United States: Bank Recovery And Resolution Directive – Implications For Repo And Derivative Counterparties

The Bank Recovery and Resolution Directive (BRRD)1introduces an EU-wide regime for recovery and resolution planning for, and for resolution action to be taken in respect of, banks and large investment firms (typically the large sell-side institutions) (FIs)2. The cut-off for implementation was 31 December 20143, except the bail-in tool (described below) which needs to be implemented by 1 January 2016.

In the US, Title II of the Dodd-Frank Act, or the Orderly Liquidation Authority, provides an alternative insolvency regime for financial companies, including bank holding companies (the resolution regime in the US is described below).

Significant Implications

BRRD gives rise to significant implications for repo and derivative counterparties4 5, discussed further below6, including the prospect of:

  • facing a new counterparty;
  • facing the good bank or the bad bank in a break-up of an FI;
  • trade(s) being terminated without there being a default and then valued by the resolution authorities;
  • any unsecured liability of the FIs being cancelled and/or converted into equity in whole or in part without any other compensation and/or
  • being temporarily prevented from exercising rights to terminate early or enforce security. Such rights may eventually be lost.

A resolution authority may take resolution action (i.e. intervene in a failing FI) upon the satisfaction of the resolution conditions. Resolution action does not per se constitute insolvency proceedings giving rise to termination rights7.

Resolution action involves the use of one or more resolution tools. In order to effectively apply the resolution tools, a resolution authority is to have various resolution powers available. The resolution authority must take all appropriate measures to ensure that resolution action is taken in accordance with the resolution principles.

Resolution Conditions

Satisfaction that:

  • the FI is failing or likely to fail;
  • there is no reasonable prospect that any alternative private solution would prevent the failure within a reasonable time frame and
  • a resolution action is necessary in the public interest. A resolution action will be in the public interest where it is necessary to achieve, and is proportionate to, one of the resolution objectives.

Resolution Objectives

The resolution objectives are:

  • the continuation of systemically important functions;
  • the avoidance of destabilisation of the financial system;
  • the protection of public funds;
  • the protection of certain depositors and investors and
  • the protection of client funds and client assets.

Resolution action is not to be taken where winding up under normal insolvency proceedings would meet the resolution objectives to the same extent.

Resolution Tools

  • The sale of business tool – allows the transfer, without shareholder consent, of all the shares or all or any assets, rights or liabilities of a failing FI to a purchaser.
  • The bridge institution tool – allows the transfer, without shareholder consent, of all the shares or all or any assets, rights or liabilities of a failing FI to a bridge institution being a state entity created for the purpose, for eventual sale or orderly wind down.
  • The asset separation tool – allows the transfer of rights or liabilities from a FI under resolution or a bridge institution to one or more asset management vehicles with a view to maximising their value through eventual sale or orderly wind down.
  • The bail-in tool8 – allows the write down, write off or cancellation of share capital and the write down, write off, cancellation or conversion into share capital of certain other liabilities (including derivative liabilities), unless excluded from the scope of bail-in.

Resolution Powers

With respect to repos and derivative contracts, resolution powers available include the power:

  • to close-out financial contracts or derivatives contracts9;
  • to calculate close-out amounts where contracts are closed-out for the purposes of bail-in10;
  • to cancel or modify the terms of a contract11 and
  • to temporarily suspend:
    • the payment and delivery obligations of the FI under resolution12;
    • the counterparty's right to enforce security13 and
    • the counterparty's contractual termination rights (the jurisdictional reach of the "stay" of termination rights is described below)14,

in each case until midnight at the end of the business day following the resolution authority's publication of a notice to take resolution action.

If a resolution authority suspends payment and delivery obligations, and a counterparty is owed a delivery of collateral, the delivery of collateral will be delayed and the counterparty will not know until the end of the suspension period whether there is a default or not.

If the resolution action has been successful, a counterparty cannot rely on its rights against the FI which was under resolution. Therefore, any rights to terminate would be lost upon a successful resolution action.

Resolution Principles

The overriding principles of BRRD include:

  • the shareholders of the FI under resolution bear first losses;
  • the creditors of the FI under resolution bear losses after the shareholders in accordance with the order of priority of their claims under normal insolvency proceedings, except where BRRD provides otherwise and
  • no creditor should be left "worse off" in resolution than they would have been under normal insolvency proceedings.

