On 14 January 2014, HM Treasury published the “Final review of the Investment Bank Special Administration Regulations 2011” conducted by Peter Bloxham. The report meets Parliament’s requirement that the Treasury hold an independent review of the special administration regime (SAR) for investment banks within two years of it coming into force. Continue reading
On 8 October 2013, HM Treasury published a draft annex on the new bail-in option to the Special Resolution Regime (SRR). The bail-in tool is being introduced through amendments to the Banking Act 2009 by the Banking Reform Bill 2013 for the purpose of offering a new stabilisation option to the Bank of England as lead resolution authority. It will be available to failing banks and investment firms, with necessary modifications to building societies via secondary legislation and under specified conditions to banking group companies.
The draft annex to the Code of Practice supports the legal framework for the SRR and provides guidance as to when and how the bail-in tool may be deployed by authorities in practice.
A summary of the key points include:
General and Specific Conditions for Use of SRR Tools (Section 7)
The conditions for use of the bail-in option are identical to those for the stabilisation options set out in the existing Code :
the regulator must determine that the institution is failing or likely to fail;
it is not reasonably likely that action will be taken by or in respect of the bank to avoid its failure; and
the Bank of England is satisfied that exercising the bail-in power is necessary having regard to the public interest.
When choosing between the original resolution tools, the Bank of England will consider the relative merits of the stabilisation options and the bank insolvency procedure given the circumstances in addition to general considerations . The Bank of England may also choose resolution by way of bail-in for situations where the use of another stabilisation power would threaten financial stability or confidence in the banking systems.
Use of the Bail-in Powers (Section 8)
The bail-in option gives the Bank of England the power to cancel or modify the terms of any contract in a resolution scenario for the purposes of reducing or deferring a liability of the bank (“special bail-in provision”). A conversion power also exists that allows for liabilities to be converted into different forms. Certain liabilities are excluded from the scope of the power to make special bail-in provision including:
deposits covered by the Financial Services Compensation Scheme (FSCS) or an equivalent overseas scheme;
liabilities to the extent they are secured;
client assets, including client money;
liabilities with an original maturity of less than seven days which are owed to a credit institution or investment firm (save in relation to credit institutions or investment firms which are banking group companies in relation to the bank);
liabilities arising from participation in a designated settlement system and owed to such systems, or to operators or participants in such systems;
liabilities owed to central counterparties recognised by the European Securities and Markets Authority (ESMA) in accordance with Article 25 of Regulation (EU) 648/2012;
liabilities to employees or former employees in relation to accrued salary or other remuneration (with the exception of variable remuneration);
liabilities owed to employees or former employees in relation to rights under a pension scheme (with the exception of discretionary benefits); and
liabilities to a creditor arising from the provision of goods or services (other than financial services) that are critical to the daily functioning of the bank’s operations (with the exception of creditors that are companies which are banking group companies in relation to the bank).
Prior to taking resolution action or converting liabilities, resolution authorities are expected to carry out a valuation of the assets and liabilities of the institution as is reasonably practicable.
The UK has chosen to exercise the discretion granted to it under the Recovery and Resolution Directive and has included derivatives in the list of liabilities which can be bailed-in. Specific power to make special bail-in provision to derivatives and similar financial transactions can be found in Sections 8.14 – 8.17 of the Annex. The Bank of England will, where appropriate, exercise its power to close-out contracts before they are bailed in with any applicable close-out netting being taken into account. If a liability is owed, it will be excluded from bail-in so far as it is secured and compensation arrangements will follow the “no creditor worse off” principle. This ensures that no person is worse off as a result of the application of the bail-in option than they would have been had the bank gone into insolvency.
H.M. Treasury yesterday published 86 proposed amendments to the Banking Reform Bill. The bill is due to enter its committee stage in the House of Lords on the 8th October 2013. The proposed amendments were widely-flagged and broadly mirror the 11th March 2013 recommendations of the Parliamentary Commission on Banking Standards. Highlights are as follows:
- Payments: the introduction of a wholly new and distinct payment systems regulator, the intention being to stimulate competition by facilitating access to payment systems for new market participants, as well as decreasing the costs of account portability. A special administration regime to deal with cases where a key element in a payment fails or is likely to.
