United States: The Impact Of EU Bail-In Provisions On Fund Finance Transactions

Last Updated: November 11 2016
Article by Michael C. Mascia, Jeremy Cross and Wesley A. Misson

Most Read Contributor in United States, September 2017

Section 1: The Context "

  • Following the Financial Crisis in 2008 and the fallout from that crisis, it became apparent that existing available procedures (based largely on various insolvency-related measures applicable in The European Union ("EU") / European Economic Area ("EEA") member states) for failing or failed EU/EEA Credit Institutions and Investment Firms whose failure could have a systemic impact on the wider financial system were it not adequate either to prevent the insolvency of such institutions or, when insolvency occurred, to minimize negative repercussions by preserving the systemically important functions of the institutions concerned, and that, as a result, a number of those institutions had to be preserved or saved using taxpayers' money.
  • In particular, existing insolvency regimes (i) differ and are differently applied across each EU/EEA member state; (ii) could not be applied speedily enough or early enough; (iii) do not ensure the continuation of the critical functions of institutions; and (iv) do not ensure that financial stability is preserved.
  • Mechanisms additional to and outside the existing insolvency regimes were therefore required (i) to ensure continuity of a failing institution of its critical financial and economic functions and (ii) to minimize the impact of any such failure on the economy and broader financial system.
  • EU-wide Bail-In tools for European Credit Institutions and Investment Firms were introduced into Europe (along with a number of other measures) by the EU Banking Regulation Recoveries Directive 2014/59/EU ("the Directive"). A number of the contents of the Directive had already been introduced into national legislation independently by a number of individual EU and EEA states prior to the entry into force of the Directive, but others, including Bail-In, have been extended or are new.
  • The Directive has now been transposed into national law by all 28 EU Member States (in the UK effective January 2015 with the Article 55 requirements – see below – taking effect on January 1, 2016 with implementation of "impracticability" exceptions effected on August 1, 2016) and will likely be adopted shortly into the laws of the EEA states which are not EU states (Norway, Liechtenstein and Luxembourg).
  • The Directive is designed to enhance (and harmonize) many of these mechanisms across all EU/EEA member states. The Bail-In tool is only one of the mechanisms introduced, but is the most directly relevant for counterparty creditors of a relevant institution.

Section 2: The Bail-In Provisions

  • Bail-In impacts all agreements to which the relevant institution is a party which "create a liability" on that institution, so in the Fund Finance context this would include unsecured liabilities as a Creditor/Lender in Credit and Security Agreements and Swap and other "treasury" type instruments and as an Investor in Partnership Agreements, Subscription Agreements, Side Letters and other related "Fund" agreements (e.g., Co-Investment Agreements).
  • The Bail-In tools can be applied by the relevant national regulator to a relevant institution that is "failing or likely to fail" and where other remedies are not available or will not be effective.
  • The Directive (in many, but not all, cases by supplementing pre-existing national legislation) effectively implements a "pre insolvency" set of potential actions which can be applied to restructure any or all of the operations, assets, structure or liabilities of a relevant institution. Any implementation of some or all of those steps in respect of a relevant institution which is (among other things) either a Lender or other Finance Party under Facility Arrangements, a Counterparty under a Swap arrangement or an Investor / Limited Partner in a Fund could operate to significantly affect the ability of that relevant institution to continue to fulfil its obligations under those Facility or Treasury Arrangements or under the relevant Partnership Documents.
  • With limited exceptions, Bail-In tools can be applied to all liabilities of a relevant institution, but there is a "waterfall" contained in the legislation which requires bail-in of Tier 1 and Tier 2 and non-regulatory capital to be effected first before bail-in of other liabilities under other agreements (referred to as "eligible liabilities" such as those under Credit or Fund Agreements).
  • Where a contract or agreement to which a relevant institution is a party is governed by the laws of an EU/ EEA member state, the Bail-In provisions are incorporated into that contract or agreement automatically. Where the contract or agreement is governed by non EU law (e.g., US law and potentially if the UK went for a "hard Brexit" UK law), specific Bail-In provisions have to be incorporated into that contract or agreement under Article 55 of the Directive. A number of industry bodies (including the LMA, ISDA, AFME and the LSTA) have prepared sample wording / provisions to be included to cover this in Finance documentation.
  • Where the Bail-In provisions are required to be written into a contract under Article 55, it is a matter of the relevant applicable law of the contract whether and to what extent these provisions will be enforceable.
  • The provisions have to be incorporated not only into "new" agreements, but also into "material amendments" to existing agreements made since the provisions came into effect.
  • Failure by a relevant institution to include the relevant wording where required can lead to penalties on that institution in the form of fines and restrictions on licensing / authorizations of that institution.
  • In the UK, the Prudential Regulatory Authority has settled on some exceptions to the above requirement where the inclusion of the wording would be "impractical". It is anticipated that the test of what is "impractical" will be based on legal or quasi legal constraints, not simply on "convenience" or commercial practicality.
  • The Bail-In tools must be applied within certain guidelines, the most relevant of which are (i) shareholders bear losses first and creditors second; and (ii) creditor losses should be no greater than they would have been if the relevant institution had been subject to insolvency proceedings.
  • While there has been a significant focus by industry bodies on the practical application and implementation of the requirement of Article 55 into Credit and Facility documentation, there has been much less formal consideration of its application in other agreements under which relevant implications might incur liability (including Fund and Fund related documentation).

