Contractual recognition of bail-in the Prudential Regulation Authority proposes to amend its rules

On 15 March 2016, the Bank of England in its capacity as the United Kingdom Prudential Regulation Authority (PRA) published a consultation paper (CP8/16) in relation to proposed amendments to the PRA rules concerning contractual recognition of bail-in.

Background

Contractual recognition of bail-in arises under Article 55 of EU Directive 2014/59 (often referred to as the Bank Resolution and Recovery Directive or the BRRD). This Article requires contracts, which are expressed to be governed by the law of a country which is not an EEA member state and which create relevant liabilities owed by in-scope institutions, to contain provisions by which creditors expressly recognise the effectiveness of the BRRD bail-in tool – that is, the power of a resolution authority to write-down and/or convert into equity a failing institution's liabilities.

The United Kingdom phased in its implementation of contractual recognition of bail-in, making it applicable to: (i) unsecured debt instruments, additional tier 1 instruments and tier 2 instruments (phase 1 liabilities) from 19 February 2015; and (ii) all other relevant liabilities (phase 2 liabilities) from 1 January 2016.

However, market participants have expressed surprise at the breadth of the scope of phase 2 liabilities, and the PRA recognises that there may be circumstances where in-scope institutions have been finding compliance with the requirement to be impracticable. To address such concerns, in 2015 the PRA published a modification by consent which disapplies the rules for a subset of liabilities where compliance is impracticable (and where in-scope institutions have notified the PRA that they consent to the modification).

Key points

• Scope of "liabilities": The scope of "liabilities" in respect of which non-EEA law governed contracts must include contractual recognition of bail-in terms has surprised many market participants. Recognising this, in November 2015 the PRA made rules allowing any affected institution to apply for a temporary modification of the relevant rules in instances where compliance would be impractical. The PRA is now proposing to formally amend its rules to reflect the terms of the earlier modification.
• Impracticality: At the same time, the PRA is proposing to issue a supervisory statement setting out the PRA's expectations with regard to "impracticability" in the context of the contractual recognition requirement.
• Regulatory Technical Standards: The PRA is also proposing to modify its rules to be consistent with the final draft European Banking Authority (EBA) Regulatory Technical Standards (RTS) on the contractual recognition of bail-in published in July 2015.

Consultation paper proposals 

The modification by consent expires on 30 June 2016, and the new consultation paper proposes an amendment to the PRA rules to the same effect as the modification. The PRA proposes that the amended rules would apply from 1 July 2016.

The consultation paper also puts forward three additional technical amendments to PRA rules to ensure consistency between the rules and the final draft European Banking Authority (EBA) Regulatory Technical Standards (RTS) on the contractual recognition of bail-in published in July 2015 and due to be adopted shortly by the European Commission. The amendments are:

• the inclusion of contractual recognition language into contracts for liabilities which are not fully secured and for secured liabilities which are not under a continuous full collateralisation requirement in accordance with EEA or equivalent non-EEA-country law;
• the inclusion of contractual recognition language into liabilities created before the date of application of the contractual recognition requirement if the agreement governing the liability is subject to a material amendment after 30 June 2016; and
• the replacement of the reference in the PRA rules to liabilities "arising" after a certain date with a reference to liabilities "created" after that date. The amendment intends to ensure consistency with the draft RTS and provide greater clarity as to which liabilities are in scope of the contractual recognition requirement.

What is "impractical"?

The PRA expects in-scope institutions to make a reasoned assessment as to whether the inclusion of contractual recognition language in the terms of a given phase 2 liability is impracticable, and Appendix 2 to the consultation paper sets out examples of situations where this may be the case, including where:

• a relevant non-EEA authority has informed the in-scope institution that they would not allow the inclusion of such language or that local laws would not permit it;
• the creation of liabilities is governed by international protocols which the in-scope institution has in practice no power to amend;
• contractual terms are imposed on an in-scope institution by virtue of its membership of a non-EEA body in circumstances where those terms are necessarily standard terms for all members and impracticable to amend bilaterally; and
• the liability which would be subject to the contractual recognition requirement is contingent on a breach of the contract.

The final example given above should cover indemnities and other liabilities for breach of contract by in-scope institutions in programme dealer and agency agreements.

Note, however, that the consultation paper expressly provides that the PRA does not consider loss of competitiveness or profitability to be grounds for an impracticability judgment.

Next steps

Once adopted by the European Commission, the RTS will be directly applicable in the United Kingdom as an EU regulation and will have precedence over PRA rules. The proposed amendments to the PRA rules have been formulated in light of the draft RTS and, if there are changes to the final text of the RTS, the PRA would anticipate making any necessary consequential amendments to the PRA rules at the point of finalisation. In-scope institutions should ensure that they comply with the RTS in the first instance. They should refer to the PRA rules as well as to the RTS to ensure compliance with the contractual recognition requirement.

This consultation closes on Monday 16 May 2016.

More information

For more information on BRRD and its implications see the following recent Ashurst briefings: "Contractual recognition of bail-in" as a term of debt instruments; "Contractual recognition of bail-in" – EBA releases Final Report; Valuation of derivatives and contractual stays in financial contracts; Islamic finance opportunities and challenges; and BRRD update: Does Recognition of Bail-In Go Too Far?

Authors: Michael Logie, Partner, Global Head Securities and Derivatives; James Knight, Partner; Detmar Loff, Partner; Tim Morris, Consultant