Beyond the Bail-In: Additional Resolution Powers under the BRRD

Jasmine Mazza (*)(**)

The lion king of all discussions on the EU banks resolution framework (1) is undoubtedly the “bail in” (2). However, truth be told, it resembles a mythological creature more than a lion: a beast surrounded by mysterious stories, but never seen in nature.

The bail-in had been presented to the public as a real game-changer in the management of banking crisis in the EU, as it would have been able to shift the burden of bank bail-outs from the taxpayers’ pockets to the bank shareholders’ and creditors’ shoulders and to the banking system, through the establishment of the resolution funds.

That is surely true in principle, but as a matter of fact resolution Authorities appear to be quite reluctant to adopt it (3). And this is unlikely to change, not at least until the bail-in will be manageable by converting/writing down only MREL liabilities (4).

In the meantime, little attention has been paid to certain additional resolution tools, which are equally formidable and possibly more likely to be exercised in case of a resolution than the bail-in.

In particular, I would like to focus here on certain powers entrusted with the resolution authorities in connection with three other tools available to the resolution Authorities: (a) the sale of business, (b) the bridge institution; and (c)the asset separation (5).

These different tools pursue substantially the same purpose: separating the “good bank” from the “bad bank”. Part of the assets, rights or liabilities of the institution under resolution are transferred to a “good” entity (which will ensure the continuity of the transferred relationships), while the remaining part of the institution is wound up under normal insolvency proceedings (as it was the case for the resolution of the Italian so-called “four banks” in 2015).

In the context of such separation process, resolution Authorities have been granted with far-reaching powers, which may directly affect the agreements that the bank to be resolved has in place with its clients, counterparties, and service providers.

Consider this example: failing bank Alfa has entered into multiple agreements with the investment firm Beta, including (i) a distribution agreement according to which Alfa has undertaken to distribute Beta’s investment services to its clients; (ii) certain derivative contracts; and (iii) a sub-custody agreement, pursuant to which the Alfa safekeeps the financial instruments of Beta’s clients. Alfa and Beta have also entered into a general set-off agreement covering any reciprocal exposures arising out of the other agreements.

In such a scenario, the resolution Authority, while applying one of the afore-mentioned tools, i.e. sale of business, establishment of the bridge bank, or asset separation, is in principled entitled to:

(a) select which of the contracts between Alfa and Beta shall be transferred to the “good bank” and which of them shall be left behind in the “bad bank”;

(b) close out and terminate the derivatives contracts between Alfa and Beta;(c) cancel or modify the terms of the distribution contract between Alfa and Beta (6).

And that might not be the end of the story. The powers of the resolution Authority, at least in the initial phases of the resolution, are far reaching, as the Authority may also: (a) re-transfer a contract (for example, the distribution contract) from the “good bank” back to the “bad bank” (without the need of a prior consent of the counterparty) (7); and (b) request the court to apply a stay, for an appropriate period of time, on judicial actions against Alfa (i.e., in the aforesaid example, temporarily blocking any judicial initiative by Beta, even if the latter deems to be damaged by the application of resolution powers) (8).

Banks’ counterparties (in principle counterparties to almost any kind of contract) may thus face, in case of resolution, a unilateral transfer of the contract to another counterparty, modification of its terms and conditions or even its cancellation. And all of the above without any prior notice, it would appear.

To be sure, the BRRD sets out certain safeguards for banks’ counterparties, in case of partial transfers. But will these provide sufficient protection?

Consider firstly the “No Creditor Worse off” principle (NCWO), one of the keystones of the whole resolution framework (9).

Thanks to the application of the NCWO principle, Beta is entitled to receive in satisfaction of its claims — even if the relevant contract has been left behind in the “bad bank” — at least as much as the amounts it would have received if Alfa had been wound up under the ordinary national insolvency proceeding.

This is of course a promising safeguard. However, its application requires an utterly discretional judgement, as it is based on a counterfactual scenario (the winding up of Alfa under normal insolvency proceeding) which by its very nature cannot be double-checked and entails a considerable degree of discretion (10). The development of insolvency proceedings is inevitably subject to a number of variables, for instance, in relation to the initiation of claw-back actions and more generally the initiatives undertaken by the receiver. Beta would of course be entitled to appeal before a Court to seek redress, claiming that there has been a violation of the NCWO principle. On its face, however, this would be an extremely complex case to be brought.

