Bank Recovery and Resolution : A Conference Book 9789462740334, 9789462364080

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Bank Recovery and Resolution

Bank Recovery and Resolution A Conference Bo ok

M at t h i a s H a e n t j e n s a n d B o b We s s e l s ( E d s . )

Published, sold and distributed by Eleven International Publishing P.O. Box 85576 2508 CG The Hague The Netherlands Tel.: +31 70 33 070 33 Fax: +31 70 33 070 30 e-mail: [email protected] www.elevenpub.com Sold and distributed in USA and Canada International Specialized Book Services 920 NE 58th Avenue, Suite 300 Portland, OR 97213-3786, USA Tel.: 1-800-944-6190 (toll-free) Fax: +1 503 280-8832 [email protected] www.isbs.com Eleven International Publishing is an imprint of Boom uitgevers Den Haag.

ISBN 978-94-6236-408-0 ISBN 978-94-6274-033-4 (E-book) © 2014 The authors | Eleven International Publishing This publication is protected by international copyright law. All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without the prior permission of the publisher. Printed in The Netherlands

Table of Contents Notes on contributors

xiii

Part 1 Introduction 1

Work of International Organizations on Bank Recovery and Resolution: an Overview Matthias Haentjens 1 1.1 1.2 1.3 2 2.1 2.2 2.2.1 2.2.2 2.2.3 2.2.4 2.3 2.3.1 2.3.2 2.4 2.4.1 2.4.2 2.4.3 2.4.4 3 3.1 3.2 3.2.1 3.2.2 3.2.3 3.3 3.4 3.5

Introduction The earliest history of bank insolvencies Background of recent legislative initiatives Theme of today’s conference Territorial General Global FSF/FSB Basel Committee on Banking Supervision (BIS) IMF UNCITRAL Regional EU United States National United Kingdom Germany Spain The Netherlands Thematic General Scope Insurance companies Financial Market Infrastructures Securities and investment firms Recovery and resolution plans Bail-in Counterparties/contractual early termination

v

3

3 3 5 8 8 8 8 9 10 11 11 12 12 12 13 13 13 13 14 14 14 14 15 15 15 16 17 18

Table of Contents

3.6 3.7 4 5

Cooperation/cross-border groups Rule of law Conclusion Chronological overview

19 20 21 21

Part 2 Recovery Plans 2

Bank Recovery Plans: Strengths and Weaknesses – How to Make a Boiling Banker Frog Jump Tim Verdoes, Jan Adriaanse and Anthon Verweij 1 2 2.1 2.2 2.3 3 4 5 6

General introduction Early warning and recovery plans in other industries Recovery plans: early warning Recovery plans: turnaround process Recovery plans: content Characteristics of banks and the banking industry EU Directive on the Recovery and Resolution of Credit Institutions and Investment Firms Recovery plans: triggers, concepts, criteria, strengths and weaknesses Conclusions

25

25 27 28 29 30 32 35 38 44

3 Bank Failure and Pre-emptive Planning Stephan Madaus

49

1 2 2.1 2.1.1 2.1.2 3 3.1 3.2 3.2.1 3.2.2 3.3 3.3.1 3.3.1.1

49 49 50 51 52 54 54 54 55 56 58 58 59

Introduction The special purpose of a bank resolution regime ‘Too big to fail’ Special requirements in a bank failure scenario The shortcomings of insolvency proceedings in bank failure The proposed EU bank resolution mechanism The scope: financial institutions The decision: made by resolution authorities Reasons for a ‘dictated’ resolution plan The indispensable involvement of courts Decision content: pre-packaged (Pre-packaged) resolution plans Right to set up a plan

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Table of Contents

3.3.1.2 3.3.1.3 3.3.1.4 3.3.1.4.1 3.3.1.4.2 3.3.1.4.3 3.3.1.4.4 3.3.1.5 3.3.2 4 4.1 4.2 5 5.1 5.2 6 7 7.1 7.2 7.3 8

Duties to report Resolution planning and the core issue of resolvability Resolution tools Sale of business (and asset separation) Bridge institution (and asset separation) Who shall wind up a failing bank’s business and assets? The bail-in tool – reorganization efforts in a bank failure regime? Implementing a resolution plan Side-effect: recovery plans Early intervention by supervisors and recovery plans When should a supervisor intervene? What may a supervisor do? Addressing banking groups Group recovery plans and group financial support agreement Group resolution plans Evaluation Outlining a ‘default resolution option’ Resolution planning and resolvability Resolution of a failing financial institution Post-failure activities Conclusion

59 60 61 61 61 62 63 65 65 66 66 66 68 68 69 70 71 71 72 73 74

Part 3 Rule of Law v. Authorities Discretion 4

Does the Directive on the Recovery and Resolution of Credit Institutions Provide Sufficient Fundamental Rights Protection? Alexander Schild