- Misconduct: an extension of the FSMA approved persons regime. If passed, the amendments will allow the regulators to: make the approval subject to conditions or time-limits, extend time limits for sanctions against individuals, impose “banking standards rules” on all employees , and to hold senior managers responsible for regulatory breaches in areas which they control. PCBS chairman Andrew Tyrie, (perhaps confusing Ford Open Prison with Guantanamo), had previously advocated putting “guilty bankers in bright orange jump suits”; as widely expected, the proposals introduce criminal sanctions for reckless misconduct in the management of a bank.
- Electrified ring-fence: proposed new powers to formalise and streamline the “electrification” power introduced at the Commons report stage. The electricity in the ring-fence is the regulator’s power to compel separation of a banking group which breaches the boundary between retail and investment banking. The effect of the new powers is to make the ring-fence into a “variable-voltage” device. Under the proposal, the regulator will:
- issue a preliminary notice, the affected party will have a minimum of 14 days to reply and 3 months to make necessary changes to its behaviour/structure
- failing this and with the consent of the Treasury, a warning notice will then be issued, itself triggering a minimum of 14 days for representations by the affected party
- a decision notice is then issued, which may be appealed before a Tribunal
- a final notice is issued which set s a dead line by which a bank must separate its activities
The whole process will take approximately 14 months and the various notices will be issued in accordance with general FSMA principles.
Bail-in: the introduction of a bail-tool as initially mandated by the European BRRD and recommended by the domestic ICB and PCBS. The Banking Act of 2009 will be amended to include a “stabilisation option” (bail-in), covering banks and investment firms and to be applied by the bank of England as lead resolution authority. The conditions for its use are identical to those of the Special Resolution Regime:
- the regulator must determine that the bank is failing or is likely to fail
- it is not likely that any other action can avoid the failure
- The BoE determines that application of the bail-in power is in the public interest
The bail-in option includes the right to modify existing contracts for the purpose of mitigating the liabilities of a bank under resolution. There are a number of liabilities which will be excluded from the provision: client money, FSCS protected deposits, employee pension schemes, payment system liabilities, debts to a creditor who is critical to the bank’s daily functioning etc.
In short- the electric ring-fence is reconnected to the mains and bail-in is set to become a reality. These and other less fundamental proposed amendments represent a significant extension of regulatory powers. It remains to be seen if they will be rigorously and consistently applied to their full extent.
On 26 September 2013, HM Treasury published a consultation paper regarding secondary legislation for non-bank resolution regimes. The consultation will remain open until 21 November 2013.
As currently drafted, the Special Resolution Regime (SRR) established by the Banking Act 2009 applies to most deposit-taking institutions such as banks and building societies. The Financial Services Act 2012 widened the SRR to include undertakings in the same group as a failing entity, investment firms, and central counterparties (CCPs). However, these provisions have not yet been brought into force. The consultation seeks comment on a number of proposed statutory instruments required to underpin the widened SRR as detailed below:
- The Banking Act 2009 (Exclusion of Investment Firms of a Specified Description) Order 2013
- The Banking Act 2009 (Banking Group Companies) Order 2013
- The Banking Act 2009 (Restriction of Partial Property Transfers) (Recognised Central Counterparties) Order 2013
- The Banking Act 2009 (Third Party Compensation Arrangements for Partial Property Transfers)(Amendment) Regulations 2013
Broadly, the issues discussed include:
Exclusion of certain investment firms from the scope of the SRR
The government is proposing to narrow the scope of the SRR so that it applies only to those investment firms that are required to hold initial capital of €730,000 (“€730k investment firms”) as specified in the Capital Adequacy Directive. The government believes that there are approximately 2,000 investment firms in the UK, about 250 of which are €730k investment firms. Non-€730k investment firms which fail will continue to be dealt with under normal insolvency procedure, or enter into the special administration regime (SAR).
