Important Consequences for Buy-side Parties to Derivatives with EU Institutions
Background
The International Swaps and Derivatives Association, Inc. (ISDA) has released the “ISDA 2016 Article 55 BRRD Protocol (Dutch/French/German/Irish/Italian/Luxembourg/Spanish/UK entity-in-resolution)” (the Protocol).
The purpose of the Protocol is to amend derivatives agreements of certain EU institutions that are governed by New York law or the law of another non-EU jurisdiction. The amendments relate to Article 55 of the Bank Recovery and Resolution Directive (the BRRD).1
The BRRD imposes an obligation on institutions subject to the BRRD to include a new contractual term (an Article 55 Clause) in agreements governed by the laws of a non-EU country (Third Country Agreements). The Article 55 Clause must include (i) a recognition by the institution’s counterparty that amounts owed by the institution subject to the BRRD may be written down or converted into equity as part of a bail-in and (ii) an agreement to be bound by any such reduction or conversion. The Article 55 requirement is supplemented by regulatory technical standards which were adopted by the Commission on March 23, 2016 and published in the Official Journal of the EU on July 8, 2016 (the Article 55 RTS).2 The purpose behind the Protocol is to permit adherents to introduce an Article 55 Clause into the non-EU law-governed documentation.
Which institutions are subject to bail-in?
The BRRD applies to the following institutions3 (Affected EU Institutions):
- certain EU investment firms authorized under the Markets in Financial Instruments Directive (MiFID);4 and
- EU credit institutions (i.e., banks and building societies).5
As a consequence of this definition, it is safe to assume that all EU banks and all other EU dealers fall within the scope of the BRRD.6
Are Affected EU Institutions required to include an Article 55 Clause?
Any Affected EU Institution that is a party to any Third Country Agreement is required to include an Article 55 Clause except in the limited circumstances described below.The Affected EU Institution is not required to include an Article 55 Clause in Third Country Agreements which only give rise to liabilities that are excluded from bail-in (Excluded Liabilities).7 Of these exclusions, the most relevant for derivatives transactions is likely to be the exclusion for secured liabilities summarized below.
The UK Prudential Regulation Authority (PRA) has promulgated changes to its Rulebook which will take affect from August 1, 2016. Although these rules allow an Affected EU Institution not to include an Article 55 Clause in a Third Country Agreement where the Affected EU Institution determines that it is impracticable to do so, the scope of the impracticability definition is limited and is unlikely to apply in the case of most derivatives transactions.8
Note that a liability under a Third Country Agreement that does not contain an Article 55 Clause is, under the terms of the BRRD, still eligible for bail-in by a resolution authority.9 However, the BRRD recognizes that the resolution authority does not need to proceed with a write-down or conversion of liabilities governed by the law of a non-EU country where it is highly unlikely that the write-down or conversion will be effective.10 Whether or not the write-down or conversion would be effective, absent an Article 55 Clause, is a matter of the relevant governing law and applicable conflicts of law principles.
Which derivatives should not be subject to bail-in?
Collateralized Derivatives: Although Article 44(2) of the BRRD provides that a resolution authority may not exercise bail-in powers where the Affected EU Institution’s liability is secured,11 the meaning of this provision in connection with collateralized derivative contracts is not clear.
The European Banking Authority (EBA) has given some guidance in the background and rationale to its final regulatory technical standards on the valuation of derivatives (Valuation RTS). The background and rationale states that the provision relates to “the exclusion of secured liabilities to the extent that the value of the liability does not exceed the value of the collateral.”12 Presumably, this means that secured liabilities would not be subject to conversion or write-down to the extent that this condition is met. However, no guidance is currently available as to, among other things, how “value” will be determined for this purpose or how “excess” collateral will be treated.
The Article 55 RTS further provides that Article 55 Clauses are not required where the liability is: “fully secured [and] governed by contractual terms that … oblige the debtor to maintain the liability fully collateralized on a continuous basis in compliance with regulatory requirements of [EU] law or of a third country achieving effects that can be deemed equivalent to [EU] law.”13
The meaning of “fully collateralized on a continuous basis in compliance with regulatory requirements…” is unclear. Although at present there are no EU requirements requiring the margining of uncleared derivatives, it appears to be drafted to cover the forthcoming mandatory margin rules. Where parties comply with U.S. requirements requiring the margining of uncleared derivatives, then only where such requirements are equivalent will derivatives margined under the U.S. regime be excluded.