77

1 2 2.1 2.2 2.3 3 3.1 3.2 3.3 4 5

77 78 79 79 80 83 83 84 84 85 85

Introduction The right to the peaceful enjoyment of property Principle of lawfulness Principle of a legitimate aim Principle of fair balance Safeguards under the RRD Safeguards for counterparties in partial transfers Safeguards for the bridge institution and the asset separation-tool Safeguards for the bail-in instrument The right to an effective remedy Conclusion

vii

Table of Contents

5

Resolution Regimes for Financial Institutions and the Rule of Law Alexander Bornemann 1 1.1 1.2 1.3 1.3.1 1.3.2 1.3.3 1.4 2 2.1 2.2 3 4 4.1 4.2 5

Rule of law issues relating to resolution regimes for financial institutions Role and functions of resolution regimes Illustration: debate over constitutionality of the ‘orderly liquidation authority’ under the U.S. Dodd-Frank Act The European perspective Proposal for a recovery and resolution directive Rule of law in EU law Instantiations of the rule of law in the fundamental rights guaranteed under the Charter Rule of law issues – overview Principle of legality Vagueness and margins of assessment in the context of systemic risk tests Use of and choice between specific resolution tools and powers Right to good administration and the due process of law Right to effective remedy and fair trial Scope and standard of judicial review Prohibition against a reversal of the decision’s legal consequences Conclusions

87

87 87 88 89 89 90 93 94 95 97 102 104 105 106 109 110

Part 4 Treatment of Cross-Border Groups 6

Federal Deposit Insurance Corporation and Bank of England Memorandum on Resolving Globally Active Systemically Important Financial Institutions Paul Davies 1 2 3 4 5

Introduction General approach US and UK approaches: functional but not formal convergence Common Issues Conclusion

viii

115

115 117 118 123 126

Table of Contents

7

Resolution of Cross-Border Groups – According to the Proposal for a Directive Establishing a Framework for the Recovery and Resolution of Credit Institutions and Investment Firms Giulia Vallar 1 1.1

2 2.1 2.2 2.3 2.4 2.5 2.6 2.7 2.8 3 3.1 3.2 3.3 4

Introduction The path towards a discipline of insolvent cross-border groups in the proposal for a directive establishing a framework for the recovery and resolution of credit institutions and investment firms Analysis of the relevant provisions contained in the Proposal Group resolution plans (Articles 11 and 12) Assessment and removal of impediments to resolution (Article 15) Resolution colleges (Article 80) European resolution colleges (Article 81) Information exchange (Article 82) Group resolution (Article 83) Financing of group resolution (Article 98) Groups established in both EU and non-EU countries: cooperation in resolution among authorities (Articles 84, 88 and 89) Comments and observations A three-step itinerary to resolution What impact do structure and nature of the exercised activity have on the content of provisions governing resolution? Other recent international initiatives dealing with insolvency of crossborder financial groups Concluding remarks

131

131

131 133 133 135 136 139 140 140 141 142 144 144 145 146 147

Part 5 Bail-in and Counterparties 8 Bail-in: Some Fundamental Questions Victor de Serière

153

1 2 3 4 5 6 7

153 154 155 156 157 159 161

Introduction Relationship between bail-in and other resolution tools Collective responsibility of the banking sector? Liquidity versus solvency Collective responsibility for shareholders and creditors Why loss absorption? Volcker Rule impact

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Table of Contents

8 9 10 11 12 13 14 15 16 17 18 19

The positioning of the bail-in tool in terms of timing The ‘no creditor worse off’ (NCWO) principle Using the insolvency ladder principle Insured deposit holders Suppliers Derivatives Senior bondholders Contractual bail-in versus statutory bail-in Covered bonds and other secured liabilities Set-off Valuation Conclusion

162 163 166 168 169 171 173 175 175 177 177 178

9 Resolution Tools and Derivatives Francisco Garcimartín

181

1 2 2.1 2.2 2.3 3 3.1 3.2 4

181 182 182 183 184 186 186 187

4.1 4.2 4.3

Introduction Bail-in: eligible liabilities Introduction Scope: eligible liabilities Cross-border dimension Derivatives Derivatives as eligible obligations How does the bail-in tool apply to derivatives? Other issues: suspension of termination rights and transfer to another entity Suspension and termination rights Cross-border aspects Transfer to a bridge bank

189 189 192 193

Part 6 Reports on Workshops 10 Report on Workshop 1: Recovery Plans Anthon Verweij

197

1 2 3

197 200 203

Recovery planning Resolution planning Discussion

x

Table of Contents

11 Report on Workshop 2: Rule of Law v. Authorities Discretion Xinyi Gong

209

1 1.1 1.2 1.2.1 1.2.2 1.2.2.1 2

209 209 210 210 210 211

2.1 2.2 2.2.1 2.2.2 2.2.3 2.3 3 4

Resolution regimes for financial institutions and the rule of law The relevance of the rule of law Problems incurred by resolution regimes Margins of assessment in the context of systemic risk tests Use of specific resolution tools and powers Solutions Does the directive on the recovery and resolution of credit institutions provide sufficient fundamental rights protection? Introduction The three requirements Principle of lawfulness Principle of a legitimate aim Principle of fair balance The Northern Rock case Conclusion Discussion