The Bail-in Tool

Bail-in is available as a resolution tool only for very specific purposes—to recapitalise an FI by way of reducing its liabilities and/or bolstering Common Equity Tier 1 or to reduce the liabilities that are transferred under the other resolution tools.

It can be used in combination with other resolution tools. Derivative liabilities should, in principle, be available for bail-in and this can take the form of a write down or write off of the liability in question or a full or partial conversion into Common Equity Tier 1.

However, for derivative liabilities to be subject to bail-in, the FI subject to resolution action will have to have suffered serious losses. Shareholders bear the first losses and thereafter creditors in accordance with the order of priority of their claims under normal insolvency proceedings. For example, bail-in by the conversion of derivative liabilities to restore Common Equity Tier 1 capital would only kick in if the conversion of the FI's regulatory capital instruments would be insufficient to meet the minimum Common Equity Tier 1 capital ratio.

Resolution authorities may not exercise the bail-in tool with respect to secured liabilities,15 albeit liabilities in excess of the amount of security are available for bail-in by the resolution authorities. A derivative contract cannot be bailed-in until it has been terminated.

Where bail-in is to be applied, unsecured liabilities are to be bailed-in unless excluded by the resolution authority in exceptional circumstances16.

Repos will always be secured liabilities. Derivative contracts will be secured liabilities, irrespective of the party who is "in-the-money," provided there is a security or title transfer collateral arrangement under which some collateral has been posted or delivered and is currently outstanding.

A resolution authority has the power under Article 63(1)(k) of BRRD to close-out repos and derivative contracts even where they are secured liabilities. Any resulting close-out amount payable by a FI under resolution, to the extent that it is not a secured liability, is within the scope of bail-in, even though the actual contract was a secured liability.

Some Practical Issues and Consequences

  • EU branches of third-country firms can be subject to resolution, for example, a London branch of a US bank.
  • Where a resolution authority transfers the transactions to another entity, the third-party entity may not satisfy the credit and due diligence requirements of the counterparty.
  • Where a resolution authority exercises its power to close-out:
    • counterparties will lose their hedges, which could result in a breach of hedging requirements under other financing documents and
    • the resulting close-out amount may be payable by a counterparty creating possible liquidity issues.
  • Where a resolution authority exercises its power to close-out for the purposes of bail-in, the close-out amount will be calculated by the resolution authority (rather than the non-defaulting counterparty)17
  • Derivative liabilities may be written down or written off in whole or in part without any compensation.
  • If derivative liabilities are converted into Common Equity Tier 1, counterparties will have to consider whether there are any impediments in holding the equity of the FI. For example, does the size of position require regulatory approval?
  • Counterparties' rights to terminate may be suspended and eventually lost. Following a successful resolution action, counterparties will not be able to exercise their rights against the FI that was under resolution.
  • Counterparties may not be able to enforce security.
  • If a counterparty is regulated, there may be an impact on its regulatory capital.
  • During a period of resolution action, values may become volatile and delivery of collateral may be delayed. The amount of collateral held may not reflect the risk.
  • Liabilities in excess of the amount of collateral are available for bail-in.
  • The days of uncollateralised trading would seem to be limited. This would be consistent with the direction of global regulatory reform. Counterparties should consider the need to negotiate or renegotiate collateral documentation.

Resolution Regime in the US

In the US, Title II of the Dodd-Frank Act, or the Orderly Liquidation Authority, provides an alternative insolvency regime for financial companies, including bank holding companies, if, among other things, the failure of the financial company and its resolution under the otherwise applicable insolvency regime would have serious adverse effects on financial stability in the US.

In order to invoke Title II, generally two-thirds of the members of the Board of Governors of the Federal Reserve System and two-thirds of the board of the Federal Deposit Insurance Company (FDIC) must make a recommendation to the US Secretary of the Treasury, who makes the determination in consultation with the President of the United States.

Like BRRD, Title II is based on several overriding principles, including that:

  • unsecured creditors bear losses in accordance with the priority of claim provisions, and that shareholders of the covered financial company should not receive payment until all other claims are paid in full;
  • management and/or the board of directors responsible for the failed condition should be removed and
  • no taxpayers shall bear losses from the exercise of authority under Title II.