Central Counterparty (CCP) Cleared Derivatives: There is no specific exclusion in the BRRD relating to cleared derivative contracts with an Affected EU Institution. However, the EBA has stated that bailing in liabilities owed by an Affected EU Institution to a CCP14 “seems unlikely under normal risk-management conditions,” given that such liability is unlikely to exceed the collateral posted by the Affected EU Institution if the CCP’s risk mitigation policies are properly followed.15 Accordingly, although the Valuation RTS do not appear to address the “client leg” of a cleared transaction (i.e., the transaction between the Affected EU Institution (as clearing member) and its client), the EBA’s expectation appears to be that, absent unusual circumstances, cleared derivative contracts will be excluded from bail-in procedures.
Exclusion of Derivatives from Bail-in in Exceptional Circumstances: Article 44(3) of the BRRD allows the resolution authority to exclude or partially exclude certain liabilities from bail-in where, among other things, it is not possible to bail-in the liability within a reasonable time or the application of the bail-in tool to those liabilities would cause a destruction in value such that losses borne by other creditors would be higher than if those liabilities were excluded. The background and rationale to the Valuation RTS recognizes that a resolution authority may apply both of these exclusions to derivative contracts on a discretionary basis.
What will happen to derivative contracts on bail-in?
By virtue of legislation recognizing the stay provisions of the BRRD, together with the ISDA 2015 Universal Resolution Stay Protocol (and the ISDA Resolution Stay Jurisdictional Modular Protocol),16 the counterparties of Affected EU Institutions are expected to have restricted rights to terminate their derivative contracts on any default by the Affected EU Institution arising from application of the bail-in tool or other resolution measures.
If the bail-in tool is applied to derivative contracts, the resolution authority will terminate all affected derivative contracts and will set a date for valuation.17
For the purposes of such valuation, counterparties will be entitled to submit evidence of an actual transaction entered into on or before the valuation date, to re-establish, on a net exposure basis, any hedge or related trading position that has been terminated on equivalent economic terms as the affected contract.18 The hedge or related trading position must be on terms consistent with common market practice and the counterparty must have made “reasonable efforts to obtain the best value for money.”19
The resolution authority, or the valuer it appoints, will evaluate the evidence submitted by counterparties in order to determine whether it satisfies the criteria above. If it concludes the criteria are satisfied, the price of the submitted transaction will be used as the value of the derivative contract for the purposes of determining the close-out amount. However, where the resolution authority concludes that the criteria above are not satisfied, the resolution authority or valuer will determine a mid-market value taking into account various data sources, and that mid-market value will be used for the purposes of determining the close-out amount.20
If the bail-in tool is used to convert liabilities into equity, the value determined by this process will be used to allocate equity to the counterparty. If the bail-in tool is used to write down liabilities, then the amount determined as the close-out amount owing to the counterparty will simply be written down, potentially to zero.21
Clearly, the process from termination to valuation to conversion or write-down may differ substantially from the rights afforded to counterparties under the contractual terms of their contracts.
What is the Protocol?
The Protocol is intended to amend the existing documentation of adhering parties in order to incorporate an Article 55 Clause.
Parties can adhere to the Protocol by submitting an adherence letter to ISDA through the “Protocol Management” section of its website. The adherence letter of each adhering party will be published by ISDA on the ISDA website so that it can be viewed by all adhering parties. Following adherence, an adhering party’s “Protocol Covered Agreements” with each other adhering party are deemed amended, upon the date on which the later of the two parties adheres to the Protocol (the Implementation Date), in order to include the provisions set out in the Attachment to the Protocol. Accordingly, a party is able to amend documentation that is subject to the Protocol by submitting a single adherence letter, rather than by negotiating bilateral amendment agreements with each of its counterparties.
Note that the Protocol covers only jurisdictions which have thus far published implementing legislation with respect to Article 55 of the BRRD, namely the Netherlands, France, Germany, Ireland, Italy, Luxembourg, Spain and the United Kingdom (each, a Relevant Jurisdiction). Nonetheless, the jurisdictions covered by the current Protocol are the jurisdictions in which most significant EU dealers are established.