Another safeguard is the rule which prevents the splitting of linked liabilities, rights and contracts. In principle, such restriction on cherry picking practices regards — inter alia — security arrangements, set-off arrangements, close out netting agreements and structured finance arrangements. One might think that this is the key: Alfa and Beta have entered into a set-off agreement which is meant to cover all mutual exposures and as such should benefit from the protection afforded to linked agreements.

Not so fast. First of all, not all the arrangements belonging to the mentioned classes of arrangements (including set-off arrangements) are covered by the protection. As highlighted by the EBA (11), if those classes of arrangements were to be fully protected, resolution authorities could find it difficult to effect partial transfers. This is an understandable concern, which has been shared by the Commission: the Delegated Regulation (EU) 2017/867 has thus limited the scope of the protection.

In particular, set-off arrangements of the type entered into by Alfa and Beta would not necessarily benefit from the mentioned safeguard. According to the Regulation, ‘catch all’ or ‘sweep up’ set-off agreements cannot qualify as protected arrangements, taking into account that “if any liabilities between the parties would be protected against being separated from each other, this would make the partial transfer with regard to this counterparty unmanageable”, and it would “jeopardize the feasibility of the tool altogether” (12).

The above considerations have clear implications in terms of drafting of arrangements, as they tend to favour clauses which cover specific types of liabilities over catch-all clauses.

Alfa and Beta may thus try to structure the set-off arrangement differently, in order to make it fall into the scope of the provisions of the Delegated Regulation, for example by limiting the scope of the protection (e.g. by listing in detail the main obligations which would be covered by the set-off arrangements).

However, even if Alfa and Beta were careful enough to build their arrangements so that the safeguard applies, resolution authorities could still decide not to transfer the linked contracts within the protected arrangement to the “good bank”, leaving them behind all with the “bad bank”.

The resolution is much more than the bail-in. The BRRD framework is an extremely complex legal construction, where the complexity results mainly from an intricated system of checks and balances aimed at ensuring, on one hand, that legitimate capital market arrangements are preserved and, on the other hand, that resolution authorities have sufficient flexibility to pursue the goals of the resolution. In an attempt to have the cake and eat it too, the predictability of legal outcomes and certainty of law appear to have been put under pressure.

(*) Views expressed herein are strictly personal and do not necessarily reflect the views of the law firm for which I work.

(*) This article has been previously posted on soundandprudent.com.

(1) Introduced by the Directive 2014/59/EU (the so-called “BRRD”).

(2) That is, the mechanism which allows resolution authorities to write-down or convert into equity certain liabilities of the bank under resolution (art. 2, para. 1, n. 57 of the BRRD).

(3) From the entry into force of bail-in (2016), it has been applied only twice: in 2016, in Denmark, where it was used in conjunction with the bridge bank tool, with regard to a small bank (Andelskassen); and in April 2016, in Austria, with regard to HETA Asset Resolution AG. However, in this second case, the bail-in has been accompanied by an out-of-court agreement between the bondholders and the Austrian region of Carinthia. After April 2016, no other case has been registered.

(4) See, for a pessimistic view on the potential of MREL Tr?ger, Tobias Hans, Why MREL Won’t Help Much (August 21, 2017). Journal of Banking Regulation Vol. 20, 2019, available at SSRN: https://ssrn.com/abstract=3023185 or https://dx.doi.org/10.2139/ssrn.3023185.

(5) In isolation or together with the bail-in.

(6) See Articles 63 and 64 of the BRRD.

(7) See Articles 38, para. 6, and 40, para. 6, of the BRRD.

(8) See Article 86, para. 3 of BRRD.

(9) See Article 73 of the BRRD.

(10) Ventoruzzo, Marco and Sandrelli, Giulio, O Tell Me The Truth About Bail-In: Theory and Practice (February 27, 2019). Bocconi Legal Studies Research Paper; European Corporate Governance Institute (ECGI) — Law Working Paper №442/2019.

(11) Opinion on classes of arrangements to be protected in a partial property transfer published on 14 August 2015.

(12) Recital no. 5.