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26 January 2018
On November 23 2016 the European Commission published a legislative proposal amending the Bank Recovery and Resolution Directive (EU Directive 2014/59/EU) to modify creditor hierarchy in insolvency with a view to facilitating the resolution of EU credit institutions. The proposal, which was fast tracked, resulted in the adoption of EU Directive 2017/2399 (December 12 2017), which amends the Bank Recovery and Resolution Directive as regards the ranking of debt instruments in insolvency. EU Directive 2017/2399 must be implemented by the member states by December 29 2018.
EU Directive 2017/2399 introduces a new rank in insolvency for ordinary, long-term, unsecured debt instruments issued by credit institutions and financial institutions within their consolidation perimeter that are established in the European Union. These so-called 'senior non-preferred' instruments will rank as senior to regulatory capital, but as junior to other senior liabilities.
This proposal is designed to improve the resolvability of EU institutions. In particular, in line with the objectives of the Financial Stability Board's total loss absorption capacity (TLAC) standard and the Bank Recovery and Resolution Directive's minimum requirement for own funds and eligible liabilities (MREL), it will allow resolution authorities to bail-in senior ordinary bonds in priority to other senior liabilities, rather than being required (as is the case under the Bank Recovery and Resolution Directive) to bail-in all such bonds simultaneously and on a pari passu basis bail-in all senior liabilities, including operational liabilities, derivatives and deposits, which are difficult to bail-in.
EU Directive 2017/2399 builds on legislation recently enacted in certain members states (including France, Germany and Italy) and is closely aligned with the 2016 French Sapin 2 law.
The Bank Recovery and Resolution Directive framework requires the capital and debt instruments of an entity in resolution to be written down or converted in accordance with the following loss absorption waterfall:
Claims within the same rank in the above waterfall must be reduced pari passu among themselves. In addition, the 'no creditor worse off' principle applies (ie, creditors must not suffer worse treatment in resolution than they would have suffered in insolvency and are entitled to compensation for the difference).
As an exception to the pari passu treatment, certain categories of eligible liability can be excluded from the resolution waterfall pursuant to Article 44(3) of the Bank Recovery and Resolution Directive in certain exceptional circumstances – for example, if:
However, the Article 44(3) exclusions remain subject to the 'no creditor worse off' principle. Accordingly, where a resolution authority decides to exclude or partially exclude an eligible liability or class of eligible liabilities under this provision, the level of write down or conversion applied to other eligible liabilities may be increased to take account of such exclusions, to the extent that the holders of such eligible liabilities do not suffer a greater loss than they would have suffered in insolvency.
As a result, except under Article 44(3) (which may give rise to indemnity claims under the 'no creditor worse off' principle and is therefore not optimal from the standpoint of the resolution authority), the Bank Recovery and Resolution Directive framework does not allow resolution authorities to bail-in certain liabilities in priority to others if those liabilities have the same rank under national insolvency law.
Specifically, in situations where senior liabilities must be bailed-in (ie, where the entity's regulatory capital does not provide a sufficient cushion to absorb losses), the Bank Recovery and Resolution Directive does not allow resolution authorities to bail-in senior debt investors in priority to holders of other senior liabilities (eg, operational creditors, holders of derivative liabilities or depositors).
Under the framework, resolution authorities are therefore faced with the following alternatives in the most critical situations (ie, where an institution's regulatory capital is insufficient to absorb losses):
In most of the post-directive banking crises where a bail-in of senior liabilities would have been required to absorb losses, resolution authorities have, perhaps unsurprisingly, sought to avoid resolution and bail-in altogether and reverted to the pre-directive method of addressing banking crises (ie, taxpayer funded bailouts, with the holders of subordinated debt being subject to burden sharing under state aid rules, thereby calling into question the effectiveness, credibility and usefulness of the Bank Recovery and Resolution Directive framework).
This was the case in particular with respect to:
The cases in which placement in resolution occurred did not require a bail-in of senior liabilities and resulted in protracted litigation.
The Financial Stability Board anticipated the potential impediment to resolvability resulting from the pari passu principle illustrated by these cases. It put forward the TLAC standard in November 2015. The standard requires global systemically important banks (G-SIBs) to hold a minimum amount of "minimum external loss-absorbing capacity" in the form of resources that are either regulatory capital or loss-absorbing liabilities that:
EU Directive 2017/2399 implements the TLAC principles in the EU framework by requiring member states to introduce a new statutory senior non-preferred rank in insolvency for credit institutions and financial institutions within their consolidation perimeter that are established in the European Union.
In order to be eligible for senior non-preferred rank, liabilities must have the following characteristics:
The new rank will be eligible for instruments issued after the entry into force of national measures implementing EU Directive 2017/2399, subject to grandfathering provisions taking into account regimes implemented in certain member states before December 31 2016 in order to implement the TLAC standard, as well as measures adopted by member states after December 31 2016 to anticipate the adoption of the directive.
Given that senior non-preferred instruments are designed to absorb losses in priority to other senior liabilities, the European Parliament's Committee on Economic and Monetary Affairs (ECON) proposed several amendments driven by the wish to protect investors buying those instruments, ranging from specifying that senior non-preferred instruments will qualify as complex under Article 25 of EU Directive 2014/65/EU to proposing that "only professional clients should be allowed to purchase" such instruments. These principles, while not incorporated in the directive, are in any event – at least, in part – reflected in the European Securities and Markets Authority guidelines on complex debt instruments and structured deposits, which provide that all "debt instruments eligible for bail-in tool purposes" are to be deemed complex.
The ECON draft report (September 8 2017) also proposed adding an additional rank consisting of debt instruments, which would rank senior to senior non-preferred debt, but junior to all other ordinary unsecured claims. This proposal was in line with the European Central Bank recommendation to introduce "a general depositor preference, based on a tiered approach". However, it was not reflected in the directive, which maintains a preference for covered deposits, as well as deposits from natural persons and micro, small and medium-sized enterprises, but does not introduce a general preference covering depositors such as corporate depositors. EU Directive 2017/2399 nevertheless leaves member states free to adopt a general deposit preference under their national laws:
For further information on this topic please contact Amélie Champsaur, Bernardo Massella Ducci Teri or Michael Kern at Cleary Gottlieb Steen & Hamilton LLP by telephone (+33 1 40 74 68 00) or email (email@example.com, firstname.lastname@example.org or email@example.com). The Cleary Gottlieb Steen & Hamilton LLP website can be accessed at www.clearygottlieb.com.
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