What are Protocol Covered Agreements?
The Protocol applies to a wide range of documentation existing between adhering parties at the Implementation Date, broadly:
- ISDA Master Agreements (including those deemed to exist pursuant to the execution of a long-form confirmation and including where amended to provide for client clearing);
- other master agreements, framework agreements, master netting or set-off agreements or agreements incorporating master trading terms (where such terms may cause all transactions relating to one or more netting sets to terminate) governing one or more transactions (including any compensation agreement or execution agreement), in writing, electronic format or other agreed official record; and
- any credit support documents (e.g., ISDA Credit Support Annexes)
where, in each case, the following conditions are satisfied:
- the agreement is governed by the law of a non-EU country (e.g., New York law);
- the agreement is executed on or prior to the Implementation Date by two adhering parties;
- at least one of the two adhering parties is a “Relevant BRRD Party”, i.e., a party that could become subject to bail-in powers in a Relevant Jurisdiction (such as an English bank); and
- the parties have not otherwise addressed by way of alternative written arrangements or excluded the matters covered by the Protocol.
As in the case of other protocols published by ISDA, the Protocol also may extend to agreements signed by an investment manager or asset manager as principal or as agent on behalf of its clients. Where such an adhering party adheres both on behalf of itself as principal and as agent on behalf of its clients, it should submit two adherence letters.
Accordingly, the Protocol applies to a wide range of non-EU law-governed master documentation in addition to ISDA Master Agreements; for example repurchase agreements, securities lending agreements, clearing and execution agreements and futures agreements.
The Protocol is not “forward-looking” and will amend only documentation in place at the time of adherence. To the extent adhering parties enter into new documentation with an Affected EU Institution following adherence, they will need to incorporate the terms of the Protocol expressly in such documentation.
What does the Protocol do?
The Protocol incorporates into each Protocol Covered Agreement between adhering parties a provision whereby the parties acknowledge and accept that liabilities arising under the relevant Protocol Covered Agreement may be subject to the exercise of write-down and conversion powers by the resolution authority in a Relevant Jurisdiction, and the adhering parties agree to be bound by any such exercise of write-down and conversion powers.
Pursuant to the Protocol, adhering parties recognize that actions taken by a resolution authority in connection with the exercise of a bail-in power may, if a termination amount is payable to the party which is not subject to bail-in, include (without limitation):
- the reduction in full or in part of such termination amount; and/or
- the conversion of all or part of such termination amount into shares or other instruments.
The Protocol is intended to be non-negotiable and adhering parties may not specify additional provisions, conditions or limitations to the Protocol in their adherence letters. If an adhering party wishes to amend the Protocol then it must do so through bilateral negotiations with the relevant adhering counterparty which should be contained in an amendment to the existing Protocol Covered Agreement between the adhering parties.
In what circumstances will the Protocol cease to apply?
In line with Article 55 of the BRRD and the Article 55 RTS, the contractual recognition of write-down and conversion powers of resolution authorities in the Protocol are expressed to cease to apply in the following circumstances:
- the relevant resolution authority determines that a non-EU country has in place laws which recognize and allow the resolution authority to exercise write-down and conversion powers with respect to the derivative contract. In practice, this would likely involve the resolution authority recognizing the equivalence of a non-EU country’s laws; or
- the national laws implementing Article 55 of the BRRD are amended or repealed so that there is no longer a requirement for counterparties to derivative contracts to include an Article 55 Clause.
Should you adhere to the Protocol?
Given the fact that Affected EU Institutions are required to address Article 55 of the BRRD in their contractual documentation, Affected EU Institutions in the Relevant Jurisdictions are likely to insist that their counterparties adhere to the Protocol and may refuse to trade with counterparties that do not adhere. Although it remains open to parties to agree bilateral amendments to relevant contracts, rather than adhering to the Protocol, we suspect that the volume of agreements which will require amendment in accordance with Article 55 of the BRRD may result in Affected EU Institutions being unwilling to contemplate a significant volume of bilateral negotiations on this point.