212 212 212 212 212 213 213 214 214

12 Report on Workshop 3: Treatment of Cross-Border Groups Valentina Caria

215

1 2 3 4

215 215 217 219

Introduction The multiple point of entry strategy The single point of entry strategy Conclusion

13 Report on Workshop 4: Bail-in and Counterparties Olga Falgueras del Álamo

221

1 2

221 223

Bail-in: some fundamental questions Bail-in powers and derivatives

Part 7 Report on Forum 14

Conference Discussion Report: Valuation and Depositor Preference Tom Dijkhuizen and Mark van der Veer

xi

229

Table of Contents

Verschenen publicaties in deze reeks

235

xii

Notes on contributors Alexander Bornemann Regierungsdirektor at the Insolvency Law Division of the German Federal Ministry of Justice Prof. Dr. Paul Davies Allen & Overy Professor of Corporate Law, University of Oxford, and Fellow of Jesus College Prof. Dr. Francisco Garcimartín Chair Professor of Private International Law at Universidad Autónoma of Madrid, Consultant for Linklaters SLP Prof. Dr. Matthias Haentjens Hazelhoff Professor of Financial Law and Director of the Hazelhoff Centre for Financial Law at Leiden Law School Prof. Dr. Stephan Madaus Professor of Civil Law, Civil Procedure and Insolvency Law, University of Regensburg Dr. Alexander Schild Law Clerk at the Netherlands Supreme Court Prof. Dr. Victor de Serière Of Counsel to Allen & Overy and Professor of Securities Law, Radboud University Nijmegen Giulia Vallar Ph.D. Candidate in International Law at the University of Milan Dr. Tim Verdoes Assistant Professor at Leiden Law School, Institute for Tax Law and Economics Prof. Dr. Bob Wessels Independent legal counsel and Professor of International Insolvency Law at Leiden Law School

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Bank Recovery and Resolution

Series Preface While some may claim that the European debt crisis is over, many European legislative instruments directed at crisis management in the banking sector, including Banking Union legislation, are still pending enactment at the moment of writing. These legislative instruments, once enacted, will bring about an unprecedented harmonization of European bank insolvency law. Also, a multitude of legal disputes following the nationalization of SNS Reaal, the fourth largest bank in the Netherlands, in February 2013, are still unresolved. On 23 May 2013, the Hazelhoff Centre for Financial Law at Leiden Law School and the Netherlands Association for Comparative and International Insolvency Law (NACIIL) organized a conference on the highly topical theme of recovery and resolution of credit institutions and investment firms. The key question to which answers were sought during this conference was: ‘Which rules should govern banks in difficulties?’ This question has also been the Hazelhoff Centre for Financial Law’s research theme for the past two years. As directors of the Hazelhoff Centre, we are NACIIL, our co-organiser of the conference, immensely grateful for their inspiring cooperation, and we are delighted that we may add this conference book to the Hazelhoff Financial Law Series. The Hazelhoff Financial Law Series intends to deepen and further the debate on topical issues of financial law. It represents key results of the work of the Hazelhoff Centre for Financial Law at Leiden Law School. We understand financial law to encompass, inter alia, the legal aspects of financial supervision, the organization, functioning and regulation of financial markets, securities and finance transactions, market abuse, payments and payment systems, duties of care in the banking sector and bank insolvency. Another key characteristic of the work of the Hazelhoff Centre for Financial Law is our focus on the international dimension of financial law. Should you share our enthusiasm in any of these areas of the law, we are confident that you will find much of interest in the present volume. Prof. Dr. Matthias Haentjens Prof. Dr. Rogier Raas Prof. Dr. Pim Rank

xiv

Editorial Preface

Editorial Preface On 23 May 2013, the Netherlands Association for Comparative and International Insolvency Law (NACIIL) and the Hazelhoff Centre for Financial Law at Leiden Law School (HCFL) organized a conference on the recovery and resolution of credit institutions and investment firms. Much attention was paid to the draft Directive of the European Commission on the same subject published in June 2012. More specifically, practitioners as well as academics hailing from some 10 different jurisdictions gave general introductions and specific workshops on various themes. These included requirements for a rescue or recovery plan; bail-in and the position of counter-parties; the rule of law versus authorities’ discretion; and the treatment of cross-border groups. Both for the keynote plenary addresses and for the five workshops, papers had been prepared. The workshop papers had been distributed in draft prior to the conference and were discussed during the working group sessions. Subsequent to these discussions, the authors have amended their papers. Other than the paper for the workshop on an actual bank insolvency case, which could not be published for reasons of confidentiality, you will find these papers before you. In addition, we have added a keynote plenary address paper, the reports of the workshops, as well as the report of the plenary discussion. We are deeply grateful to the authors who have made the conference and the publication of the present book possible. We are also grateful to our sponsors, the global law firm of Baker & McKenzie and the International Insolvency Institute. Without their support, the conference and its output would have been much less international than it is now. Finally, we are indebted to Anthon Verweij, Ph.D. candidate, and student-assistants Bastiaan Krouwel, Matthijs Krul, Boudewijn Smit and Denise Stalenberg, all from Leiden Law School, for their assistance in the organization of the conference and the preparation of this book, which we trust will prove of added value to your work and may serve as an inspiration for your research. Prof. Dr. Matthias Haentjens Prof. Dr. Bob Wessels