Extension of stabilisation powers to “banking group companies”
At present, the SRR only permits the Bank to exercise stabilisation powers over a failing institution. However, these powers are to be extended to cover banking group companies (“BGCs”), being:
subsidiaries of the failing institution;
parents which are “financial holding companies”; and
undertakings which are in the resolution group (i.e. subsidiaries of the “resolution group holding company”).
By virtue of the application of the SSR to investment firms and CCPs, the Bank’s SRR powers will also extend to undertakings within the same group as a failing investment firm or CCP (though the legislation refers to all such group undertakings as “banking group companies” irrespective of whether they are grouped with a bank, a building society, an investment firm or a CCP).
Introduction of further partial property transfer (“PPT”) safeguards
PPTs transfer some, but not all, of the property, rights or liabilities of a failing institution to a private sector purchaser or bridge bank. A number of safeguards currently exist in relation to PPTs. These safeguards are designed to protect contractual and market arrangements (and so provide clarity to, and bolster the confidence of, the market) within the context of a flexible regime which is able to resolve failing institutions effectively. Specifically the safeguards include protection for set-off arrangements, netting arrangements and title transfer financial collateral arrangements; secured liabilities; capital market arrangements; and financial markets. The government proposes to extend these safeguards to investment firms and banking group companies. It also proposes to make a separate statutory order to enact PPT protections with respect to recognised CCPs. These would protect collateral and netting arrangements by only making a PPT possible with respect to a complete segregated business line of a CCP (i.e. a product set cleared by a CCP that is covered by a segregated set of default protections).
Introduction of further ‘no creditor worse off’ safeguards
Section 60 of the Banking Act 2009 permits the Treasury to make regulations about third party compensation arrangements in the case of PPTs, often called ‘no creditor worse off’ (“NCWO”) provisions. As an example, an independent valuer is required to be appointed to determine whether pre-transfer creditors should be paid compensation and, if so, what amount, and the principles they must apply when making the valuation. The government proposes to extend the NCWO provisions to PPTs made in respect investment firms and banking group companies.
Extension of the Bank Administration Procedure (BAP) rules
The government is proposing to amend insolvency rules to extend the bank administration procedure to (the residual part of) investment firms and banking group companies. However, the BAP has not been extended to CCPs, as the resolution authority has powers of direction over the administrator of an insolvent CCP.
On 25 April 2013, HM Treasury published a consultation paper on the introduction of a Special Administration Regime (SAR) for inter-bank payment systems (such as Bacs, CHAPS, Continuous Linked Settlement, CREST, LCH Clearnet Ltd, Faster Payments Service and ICE Clear Europe), operators of securities settlement systems (CREST being the only example in the UK) and key service providers to these firms (e.g. IT and telecommunications providers). Responses are requested by Wednesday 19 June 2013.
The SAR would be a variant of a normal corporate administration and would be modelled on the special administration framework used in the utilities industries and the investment bank SAR. However, it would be modified to allow the Bank of England to exercise control of the SAR process, to enable a special administrator to transfer all or part of the business to an aquirer on an expedited basis, and to facilitate the enforcement of restrictions on early termination of third party contracts. Under the SAR, the special administrator would have the overarching objective of maintaining the continuity of critical payment and settlement services in the interest of UK financial stability. “Non-CCP FMI”, such as exchanges and trade repositories, and entities already covered by resolution powers for central counterparties (such as LCH and ICE) would be excluded from the regime.
On 25 April 2013, HM Treasury also published a statement confirming the fact that, before the end of the summer, it will consult on the extension of the special resolution regime (SRR) established under the Banking Act 2009 to group companies, investment firms and UK clearing houses.
On 23 April 2013, HM Treasury published the initial report prepared by Peter Bloxham on the special administration regime for investment banks (SAR). The independent review makes a number of immediate recommendations, which include:
- The SAR should continue to have effect;
- The introduction of a mechanism to facilitate the rapid transfer of customer relationships and positions, where feasible;
- The bar date mechanism should be broadened to include client monies;
- The statutory objective in relation to client assets should be modified to include a reference to the “transfer” of assets to another institution in addition to the option of the “return” of client assets;
- SAR administrators should be permitted to make distributions of client assets during the period after the bar date process has commenced;
- Limited specific immunities to be introduced for SAR administrators;
- Good practice recommendations for firms, the FSA, and other institutions;
- A number of recommendations relating specifically to the work of the Financial Services Compensation Scheme (FSCS).