If Title II is invoked, the FDIC is appointed as receiver of the covered financial company, and has certain powers, similar to those that the FDIC has for resolving banks in the US. Among these, the FDIC is empowered to:

  • establish and operate a bridge financial company, and to transfer any assets or liabilities of the covered financial company to such bridge company without obtaining any approvals or consents for the transfer;
  • arrange for a merger of the covered financial company with another company (subject to applicable antitrust laws) or arrange for the transfer of assets and liabilities of the covered financial company without obtaining any approvals or consents for the transfer and
  • repudiate certain contracts that may be burdensome or otherwise impede the orderly liquidation of the covered financial company.

Unlike the rules under the US Bankruptcy Code, counterparties of the covered financial company are prohibited from closing-out qualified financial contracts (QFCs) for one business day following the FDIC's appointment as receiver, during which period the FDIC can transfer the QFCs to a bridge financial company or other financial company, provided that the FDIC transfers all the QFCs with that counterparty and its affiliates. Once a contract or QFC has been transferred to a bridge financial company or third party, it cannot be closed-out, terminated or liquidated based on the appointment of the FDIC as receiver or the insolvency or financial condition of the covered financial company. Title II does not explicitly provide for a bail-in, but the FDIC has issued a public statement describing how it would use the powers under Title II to effect a "single point of entry" (SPOE) resolution of a covered financial company.

Under the SPOE resolution strategy, debt holders of the top-tier holding company would be converted to equity holders in the new, resolved financial company, and old equity holders would be left behind in the receivership18.

ISDA Stay Protocol

In November 2014, the International Swaps and Derivatives Association, Inc. published a Resolution Stay Protocol (ISDA Stay Protocol) which extends the jurisdictional reach of certain provisions of national resolution regimes, such as the UK-implementation of BRRD, the Federal Deposit Insurance Act (FDIA) and Title II of the Dodd-Frank Act, which mandate stay provisions under certain swap and derivative contracts.

The ISDA Stay Protocol requires that, if an adhering party (or its parent or certain of its affiliates) becomes subject to a "special resolution regime" (SRR), any counterparty to such party in respect of covered master agreements and credit enhancements who also adheres to the ISDA Stay Protocol will only be permitted to exercise default rights that it would have otherwise been entitled to exercise under the SRR if the underlying agreement were governed by the laws of the jurisdiction of the SRR.

Current SRRs under the ISDA Stay Protocol include the FDIA and Title II of Dodd-Frank, along with SRRs in France, Germany, Japan, Switzerland and the UK. Therefore, entities opting into the ISDA Stay Protocol would be bound by the UK-implementation of BRRD to the extent that their counterparties (or certain of their affiliates) become subject to the UK's BRRD implementation.

The ISDA Stay Protocol was developed in response to requests from regulators to address concerns and uncertainty where stays of termination rights under national resolution regimes were not necessarily required to be recognised in other jurisdictions. Currently, the ISDA Stay Protocol only binds parties who have elected to adhere to its provisions. The 18 major global banks (the G-18) agreed to voluntarily adhere to the ISDA Stay Protocol19, and the SRR provisions became effective between the initial adhering banks on 1 January 2015. Broader market adherence to the ISDA Stay Protocol is expected only as a result of related regulations which are expected in 2015, with effectiveness in 2016 or possibly 2017.

Footnotes

1 Directive 2014/59/EU of the European Parliament and of the Council of 15 May 2014 establishing a framework for the recovery and resolution of credit institutions and investment firms and amending Council Directive 82/891/EEC, and Directives 2001/24/EC, 2002/47/EC, 2004/25/EC, 2005/56/EC, 2007/36/EC, 2011/35/EU, 2012/30/EU and 2013/36/EU and Regulations (EU) No 1093/2010 and (EU) No 648/2012.

2 The BRRD applies to both banks and large investment firms, including the EU branches of third-country firms.

3 Some member states implemented BRRD early and some member states had certain of the resolution tools and powers already available to them under national legislation.

4 This note deals with the situation where one of the counterparties becomes subject to resolution. The impact of BRRD on derivatives is also relevant in situations where the entity subject to resolution is (not a counterparty, but) the reference entity under a CDS.

5 This note is focused towards OTC derivatives. Additional considerations are relevant with regard to cleared derivatives. Cleared derivatives have a number of protections under BRRD.

6 See "Some Practical Issues and Consequences".

7 Article 68(3) of BRRD.

8 As noted, the bail-in tool may already be available to some EU member states but is required to be available not later than 1 January 2016.