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Bank Recovery and Resolution

A note on the NACIIL and the HCFL Netherlands Association for Comparative and International Insolvency Law In August 2011 the Netherlands Association for Comparative and International Insolvency Law (NACIIL) (in Dutch: Nederlandse Vereniging voor Rechtsvergelijkend en Internationaal Insolventierecht, NVRII) was established. Its goal is to promote interest in and knowledge of comparative and international insolvency law. For this purpose the association will hold conferences and organize lectures or courses, initiate student initiatives and the publication and distribution of articles and reports. As many of the initiatives will be in English, the association also reaches out to professionals, scholars and students (with their COMI) outside the Netherlands with the aim of furthering, jointly, the development of comparative and international insolvency law. At present the Association has more than 160 members. Until now NACIIL has organized some ten conferences and workshops, which, among others, resulted in the association’s yearly reports on The Review of the EU Insolvency Regulation; Some Proposals for Amendment (2011), and Corporate Rescue (2012). The Reports are available on the association’s website. Other major events organized by NACIIL were the conferences concerning Ten Years European Insolvency Regulation, Cross-border insolvency: Practical Topics and a meeting with judges on Cross-border Judicial Cooperation. Many of the events included non-Dutch speakers and the tremendous support of many sponsors. In 2013 NACIIL organised a workshop on the European Committee’s proposals to amend the EU Insolvency Regulation (26 February), a meeting with PhD researchers for some eight law faculties (15 March), a meeting with academics following the 18-19 May INSOL International Academic’s conference, a conference on the topic of recovery and resolution of credit institutions and investment firms (23 May, together with the Hazelhoff Centre for Financial Law (HCFL), Leiden Law School), while the third Annual conference of NACIIL (21 November) was (in Dutch) related to the topic of subordination. Prof. Bob Wessels

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A note on the NACIIL and the HCFL

Chair NACIIL For further information, please visit our website: http://www.naciil.org, or write an e-mail: [email protected]

Hazelhoff Centre for Financial Law The Hazelhoff Centre for Financial Law at Leiden Law School was founded in 2012. It is committed to providing education and research in the field of (international) financial law at the highest levels. The Hazelhoff Centre’s research focuses on issues of financial law where different traditional areas of law intersect: we believe analysis is particularly important where commercial law, public/regulatory law, tort law and criminal law meet, especially in a cross-border context. Our research results are published nationally and internationally in books and articles. Also, we contribute to (international) conferences and congresses. Thus, the Hazelfhoff Centre is in the forefront of the academic debate. Furthermore, the Centre is available to bring its expertise in practice by performing research on commission and providing advice to (regulatory) authorities, practice and the industry. The Hazelhoff Centre has recently initiated a comprehensive research project Banking in Difficult Times. The central question to which this research project seeks answers is, which rules should facilitate the recovery and resolution of banks that suffer from financial difficulties? We believe that this project is a unique and innovative one, considering that it employs a multi-level, multi-disciplinary and multi-jurisdictional approach. The Hazelhoff Centre provides a broad range of post-graduate courses. We organize conferences and congresses, and we give lectures and courses to attorneys, financial supervisors and in-house lawyers on the aspects of financial law that are of their specific interest. Furthermore, the Centre takes part in the post-graduate programme of Leiden Law School. Since 2012, the Hazelhoff Centre has been offering an LL.M. programme in financial law. This programme prepares our students for commercial practice and public policy, considering the increasing importance of financial law in those areas. Specific attention is devoted to current regulatory developments and real-life cases, which are explained by lecturers with practical experience in this field. Students get introduced to regulatory authorities and financial markets by meetings at the offices of a Dutch financial supervisor or at Euronext. As our research, our LL.M. programme is internationally oriented.

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Bank Recovery and Resolution

The Hazelhoff Centre’s board is composed of Prof. Dr. M. (Matthias) Haentjens, Prof. Dr. R.P. (Rogier) Raas and Prof. Dr. W.A.K. (Pim) Rank. For further information, please visit our website: www.law.leiden.edu/financial-law/ or send us an e-mail: [email protected]

xviii

Part 1 Introduction

1

Work of International Organizations on Bank Recovery and Resolution: an Overview

Matthias Haentjens

1

1.1

Introduction

The earliest history of bank insolvencies

These are stormy times for European bank insolvency law. The final text of the common rules for the recovery and resolution of credit institutions and investment firms has not yet been adopted, and the European Commission is already pushing an even more ambitious project: the creation of a ‘Single Resolution Mechanism’.1 This proposal, which would probably include a central resolution authority, has already encountered fierce resistance. The German finance minister, for instance, has stated that it would require a Treaty change, so it is doubtful whether this Single Resolution Mechanism will be introduced in the short term.2 In the midst of these heated debates on the fundamentals of the European Union and bank insolvency law, this seems the right time to look back to its earliest days. We should have known that banks may fall insolvent, as banks have done so since they have come into existence. The word ‘bankrupt’, which can be found in practically all languages of the world to mean insolvency, even derives from the failure of a bank. Bankruptcy (English), bankroet (Dutch), Bankrott (German), bancarotta (Portuguese) and банкротство (Russian) all find their origin in the Italian banca rotta. The ritual act of

