders – including removal of management;
- transfer rights, assets, liabilities and instruments of an institution under resolution;
- separate good assets of a failing institution from bad assets; and
- impose a temporary moratorium on the payment of claims.
Some legislation, such as that in the EU, looks set to go further and grant regulators the power to:
- write-down debt of a failing institution or convert the same into ordinary shares;
- amend or alter the maturity of, or interest payable with respect to, debt instruments issued by an institution under resolution; and
- cancel shares and other instruments of ownership issued by an institution under resolution.
By way of safeguard against the sweeping powers granted to resolution authorities, most legislation enshrines the general guiding principal that, as far as possible, creditors of a failing institution should not be subject to less favourable treatment than they would have received under normal national insolvency proceedings. Nonetheless, it is important for buyside firms to understand the potential risks to investors in, or creditors of, failing financial institutions.
5: Differing Approaches to Resolution
At a high level, there are two basic approaches to resolving a failing institution – the unitary approach and the territorial approach. Under the unitary approach, the bank is resolved as a single entity under the laws of the home state, with all assets being pooled and liquidated for the benefit of the bank’s creditors, irrespective of location. Under the territorial approach, each jurisdiction resolves the branch within its territory as if it were a separate, independent legal entity.
Risks to investors in, or creditors of, failing institutions can arise with respect to cross-border firms where different jurisdictions in which the firm has offices adopt different approaches to the question of resolution. Specifically, the EU looks set to adopt a unitary approach to resolution. In contrast, the United States takes a territorial approach. As such, the assets of any US branch of an EU bank may potentially be unavailable in the event of bank’s insolvency, with the effect that the amount of assets available to EU creditors may be less than would otherwise be the case.
4: The Exercise of Transfer Powers
In transferring shares, assets, rights or liabilities of a failing firm, a resolution authority will typically not be required to obtain the consent of the shareholders of the institution under resolution or any third party, and will not be required to comply with any procedural requirements under company or securities law that would otherwise apply. There is also a general lack of clarity over the exact valuation to be placed on assets which are transferred, although under EU law at least, any transfer must usually be made on arms-length commercial terms. In addition, counterparties of failing institutions are typically granted protection against partial transfers of assets by resolution authorities so as to prevent “cherry picking”, particularly with respect to financial transactions and the safeguarding of close-out netting and security, collateral and set-off arrangements.
3. Interference with Contractual Rights
Payment and Delivery Obligations
Counterparties to failing institutions should be aware that resolution authorities will typically have the power to suspend any payment or delivery obligations of the failing institution pursuant to any contract (although obligations with respect to insured deposits are often excluded). However, by way of safeguard, it is usual for this suspension to be limited in time to a maximum of 24 to 48 hours.
Usually, where a resolution authority exercises any right to:
- transfer shares or other instruments from an institution under resolution to another entity, or
- write down debt of a failing institution
the original counterparty of the institution under resolution will not, simply by virtue of the transfer or write-down, be able to exercise any right or power to terminate, accelerate, exercise any “walk away” clause, or otherwise declare a default.
Again, in order to protect counterparties to failing institutions, the limitation of termination rights will typically last for only 24-48 hours, and resolution authorities will usually be required to make reasonable efforts to ensure that margin, collateral and settlement obligations of the failing institution that arise under financial contracts during the period of suspension are met. Furthermore, pre-existing rights to terminate are typically not subject to any restriction to the extent that:
- they relate to any subsequent or unrelated default by the recipient of the transferred contract (for example a failure to pay or deliver collateral);
- the rights and liabilities in question remain with the failing institution; or
- they relate to defaults other than ones which arise solely by reason of the actions of the resolution authority.
When exercising transfer powers, resolution authorities will usually be entitled to restrict secured creditors from enforcing security interests in relation to any assets of the institution in question. However, this power does not normally extend to include any security interest of a central counterparty over assets pledged by way of margin or collateral by the institution under resolution.
In circumstances where a resolution authority has exercised its transfer or debt write-down powers, creditors of the institution under resolution will not usually be entitled to exercise any statutory set-off rights. However, counterparties to a failing institution should take some comfort from the fact that exemptions typically provide protections for transactions executed under financial netting agreements such as the ISDA Master Agreement.