Nonetheless, there are a number of points for counterparties to Affected EU Institutions to consider before adhering to the Protocol. In particular:
- Pre-January 1, 2016 transactions: Although Article 55 of the BRRD applies only to liabilities created after January 1, 2016, Protocol Covered Agreements are amended with reference to all transactions subject to their terms (i.e., including those under which liabilities arose prior to January 1, 2016). Although this could have economic consequences, it is undoubtedly designed to facilitate the netting of all transactions under the relevant master agreement and facilitate the operational management of derivatives portfolios.
- Right to dispute valuation: The BRRD contains a right to appeal the decision by a resolution authority to take a crisis management measure (such as bail-in), however, remedies are limited to compensation from the relevant resolution authority for loss suffered as a result of a wrongful or unlawful bail-in action and not the Affected EU Institution.22
- Member States not covered by the Protocol: Not all EU Member States are subject to the Protocol and accordingly parties transacting with dealers in Member States which are not Relevant Jurisdictions may be asked to amend documentation bilaterally in order to address Article 55 of the BRRD.
- UK Referendum: We note that, in the event the UK leaves the EU, it would be considered a third country for the purposes of the BRRD. Consequently, counterparties to EU dealers would be required to include an Article 55 Clause in their English law ISDA Master Agreements and Credit Support Annexes.
1 Directive 2014/59/EU of May 15, 2014.
2 The Article 55 RTS will enter into force July 28, 2016.
3 Article 1(1), BRRD.
4 Directive 2004/39/EC, i.e., those investment firms that are subject to an initial capital requirement of at least EUR 730,000. This initial capital requirement would, in general, apply to those firms authorized to deal on their own account or to underwrite issues of financial instruments on a firm commitment basis.
5 The full list of in-scope entities appears at Article 1 of the BRRD. In addition to credit institutions and relevant investment firms, the BRRD applies to certain group companies of such institutions, financial holding companies and certain EU branches of non-EU or “third country” institutions (in accordance with specific conditions laid down in the BRRD).
6 This would include EU dealers whose parent entities are established in the U.S. or elsewhere.
7 Article 44(2), BRRD.
8 This note does not discuss the national implementation of the BRRD in any EU Member State other than the UK.
9 Article 55(2), BRRD.
10 Article 67, BRRD.
11 A secured liability is defined as a liability secured by a charge, pledge or lien, or collateral arrangements including liabilities arising from repurchase transactions and other title transfer collateral arrangements; Article 2(1)(67), BRRD.
12 Valuation RTS, Background and Rationale, page 6.
13 Article 44(2)(b), BRRD; Article 43(1), Article 55 RTS.
14 Note that the EBA only refers to a CCP that is authorized or recognized under EMIR. Valuation RTS, Article 1(3), definition of CCP as either established in the EU and authorized in accordance with Articles 14-21 of EMIR or established in a third country and recognized in accordance with Article 25 of EMIR.
15 Valuation RTS, Background and Rationale, page 10.
16 The ISDA protocols ensure cross-border enforcement of stay powers under various national recovery and resolution regimes. “New ISDA Resolution Stay Protocols: Challenges for Buy-side and Sell-side Firms Alike.”
17 Article 3, Valuation RTS.
18 Article 1(6), Valuation RTS.
19 Article 1(7), Valuation RTS.
20 Article 6(1) and (2), BRRD.
21 A different process applies for the valuation of derivative contracts between an Affected EU Institution and a CCP. We do not address that process in this Update.
22 Article 85, BRRD.
If you have any questions regarding the Protocol or the BRRD, please contact the Sidley lawyer with whom you usually work, or
| Matthew Dening Partner |
William Shirley Counsel |
||
| +44 20 7360 3646 mdening@sidley.com |
+1 212 839 5965 wshirley@sidley.com |
Investment Funds, Advisers and Derivatives Practice
To receive Sidley Updates, please subscribe at www.sidley.com/subscribe.
Sidley Austin provides this information as a service to clients and other friends for educational purposes only. It should not be construed or relied on as legal advice or to create a lawyer-client relationship.
Attorney Advertising - For purposes of compliance with New York State Bar rules, our headquarters are Sidley Austin LLP, 787 Seventh Avenue, New York, NY 10019, 212.839.5300; One South Dearborn, Chicago, IL 60603, 312.853.7000; and 1501 K Street, N.W., Washington, D.C. 20005, 202.736.8000.