1

2

See European Commission, ‘Communication from the Commission to the European Parliament and the Council, A Roadmap Towards a Banking Union’, 12 September 2012, COM(2012) 510 final and European Parliament, ‘Banking Union: the Single Resolution Mechanism’, February 2013. W. Schäuble, ‘Banking Union Must Be Built on Firm Foundations’, FT, 13 May 2013, p. 9. Since the conference, however, both the SSM has been enacted, and the text of the Single Supervisory Mechanism Regulations have been adopted. See Council Regulation (EU) No. 1024/2013 of 15 October 2013 conferring specific tasks on the ECB concerning policies relating to the prudential supervision of credit institutions and Regulation (EU) No. 1022/2013 of the European Parliament and of the Council of 22 October 2013 amending Regulation (EU) No. 1093/2010 establishing a European Supervisory Authority (European Banking Authority) as regards the conferral of specific tasks on the ECB pursuant to Council Regulation (EU) No. 1024/2013.

3

Matthias Haentjens

breaking a banker’s table or banca, behind which he conducted his business, used to signify this banker’s insolvency. Banks, as we know them now, have developed from moneychangers into deposit takers. This development took place in the late Middle Ages in the Italian city states, and hence the Italian origin of the word for bankruptcy. To be more precise, in Genoa this development may have taken place as early as around 1200, while in Venice, this development took place around 1300 AD.3 Back in those earliest days, deposits were credited to a current account. Also, while deposits for safekeeping were classified as depositum regulare, deposits into a current account were classified as depositum irregulare. Under depositum irregulare, the depositor lost ownership of the assets deposited. Moreover, his assets were fungible, and the banker had to return equivalent assets, i.e. not the very same assets, but the same in quality and quantity. It is from this moment on that banks have fallen insolvent, as it was the case – and has been the case since – that bankers held only a tiny fraction of the sums received in deposit available for retrieval by depositors.4 Moreover, it is since then that they have lent on longer terms than deposits could be retrieved.5 Consequently, from their very inception on, the bank’s business model was inherently risky. As a matter of course, this was widely recognized. Therefore, and as depositors had no preference over other creditors of the bank or were otherwise insured,6 bank runs were not uncommon. Bank runs sometimes were so unwieldy, that they were referred to as una gran furia.7 Also, banks failed because they lent to sovereigns who did not repay those loans. Around 1345, for instance, the three most important banks of the time, which had branches all over Western Europe, failed because they had overextended their credit to the kings of England and of Naples.8 As another example, when the Ammanati Bank of Pistoia failed in 1302, it had debtors-accountholders not only in important Italian city states such as Rome, but also in Spain, Portugal, France, England and Germany.9 Senator Tommaso

3

4 5 6 7 8 9

R. de Roover, ‘New Interpretations of the History of Banking’, in J. Kirshner (ed.), Business, Banking, and Economic Thought in Late Medieval and Early Modern Europe, University of Chicago Press, Chicago (1974), p. 201 and R.C. Mueller, The Venetian Money Market, Banks, Panics, and the Public Debt, 1200-1500, Johns Hopkins University Press, London (1997), p. 8 respectively. Mueller (1997), pp. 16-17. See Mueller (1997), p. 12. See, e.g., Mueller (1997), pp. 10-12. Mueller (1997), p. 126. de Roover (1974), p. 206. B. Wessels, International Insolvency Law (3rd ed.), Kluwer, Deventer (2012), para. 10033.

4

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Work of International Organizations on Bank Recovery and Resolution: an Overview

Contarini of Venice wrote in 1584, when a large bank had failed (again): ‘In the 1,200 years during which this Republic exists by the grace of God, one finds that 103 private banks were erected, of which 96 failed […] and 7 alone succeeded.’10 Also upon closer inspection, these early bank insolvencies seem eerily familiar. Consider, for instance, the following characteristics of those insolvencies: – ordinary depositors of money had to share pro rata with the other creditors of the bank; – as just shown, cross-border insolvencies of banking groups were not uncommon; – bank crises were ‘international’ in nature: when major Venetian banks failed around 1338, Florentine banks followed suit one or two years later;11 – in many cases, a moratorium was declared during which the insolvent could not be sued and could liquidate his assets himself;12 – creditor agreements had to be approved by the government; and – in the most serious cases, the state assumed direct responsibility, by appointing receivers, and sometimes acted as lender of last resort. When a run took place on the PisaniTiepolo bank in 1576, for instance, the government lent the bank 65,000 ducats. This bail-out led Senator Contarini to make his comment cited above.13 There are differences, however. In Venice, insolvents who failed to pay were excluded from the political and economic life of the city. On the Italian mainland, the punishment was of another kind: there, the insolvent had to strike his naked buttocks three times on the stone of infamy which stood in a public place, pronouncing the words Cedo bonis, or ‘I surrender my assets’. Whereas contemporary bankers, in general, and bankers of bailedout banks, in particular, cannot be said to enjoy great popularity, their ‘punishment’ is of a generous kind: not one CEO, for instance, has been (criminally) charged since the financial crisis that started in 2007.14