Section 3: Recommended Actions

  • Review any Facility, Swap or Fund Documentation entered into on or after January 1, 2016 (or any material amendment or accession to that documentation entered into after that date) to determine whether any party to that document is or might be a "relevant institution" for the purpose of the Directive.
  • To the extent that any such party is subject to liabilities under that documentation, then consider the inclusion in the documentation of sufficient provisions (in particular representations, undertakings and events of default or termination or close-out events, as applicable, in Facility Agreements or Swap Agreements and relevant "Default", "Exclusion" and "Transfer" provisions in an LPA or Subscription Agreement) sufficient to cover such relevant institution's inclusion in the Directive.
  • Note that in any Facility Agreement or Treasury Agreement a number of the items covered by the Directive and a number of the "tools" which may be employed will or should be covered by existing representations, undertakings, events of default or termination events or close-out (for example asset transfers or changes in ownership imposed by the Directive), and that the same will be true to some extent for an LPA. However, others may not be, and it is unlikely (unless the document has been drafted and executed on or after January 1, 2016) that drafting specific to the Bail-In Provisions section of the Directive (which are "new") will have been included.
  • Where any relevant agreement (Facility Agreement, Swap Agreement, Fund Document (including LPA or Subscription Agreement) or any accession or material amendment to any such document) is governed by the laws of a "third country" (i.e., non EU / EEA) and a relevant institution is or may become a party to it, then consider whether either (i) in the case of a Facility Agreement or Treasury Agreement entered into after the introduction of Article 55 (in the UK 1 January 2016), the recommended LMA or ISDA or, if applicable, AFME or LSTA bailin language is included, and in the case of any Fund Document, including the LPA or Subscription Agreement, whether similar or equivalent language should be included so as to give effect to the provisions of Article 55; or (ii) consider whether the relevant institution may be able to take advantage of any exception – e.g., the "impracticality" exception – to the requirements.
  • Ensure that, if necessary and if required under the Directive, any relevant agreement to which Article 55 applies is one in respect of which legal opinions can be given specifically on the enforceability and effectiveness of the contractual bail-in language referred to above. Note that in a Facility or Treasury context this may well be covered in any event by the standard requirements for the provision of legal opinions in such documentation, but that in the context of a Fund LPA or related Subscription Agreement the provision of such a legal opinion may be less of a "normal" or "standard" requirement.

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.

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