The report also sets out further areas to be reviewed as part of a second phase of work which will be co-ordinated with the FSA’s review of its Client Assets Rulebook. A final report is expected by the end of July 2013.
HM Treasury made a further announcement in a written statement to the House of Commons on 23 April 2013, accepting the main recommendations of the report. The Treasury agrees that SAR should be retained and accepts that amendments to that regime will be necessary in order to fulfil its objectives.
On 10 December 2012, the Federal Deposit Insurance Corporation (FDIC) and the Bank of England (BOE) published a joint strategy paper on the resolution of globally active, systemically important, financial institutions (G-SIFIs).
Broadly speaking, there are two main approaches to the resolution of G-SIFIs:
- “Single point of entry” (or “top down”) resolution pursuant to which a single national resolution authority applies resolution powers to the parent company of a failing financial group; or
- “Multiple point of entry” resolution whereby resolution powers are applied to different parts of a failing financial group by two or more resolution authorities in coordination.
The paper focuses on “top-down” resolution with respect to both UK and US cross-border financial services groups. The key advantage of “top-down” resolution is seen as being the ability for viable subsidiaries, both domestic and foreign, to continue to operate. Not only should this limit contagion but it will hopefully mitigate cross-border complications arising as a result of the institution of separate territorial and entity-focused insolvency proceedings. However, it is expressly recognised that there are certain circumstances where “multiple point of entry” resolution will be necessary, for example where losses are so great that they could not be absorbed by a group level bail-in or make the job of valuing the capital needs of the institution in resolution too difficult.
US approach to single point of entry resolution
The sequence of events with respect to a US single point of entry resolution is as follows:
Appointment of Receiver
The FDIC is appointed receiver of the parent holding company of the failing financial group.
The FDIC transfers assets (primarily equity and investments in subsidiaries) from the receivership estate to a bridge financial holding company. In contrast, shareholder claims and claims of subordinated and unsecured debt holders remain in the receivership. As such, the assets of the bridge holding company will far exceed its liabilities.
A valuation process is undertaken so as to estimate the extent of losses in the receivership and allow their apportionment to shareholders and unsecured creditors in accordance with insolvency rankings.
Bail-in occurs to ensure that the bridge holding company has a strong capital base. So as to provide a cushion against future losses, remaining debt claims are converted in part into equity claims in the new operation and/or into convertible subordinated debt. Any remaining debt claims are transferred to the new operation in the form of new unsecured debt.
Liquidity Concerns are Addressed
To the extent that liquidity concerns have not been addressed by the transfer of equity and investments in operating subsidiaries to the bridge holding company, the FDIC can provide assurances of performance and/or limited scope guarantees. As a last resort, the FDIC may also access the Orderly Liquidation Fund (OLF), a fund within the U.S. Treasury set up under the Dodd-Frank Act. However, the Dodd-Frank Act prohibits the loss of any taxpayer money in the orderly liquidation process. Therefore, any OLF funds used must either be repaid from recoveries on the assets of the failed financial company or from assessments made against the largest, most complex financial companies.
Firm is restructured
In this stage, the focus will be on making the failed firm less systemically important and more resolvable. Senior management are likely to be removed at this point.
The final stage of the process is to transfer ownership and control of the surviving operation to private hands.
UK approach to single point of entry resolution
The sequence of events with respect to a UK single point of entry resolution is as follows:
Initially, existing equity and debt securities will be transferred to an appointed trustee.
Subsequently, the listing of the company’s equity securities (and potentially debt securities) would be suspended.
A valuation process would then be undertaken in order to understand the extent of the losses expected to be incurred by the firm and, in turn, the recapitalisation requirement.
Following valuation, an announcement of the terms of any write-down and/or conversion pursuant to the exercise of bail-in powers would be made to the previous security holders. In writing down losses, the existing creditor hierarchy would be respected. Inter-company loans would be written down in a manner that ensures that the subsidiaries remain viable. Deposit Guarantee Schemes would also be bailed-in at this point. At the end of the process, the firm would be recapitalised and would likely be owned by its original creditors.