1.2

Background of recent legislative initiatives

These historic precedents notwithstanding, the financial world was shocked to learn, on 15 September 2008, that Lehman Brothers was not rescued and that it had to file for Chapter 11 under the US Bankruptcy Code. I will not elaborate on the Lehman Brothers 10 11 12 13 14

As quoted by Mueller (1997), pp. 121-122. Mueller (1997), p. 123. Mueller (1997), p. 124. See Mueller (1997), p. 126. See, e.g., J.S. Rakoff, ‘The Financial Crisis: Why Have No High Level Executives Been Prosecuted?’, The New York Review of Books, 9 January 2014, p. 5.

5

Matthias Haentjens

case, as Judge Peck of the Southern District of New York, who has been handling this case as a magistrate, will discuss it during lunch. Lehman’s insolvency sparked a crisis that some say continues today. As Mr. Jol of ABN AMRO Bank N.V. has just explained, in this crisis, numerous banks found themselves in trouble, and a tremendous amount of government money was injected into failing banks. Between October 2008 and October 2011 in Europe alone, the European Commission approved EUR 4.5 trillion (equivalent to 37% of the GDP of the EU) of state aid for financial institutions.15 Because of these capital injections, the costs of bank insolvencies for tax payers have been enormous. Most importantly, these bail-outs resulted from the reality that institutions were deemed ‘too big to fail’. Because these institutions were deemed so big or interconnected that their failure would cause national and international contagion, they needed (implicit or explicit) public support to be kept afloat and to avoid general financial instability. It could be argued that ‘too big to fail’ can be addressed by a modernized resolution regime under which a failing bank is wound down, while its systemically important functions are safeguarded.16 The crisis has shown that cross-border banking groups were usually resolved along national lines, which did not always yield the most optimal result. As the Basel Committee for Banking Supervision (BCBS) has shown, a harmonized regime would help to address such cross-border inefficiency by creating compatible national bank insolvency frameworks. In the Committee’s analysis, such compatibility would facilitate the continuity of key functions across borders and thus the maintenance of financial stability.17 While coordination between the national processes remains a necessary condition to achieve this result, such coordination may be helped by a harmonized regime.18 As a result of the recent crisis, a vicious bond between sovereign debt and bank debt has been created, especially in Europe. In Greece, for instance, the banking sector had taken on large amounts of local government bonds so that when it became evident that government finances were deplorable and government bonds were downgraded to junk status, the government took the banking sector with it in its financial downfall. Conversely, in Spain and Ireland, banks broke the government. Spanish and Irish banks had taken on large real estate portfolios. Thus, they were most vulnerable to any downturn of the real

15 Press Release of the European Commission of 6 June 2012, ‘New Crisis Management Measures to Avoid Future Bank Bail-Outs’. 16 Basel Committee on Banking Supervision, ‘Report and Recommendations of the Cross-Border Bank Resolution Group’ (2010), p. 3 and Explanatory Memorandum to the Draft Directive, para. 3. 17 BCBS Report (2010), p. 5. 18 BCBS Report (2010), p. 25 and Recommendation 3.

6

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Work of International Organizations on Bank Recovery and Resolution: an Overview

estate market. When that happened, their governments had to bail them out at enormous costs.19 To break this doom-loop between European sovereigns and banks and, even more ambitiously, prevent a future crisis, several initiatives have been taken under the title ‘Banking Union’. First, the Commission has proposed a ‘Single Supervisory Mechanism’, under which the European Central Bank (ECB) would act as the single prudential supervisor for all European banks. But, as Yves Mersch, member of the ECB executive board, has explained, this single supervisor will not be able to give objective verdicts on the viability of banks if they cannot be resolved in an orderly way without the risk of contagion.20 In other words, a modernized and harmonized bank insolvency regime is a necessary condition for the common supervisor to function properly and to be able to show its teeth. Such a harmonized bank insolvency regime would therefore form the Banking Union’s second leg. Finally, this modernized and harmonized bank insolvency regime would need funding. The Commission has proposed to create a common European deposit guarantee scheme as the third leg of the Banking Union, but this seems – at the moment at least – too ambitious politically.21 Here, we will focus on the second leg: a modernized and harmonized bank insolvency regime. This is a most timely matter as the Commission published a draft Recovery and Resolution Directive in June of last year (the draft Directive),22 on which the European Commission, the European Parliament and the EU Member States reached a framework agreement in December 2013.23 To further set the scene, I will briefly discuss both European and global initiatives to bring about a modernized bank insolvency regime. Thereafter, butbefore the break, Mr. Bernstein of Davis, Polk & Wardwell LLP, will provide us with some of the latest insights as regards the United States.24