Bail-in is concept to be found in the draft EU legislation and defines a process of internal recapitalisation that is triggered once a failing firm has reached the point of non-viability. In practice, ’bail-in’ losses are imposed on a certain set of creditors either by writing down their claims or by converting the same into equity. There are two main approaches to the question of bail-in – the issue of contingent capital and statutory bail-in.
This involves the issuance of debt instruments that contain a contractually agreed trigger clause specifying the circumstances in which the instrument is either written down or converted into equity. Typically, the bail-in trigger is quantifiable and is linked to regulatory capital ratios, being set at a level such that bail-in would occur at a point sufficiently early to allow the firm in question to recover without having to undergo resolution. As such, provided that contractual provisions are clear, contingent capital issuances should present no real risks to buyside firms, whose willingness to invest (or otherwise) should be a function of price.
Statutory Bail-In: the Debt Write-Down Tool
Statutory bail-in is defined as the power given to a resolution authority to subject unsecured liabilities of a failing institution to write-down or conversion into equity. Bail-in can be applied where the objective is either to restore the institution in question as a going concern or where it is to be liquidated, but only where there is a realistic prospect that the application of the tool will achieve the desired objective. Any write down or conversion should respect the pari passu treatment of creditors and applicable statutory creditor insolvency rankings. In other words, equity and regulatory capital instruments should absorb losses in full before subordinated debt is affected, and subordinated debt should be written down in full before senior debt is affected. This clarity should provide some comfort to creditors, but note that contingent capital bonds are likely to be written down in the order detailed above irrespective of whether the bail-in conditions associated with those bonds have been met. Further protection comes from the fact that, where a resolution authority exercises its power to convert debt to equity, the rate of conversion should reflect the seniority of the affected debt, meaning that senior liabilities will benefit from a higher conversion rate than subordinated liabilities.
However, creditors of a failing institution should be aware that certain exceptions are likely to apply, meaning that any write-down is unlikely to affect:
- deposits that are guaranteed as a matter of EU law;
- liabilities of a failing institution to its employees;
- commercial claims relating to goods and services; and
- claims which are secured, collateralised or guaranteed.
Furthermore, debt claims with a maturity of less than one year and claims relating to derivatives will only be subject to write down if equity, regulatory capital instruments, subordinated debt and senior debt with a maturity of more than one year are not sufficient to restore the failing institution’s fortunes.
In reality, the risks associated with bail-in lie as much in the questions that remain to be answered. For example:
• At exactly what point will write-down be triggered?
Typically, the trigger is set at the point where a firm is ‘failing or likely to fail’ certain threshold conditions, such as solvency ratios. Both UK and EU law seem similar in this respect. Whilst the need for flexibility is understandable, the ambiguous nature of the drafting creates a risk to creditors that bail-in powers could be exercised prior to the real point of non-viability.
• Under what circumstances would a resolution authority opt for write-down rather than conversion?
It is important to get clarity on this issue due to the vastly different rights and obligations associated with debt (the end-product of the exercise of the write-down tool) as opposed to equity (the end-product of the exercise of the conversion tool).
• Will the write-down tool apply to existing debt, or only new debt issuances?
The hope and expectation is that the write-down tool will only be capable of being applied to new debt issuances. However, to date, the issue has not been clarified.
1: It could be you!
In its 2012 Work Programme dated 15 November 2011, the EU Commission referred to the fact that it would report into the need for a crisis management regime for financial institutions other than banks, with specific reference to Central Counterparties, insurance companies and…hedge funds.
Whilst no panacea, recovery and resolution planning legislation represents a significant step forward in equipping regulators with the tools to minimise the risks associated with a future collapse of a major banking group. This can only be good for financial markets despite the risks to investors in, and creditors of, a failing firm. However, the fact that hedge funds may be the next target in the sights of the EU Commission is a worrying development which brings us full circle back to G20 communiqué of 2009. The administrative burden associated with preparing recovery and resolution plans should not be underestimated. Whether a hedge fund can rightly be regarded as a “systemically important financial firm” to which this legislation can be justifiably applied, is at best questionable. Ultimately, only time will tell.