Liquidity Concerns are Addressed
So as to mitigate liquidity issues and facilitate market access, illiquid assets could be transferred to an asset management company to be worked out over a longer period. In the event that market funding was simply not available, temporary funding could be provided by authorities on a fully collateralized, haircut, basis. However, any losses associated with the provision of such temporary public sector support would be recovered from the financial sector as a whole.
Firm is Restructured
On completion of the bail-in process, the firm would be restructured to address the causes of its failure.
Subsequently, the trustee would transfer the equity (and potentially some debt) back to the original creditors of the firm. Any creditors which are unable to hold equity securities (e.g. due to mandate restrictions) would be able to request that the trustee sell the equity on their behalf.
Resumption of Trading
The final stage of the process would involve the dissolution of the trust and the resumption of trading in the equity and/or debt securities of the restructured firm.
Similarities Between the Regimes
Both approaches emphasise the importance of ensuring the continuity of critical services of the failing group, whether in the home jurisdiction or abroad. Shareholders under both regimes can expect to be wiped out and unsecured debt holders can expect their claims to be written down (to reflect any losses that shareholders cannot cover) and/or partly converted into equity (in order to recapitalise the entity in question). Existing insolvency hierarchies will be respected, but in both cases, a valuation process will be required. The precise mechanics of any such valuation are unlikely to be the same across both the UK and the US, but consideration is being given in both jurisdictions as to the extent to which the valuation process can be prepared in advance. Not only would the valuation process assess the losses that a firm had incurred and what financial instruments (if any) the different classes of creditors of the firm should receive, but it would also assess the future capital needs of the business necessary to restore “confidence” in the firm. It seems likely that this will be a level significantly higher than that required simply to restore viability. In both cases, resolution will be accompanied by an restructuring of the business. This may involve breaking an institution into smaller, less systemically important entities, liquidating or closing certain operations and a replacement of management.
The high level strategies detailed by the FDIC and BOE will be translated into detailed resolution plans for each firm during the first half of 2013. It is anticipated that firm-specific resolvability assessments will be developed by the end of 2013 on the basis of the resolution plans.
On 1 November 2012, the High Court judgment of Richards J in the case of Heis and others (Administrators of MF Global UK Ltd) v MF Global Inc was published. The judgment is of interest as it provides clarity on the application of the Investment Bank Special Administration Regulations 2011 (the “Regulations”) to boilerplate clauses within standard repo documentation. The Regulations came into force in February 2011 pursuant to powers conferred under the Banking Act 2009, constituting a response to the financial crisis of 2008 and particularly the collapse of Lehman Brothers. They included, for the first time, special procedures specifically designed to deal with the issues arising in relation to insolvent banks.
The formal insolvency proceedings relating to the collapse of the MF Global group commenced on 31 October 2011 when MF Global Holdings Ltd (“MFG Holdings”), the US incorporated group holding company, filed for bankruptcy protection under Chapter 11 in the US. This was followed a few hours later by the appointment of administrators pursuant to the Regulations over MF Global UK Limited (“MFG UK”), the main trading entity for the MF Global group in Europe, on the application of its directors. Subsequently, still on the same day, a trustee was appointed under the Securities Investor Protection Act 1970 with respect to MF Global Inc (“MFG Inc”), the main trading entity of the MF Global group in the US.
The collapse of the MF Global group was attributed largely to a failed investment in European sovereign debt securities in the period between 2009 and 2011. As part of this investment policy, MFG UK purchased securities and sold them to MFG Inc via repo transactions documented under a standard 2000 Global Master Repurchase Agreement (“GMRA”) governed by English law.
Paragraph 10 of the GMRA defines Events of Default. Most default circumstances require the non-Defaulting Party to serve a “Default Notice” on the Defaulting Party before the circumstance itself crystallises into an actual Event of Default for the purposes of the GMRA. The exception to this rule is the case of:
“…an Act of Insolvency…which is the presentation of a petition for winding-up or any analogous proceeding or the appointment of a liquidator or analogous officer of the Defaulting Party …”
An “Act of Insolvency” is defined in paragraph 2(a) of the GMRA and includes the appointment of any trustee, administrator, receiver, liquidator or analogous officer over a party to the GMRA or any material part of its property. Broadly speaking, following the occurrence of an Event of Default, valuations for the purposes of closing-out transactions are performed by the non-Defaulting Party.