9 Articles 43(1) and 63(1)(k) of BRRD. Article 43(1) provides for close-out for the purpose of bailing-in derivatives liabilities. Article 63(1)(k) does not restrict close-out for the purpose of bail-in.

10 Article 49(4) of BRRD.

11 Article 64(f) of BRRD.

12 Article 69 of BRRD.

13 Article 70 of BRRD.

14 Article 71 of BRRD.

15 Article 44(2) of BRRD.

16 Article 44(3) of BRRD.

17 The European Banking Authority has until January 2016 to submit draft technical standards setting out the methodologies and principles for valuation by a resolution authority.

18 FDIC, Resolution of Systemically Important Financial Institutions: The Single Point of Entry Strategy, 78 Fed. Reg. 76614 (18 December 2013), available at: http://www.gpo.gov/fdsys/pkg/FR-2013-12-18/pdf/2013- 30057.pdf

19 A complete list of the parties that have opted in to adhere can be found here: https://www2.isda.org/functional areas/protocol-management/protocol-adherence/20

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
Barnabas W.B. Reynolds
 
In association with
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
 
Email Address
Company Name
Password
Confirm Password
Position
Mondaq Topics -- Select your Interests
 Accounting
 Anti-trust
 Commercial
 Compliance
 Consumer
 Criminal
 Employment
 Energy
 Environment
 Family
 Finance
 Government
 Healthcare
 Immigration
 Insolvency
 Insurance
 International
 IP
 Law Performance
 Law Practice
 Litigation
 Media & IT
 Privacy
 Real Estate
 Strategy
 Tax
 Technology
 Transport
 Wealth Mgt
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates
Check to state you have read and
agree to our Terms and Conditions

Terms & Conditions and Privacy Statement

Mondaq.com (the Website) is owned and managed by Mondaq Ltd and as a user you are granted a non-exclusive, revocable license to access the Website under its terms and conditions of use. Your use of the Website constitutes your agreement to the following terms and conditions of use. Mondaq Ltd may terminate your use of the Website if you are in breach of these terms and conditions or if Mondaq Ltd decides to terminate your license of use for whatever reason.

Use of www.mondaq.com

You may use the Website but are required to register as a user if you wish to read the full text of the content and articles available (the Content). You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these terms & conditions or with the prior written consent of Mondaq Ltd. You may not use electronic or other means to extract details or information about Mondaq.com’s content, users or contributors in order to offer them any services or products which compete directly or indirectly with Mondaq Ltd’s services and products.

Disclaimer

Mondaq Ltd and/or its respective suppliers make no representations about the suitability of the information contained in the documents and related graphics published on this server for any purpose. All such documents and related graphics are provided "as is" without warranty of any kind. Mondaq Ltd and/or its respective suppliers hereby disclaim all warranties and conditions with regard to this information, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. In no event shall Mondaq Ltd and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use or performance of information available from this server.

The documents and related graphics published on this server could include technical inaccuracies or typographical errors. Changes are periodically added to the information herein. Mondaq Ltd and/or its respective suppliers may make improvements and/or changes in the product(s) and/or the program(s) described herein at any time.

Registration

Mondaq Ltd requires you to register and provide information that personally identifies you, including what sort of information you are interested in, for three primary purposes:

  • To allow you to personalize the Mondaq websites you are visiting.
  • To enable features such as password reminder, newsletter alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our information providers who provide information free for your use.

Mondaq (and its affiliate sites) do not sell or provide your details to third parties other than information providers. The reason we provide our information providers with this information is so that they can measure the response their articles are receiving and provide you with information about their products and services.

If you do not want us to provide your name and email address you may opt out by clicking here .

If you do not wish to receive any future announcements of products and services offered by Mondaq by clicking here .

Information Collection and Use

We require site users to register with Mondaq (and its affiliate sites) to view the free information on the site. We also collect information from our users at several different points on the websites: this is so that we can customise the sites according to individual usage, provide 'session-aware' functionality, and ensure that content is acquired and developed appropriately. This gives us an overall picture of our user profiles, which in turn shows to our Editorial Contributors the type of person they are reaching by posting articles on Mondaq (and its affiliate sites) – meaning more free content for registered users.