19 See, e.g., M. Lewis, Boomerang: The Biggest Bust, Penguin Books, London (2011), p. 83 et seq. 20 Y. Mersch, ‘Europe’s Ills Cannot Be Healed Only by Monetary Innovation’, FT, 25 April 2013, p. 7. 21 Some economists, however, argue one should start with the introduction of the common fund – and then work backwards, via a common insolvency regime to a single supervisor. See, e.g., D. Schoenmaker, ‘Banking Union: Where We’re Going Wrong’, in T. Beck (ed.), Banking Union for Europe, Risks and Challenges, Centre for Economic Policy Research, London (2012), p. 95 et seq. 22 In full: ‘Proposal for a Directive of the European Parliament and of the Council Establishing a Framework for the Recovery and Resolution of Credit Institutions and Investment Firms and Amending Council Directives 77/91/EEC and 82/891/EC, Directives 2001/24/EC, 2002/47/EC, 2004/25/EC, 2005/56/EC, 2007/36/EC and 2011/35/EC and Regulation (EU) No. 1093/2010’, COM(2012) 0280 final – 2012/0150 (COD). 23 Press release of the European Commission of 12 December 2013, ‘Commissioner Barnier Welcomes Trilogue Agreement on the Framework for Bank Recovery and Resolution’, MEMO/13/1140. 24 See below, para. 1.3.

7

Matthias Haentjens

1.3

Theme of today’s conference

The Banking Union’s legislative initiatives and, more specifically the publication and future adoption of the EU draft Directive, have been the occasion for this conference’s topic. But, more broadly, we would wish to address from both an academic and practical perspective the following two questions: what would be the issues to address in the context of bank insolvencies, and how should these issues be addressed?25 We will approach these questions from several angles. We will touch upon rules of insolvency law, company law, (financial) regulatory law and private law. Also, today’s conference is not limited to a specific national law. Its scope is extended to supranational (European) law, as well as various national legal systems, such as English, German and Dutch law. Moreover, we will have – apart from traditional legal perspectives – an economic take on recovery plans. Maybe we could also discuss self-regulatory action or non-binding soft law rules. We, the organizers, very much wish you to engage in a lively debate. With this debate, we aim to deepen our insight, and maybe reach some conclusions as to how rules should best be enacted.

2

2.1

Territorial

General

To discuss the recent legislative initiatives as regards bank recovery and resolution, I will take both a territorial and a thematic approach, and will start territorially. From a territorial perspective, the recent initiatives have taken place on all levels of governance: national, regional as well as global.

2.2

Global

On the global level, several organizations have taken the initiative to define issues to be addressed and, in some cases, to formulate the principles to do so. Already in 1998, in the aftermath of the Barings insolvency, a report was published by G30 together with INSOL

25 This is also the theme of the research programme of the Hazelhoff Centre for Financial Law at Leiden Law School. See .

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Work of International Organizations on Bank Recovery and Resolution: an Overview

International. This report specifically addressed the problems that may arise in a crossborder insolvency in the financial sector, and it observed that no framework existed.26 Following the subprime mortgage crisis that started in 2007, but really given impetus by the Lehman Brothers insolvency in September 2008, the G20 and other leaders recognized that an effective framework for the resolution of financial institutions is essential to secure financial stability and limit moral hazard, and that such a framework must be accompanied by a robust cross-border coordination mechanism.27 They called for a review of resolution regimes and insolvency laws, which was followed up by the Financial Stability Board (FSB), the Basel Committee on Banking Supervision (BCBS) of the Bank for International Settlements (BIS), the International Monetary Fund (IMF) and the World Bank. 2.2.1 FSF/FSB In April 2009, the Financial Stability Forum, FSB’s predecessor, published ‘Principles for cross-border cooperation on crisis management’.28 These principles require, most importantly, that national authorities develop, in short, the necessary cooperation and share information between themselves. Also, they ‘strongly encourage’ firms to maintain ‘contingency plans’. Following up on G20 meetings, the FSB subsequently developed a framework to address the systemic and moral hazard risks associated with systemically important financial institutions. This framework was endorsed by the G20 in November 2011. It should be fully implemented by 2019 and demands: – amendment of national insolvency regimes in accordance with the Key Attributes of Effective Resolution Regimes for Financial Institutions (Key Attributes) to be developed by FSB; – requirements for resolvability assessments and for recovery and resolution planning for global systemically important financial institutions (G-SIFIs); – requirements for banks determined to be globally systemically important to have additional loss absorption capacity in its common equity rising from 1% to 2.5% of risk-weighted assets; and – more intensive and effective supervision of all SIFIs.

26 UN Commission on International Trade Law, Working Group V (Insolvency Law), ‘Insolvency of Large and Complex Financial Institutions, Note by the Secretariat’, 24 September 2012, p. 3. 27 IMF, ‘Resolution of Cross-Border Banks’, June 2011, p. 5. 28 Financial Stability Forum, ‘FSF Principles for Cross-border Cooperation on Crisis Management’, 2 April 2009.

