Contractual Recognition of Bail-in
Brexit has redirected and sharpened the focus of many on matters which, Brexit aside, might not have merited as much attention. One of those matters is the contractual recognition of bail-in in loan documents (and other documentation). We give a quick overview of what it is, why and when it is needed and what documents it affects.
1. What is "bail-in"?
Broadly speaking, "bail-in" empowers a national authority (a 'resolution authority') to cancel, reduce or modify a failing financial institution's liabilities either by writing down those liabilities or, in the case of debt or other capital instruments, converting them into equity. It is therefore a significant tool that permits interference with property rights to effect the resolution of a failing financial institution by recapitalisation. In practical terms, bail-in shifts losses on to shareholders and creditors, such as bondholders, thereby avoiding either liquidation or "bail-out" by governments (and the attendant costs in each case).
2. What is contractual recognition of bail in?
The Bank Recovery and Resolution Directive (2014/59/EU) ("BRRD") requires EEA banks and investment firms to insert language into contracts governed by non-EEA law recognising that the liabilities of the institution may be susceptible to bail-in.
3. Why is contractual recognition needed?
Bail-in of a liability under a contract governed by EEA law will be effective in the EEA (i.e., European Union states and Iceland, Liechtenstein and Norway) regardless of the terms of that contract (under BRRD). The reason that the BRRD requires recognition of bail-in in non-EEA governed contracts is that it is thought that if a counterparty expressly consents to bail-in, the exercise of bail-in powers is likely to be less susceptible to challenge in a non-EEA court. Otherwise the resolution of an EEA financial institution potentially could be threatened if it has significant non-EEA liabilities and creditors in those non-EEA countries brought proceedings where as a matter of that non-EEA law the bail-in was not effective and so did not as a matter of that non-EEA governing law bind them – in effect, holding the financial institution to its original deal with its creditors despite the purported bail-in.
4. What documents should contain a bail-in recognition clause?
The documents which should include contractual recognition of bail-in are those which are:
- entered into (or materially amended) after 1 January 2016;
- governed by the law of a non-EEA jurisdiction;
- do not relate to a covered bond or protected deposit; and
- not capable of otherwise being excluded from the requirement (which, generally speaking, loan market documents are not).
Plainly this potentially covers a very broad range of documents, including, for example, commitment letters, facility agreements, intercreditor agreements, letters of credit, security agreements, secondary loan trading documents and underwriting agreements.
5. Effect of Brexit
Of particular interest in light of Brexit, is whether a bail-in clause should be included in contracts governed by English law, which, if governed by non-EEA law, would require one. On this market practice is divided. Some parties are including the bail-in clause as standard in these English law documents, whilst others simply do not include them as a matter of course. It is by no means clear that the former course of including in every case is necessary, but against that, it is not unjustifiable given the lack of certainty over what Brexit will in the end entail. It seems that the most prudent cause is to deal with each particular document in its context and on a case-by-case basis.
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