We are only able to provide the material on the Mondaq (and its affiliate sites) site free to site visitors because we can pass on information about the pages that users are viewing and the personal information users provide to us (e.g. email addresses) to reputable contributing firms such as law firms who author those pages. We do not sell or rent information to anyone else other than the authors of those pages, who may change from time to time. Should you wish us not to disclose your details to any of these parties, please tick the box above or tick the box marked "Opt out of Registration Information Disclosure" on the Your Profile page. We and our author organisations may only contact you via email or other means if you allow us to do so. Users can opt out of contact when they register on the site, or send an email to unsubscribe@mondaq.com with “no disclosure” in the subject heading

Mondaq News Alerts

In order to receive Mondaq News Alerts, users have to complete a separate registration form. This is a personalised service where users choose regions and topics of interest and we send it only to those users who have requested it. Users can stop receiving these Alerts by going to the Mondaq News Alerts page and deselecting all interest areas. In the same way users can amend their personal preferences to add or remove subject areas.

Cookies

A cookie is a small text file written to a user’s hard drive that contains an identifying user number. The cookies do not contain any personal information about users. We use the cookie so users do not have to log in every time they use the service and the cookie will automatically expire if you do not visit the Mondaq website (or its affiliate sites) for 12 months. We also use the cookie to personalise a user's experience of the site (for example to show information specific to a user's region). As the Mondaq sites are fully personalised and cookies are essential to its core technology the site will function unpredictably with browsers that do not support cookies - or where cookies are disabled (in these circumstances we advise you to attempt to locate the information you require elsewhere on the web). However if you are concerned about the presence of a Mondaq cookie on your machine you can also choose to expire the cookie immediately (remove it) by selecting the 'Log Off' menu option as the last thing you do when you use the site.

Some of our business partners may use cookies on our site (for example, advertisers). However, we have no access to or control over these cookies and we are not aware of any at present that do so.

Log Files

We use IP addresses to analyse trends, administer the site, track movement, and gather broad demographic information for aggregate use. IP addresses are not linked to personally identifiable information.

Links

This web site contains links to other sites. Please be aware that Mondaq (or its affiliate sites) are not responsible for the privacy practices of such other sites. We encourage our users to be aware when they leave our site and to read the privacy statements of these third party sites. This privacy statement applies solely to information collected by this Web site.

Surveys & Contests

From time-to-time our site requests information from users via surveys or contests. Participation in these surveys or contests is completely voluntary and the user therefore has a choice whether or not to disclose any information requested. Information requested may include contact information (such as name and delivery address), and demographic information (such as postcode, age level). Contact information will be used to notify the winners and award prizes. Survey information will be used for purposes of monitoring or improving the functionality of the site.

Mail-A-Friend

If a user elects to use our referral service for informing a friend about our site, we ask them for the friend’s name and email address. Mondaq stores this information and may contact the friend to invite them to register with Mondaq, but they will not be contacted more than once. The friend may contact Mondaq to request the removal of this information from our database.

Emails

From time to time Mondaq may send you emails promoting Mondaq services including new services. You may opt out of receiving such emails by clicking below.

*** If you do not wish to receive any future announcements of services offered by Mondaq you may opt out by clicking here .

Security

This website takes every reasonable precaution to protect our users’ information. When users submit sensitive information via the website, your information is protected using firewalls and other security technology. If you have any questions about the security at our website, you can send an email to webmaster@mondaq.com.

Correcting/Updating Personal Information

If a user’s personally identifiable information changes (such as postcode), or if a user no longer desires our service, we will endeavour to provide a way to correct, update or remove that user’s personal data provided to us. This can usually be done at the “Your Profile” page or by sending an email to EditorialAdvisor@mondaq.com.

Notification of Changes

If we decide to change our Terms & Conditions or Privacy Policy, we will post those changes on our site so our users are always aware of what information we collect, how we use it, and under what circumstances, if any, we disclose it. If at any point we decide to use personally identifiable information in a manner different from that stated at the time it was collected, we will notify users by way of an email. Users will have a choice as to whether or not we use their information in this different manner. We will use information in accordance with the privacy policy under which the information was collected.

How to contact Mondaq

You can contact us with comments or queries at enquiries@mondaq.com.

If for some reason you believe Mondaq Ltd. has not adhered to these principles, please notify us by e-mail at problems@mondaq.com and we will use commercially reasonable efforts to determine and correct the problem promptly.