MFG Inc conceded that the appointment of the SIPA Trustee constituted the ‘appointment of an officer analogous to a liquidator’ and that this would automatically lead to an Event of Default under the GMRA. Ordinarily, this would also have resulted in MFG Inc being the Defaulting Party and MFG UK being the non-Defaulting Party under the GMRA. However, MFG Inc argued that the earlier appointment of an administrator in relation to MGF UK under the Regulations also constituted ‘the appointment of an officer analogous to a liquidator’. As such, MFG Inc claimed that the automatic Event of Default had actually occurred at this earlier point, with the result that MFG Inc was actually the non-Defaulting Party and MFG UK was the Defaulting Party. The fact that MFG UK would have to make payment to MFG Inc was not in dispute. However, the identity of the non-Defaulting Party was of key importance given that MFG Inc valued its claim at GBP 286.7 million, whereas MFG UK valued the claim at only GBP 37 million.
Broadly, therefore, the issue to be considered by the court was whether the appointment of an administrator in relation to MFG UK was analogous to the appointment of a liquidator and therefore automatically constituted an Event of Default under the GMRA without the need for service of a Default Notice by MFG Inc.
The court considered the nature of liquidation versus administration. It concluded that the sole purpose of a liquidation is to realise the assets of a company and to distribute proceeds to creditors. In doing so, the business of the company is brought to an end. It acknowledged that an administration may also result in the realisation of a company’s assets and a distribution of proceeds among creditors, but noted that administration can also entail the rescue of the company as a going concern. In reaching this conclusion, the court took support from the objectives of the Regulations, which are:
- to ensure the return of client assets as soon as reasonably practicable;
- to ensure timely engagement with market infrastructure bodes and Authorities; and
- either to:
- rescue the investment bank as a going concern, or
- wind it up in the best interests of the creditors.
The court also referred to Australian authority in which the appointment of statutory administrators and receivers appointed by secured creditors was held not to be analogous to the appointment of a liquidator, their relative positions being summarised as follows:
“The function of a liquidator…is to preside over the death of a company. An administrator…strives for the opposite result (even though the company may yet in the end die). A receiver appointed by a secured creditor does neither of those things, being largely unconcerned about the fate of the company.”
The court contrasted the unqualified power of an administrator “to carry on the business of the company”, establish subsidiaries, borrow money and do “all other things incidental to the exercise of the foregoing powers” against the more restricted powers of a liquidator. This, it felt, was consistent with the differing nature and objectives of the two regimes. It also drew further support from the drafting of the GMRA itself, commenting that it was understandable that a non-Defaulting Party would wish to have an opportunity to wait and see how administration proceedings develop before deciding whether to exercise its right to serve a Default Notice. In contrast, in a liquidation scenario where the company will cease to carry on business, it is equally understandable that an Event of Default occurred automatically without the need to serve notice.
Accordingly, the court held that the appointment of a special administrator under the Regulations was not analogous to the appointment of a liquidator and furthermore that an application under the Regulations for a special administration order was not analogous to a petition for a winding-up for the purposes of paragraph 10(a)(iv) of the GMRA. Accordingly the appointment of administrators with respect to MFG UK on 31 October 2011 did not constitute an Event of Default under the GMRA.
This case provides useful insight into the operation of the Regulations and their interaction with standard repo documentation. Thankfully, the Bankruptcy Events of Default under both the 1992 and 2002 ISDA Master Agreements would seem less susceptible to this issue, due to the manner in which “Automatic Early Termination” operates under the ISDA Master Agreement and the specific drafting of the standard ISDA Bankruptcy Event of Default. Nonetheless, the conclusions of the court provide a timely reminder of the way in which legal risk can develop when portfolios of documentation fail to keep pace with changing circumstances and the benefits of performing period reviews in managing that risk.