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Matthias Haentjens

The Key Attributes, published in October 2011, concern systemically significant or critical financial institutions and will be discussed below in greater detail. Here, it suffices to say that the FSB regularly publishes progress reports on the implementation of the Key Attributes. The latest report on the Key Attributes is of 15 April 2013.29 2.2.2 Basel Committee on Banking Supervision (BIS) The BCBS has also worked on a report and recommendations for the resolution of crossborder financial institutions. This work followed the BCBS’s recognition that prudential measures such as capital requirements alone cannot limit moral hazard without instituting a viable resolution process for cross-border financial institutions. In other words, in order to prevent financial institutions from relying on public lenders of last resort, a credible resolution framework should be put in place.30 The BCBS report and recommendations were published in March 2010. Based on an analysis of the failure of Fortis, Dexia, Kaupthing and Lehman Brothers, the BCBS concluded that insolvencies of banking groups have been resolved along national lines, under a so-called territorial approach. This approach has been the result of the absence of a multinational framework for sharing the fiscal burdens and the national nature of legal systems. Should such a framework ever be accomplished, a banking group could be resolved in its entirety, including foreign branches: the so-called universal approach. Between this utopian universal and the historical territorial approach, the recommendations of BCBS take a middle road. They recognize the strong likelihood of a territorial approach in a crisis, but they propose changes to national laws so as to create a more complementary legal framework for resolution.31 The BCBS concludes that national authorities should have the tools to effectuate an orderly resolution of all types of financial institutions, and thus contribute to: – the minimization of systemic risk; – the protection of consumers; – the limitation of moral hazard; and – the promotion of market efficiency.

29 FSB, ‘Implementing the FSB Key Attributes of Effective Resolution Regimes – How Far Have We Come?’, 15 April 2013, pp. 4-5. 30 BCBS Report (2010), p. 3. 31 BCBS Report (2010), pp. 5 and 16 et seq.

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Work of International Organizations on Bank Recovery and Resolution: an Overview

In my opinion, and even more generally, these four goals could be the agenda for any modernization of banking insolvency regime, and the draft Directive contains more or less the same.32 2.2.3 IMF As a third global organization, the International Monetary Fund has published on bank resolution. On 17 April 2009, together with the World Bank, the IMF published a study entitled ‘An Overview of the Legal, Institutional and Regulatory Frameworks for Bank Insolvency’.33 This study concerned only deposit-taking institutions at the domestic level, i.e. not cross-border institutions. Further to this paper, the IMF published a report ‘Resolution of Cross-Border Banks – A Proposed Framework for Enhanced Coordination’34 on 11 June 2010. This report builds on the March 2010 report of the BCBS and also stresses the importance of a harmonized resolution framework. In the IMF proposal, countries that bring about such a framework could subscribe to an ‘enhanced coordination framework’. Under this coordination framework, cooperating authorities could share the funding burden of failed banks and agree to have resolution actions taken with cross-border effect. 2.2.4 UNCITRAL In 2004, the United Nations Commission on International Trade Law (UNCITRAL) published Parts 1 and 2 of a ‘Legislative Guide on Insolvency Law’.35 This Guide concerns domestic commercial insolvency regimes. Part 3 of the same Guide, published in 2010, addresses the treatment of enterprise groups in insolvency, both nationally and internationally.36 As the issues addressed in this Part 3 are very similar to the issues addressed by the BCBS in its work on cross-border banking groups, the BCBS recommends that the UNCITRAL Guide should also be used for banking group insolvencies.37

32 Article 26 (2) of the draft Directive, as well as Explanatory Memorandum to the Draft Directive, para. 3 and Recital (27), where ‘consumers’ is replaced by deposit holders and less focus is had on market efficiency. 33 International Monetary Fund and The World Bank, ‘An Overview of the Legal, Institutional, and Regulatory Framework for Bank Insolvency’, 17 April 2009. 34 International Monetary Fund, ‘Resolution of Cross-Border Banks – A Proposed Framework for Enhanced Coordination’, 11 June 2010. 35 United Nations Commission on International Trade Law, Legislative Guide on Insolvency Law (part 1 and 2), United Nations, New York (2004). 36 See B. Wessels, International Insolvency Law (3rd ed.), Kluwer, Deventer (2012), para. 10425 et seq. 37 BCBS Report (2010), p. 26.

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2.3

Regional

2.3.1 EU As stated above, the European legislature initiated an ambitious project commonly referred to as the Banking Union in response to the financial crisis. Under the second leg of this banking union, that is, a common recovery and resolution regime for banks, the European Commission issued a public consultation on an EU framework for Cross-border Crisis Management in the Banking Sector in October 2009. On 6 June 2012, the European Commission published the draft Directive, and I believe the Commission is striving to reach agreement on the definitive text next month. But the Commission’s work on harmonization of the EU’s recovery and resolution regime for financial institutions has not stopped with the draft Directive. In September last year, the Commission has already proposed the creation of a ‘Single Resolution Mechanism’, which would include a central resolution authority.38 Additionally, on 5 October 2012, for instance, the European Commission has published a consultation on Recovery and Resolution of financial market infrastructures, to which the responses have been published in March 2013.39 Considering the current, highly charged political landscape of the EU, it remains to be seen whether these ambitious plans will be realized in the near future.40 2.3.2 United States I will not say much about the United States, as Mr.Bernstein will do so right after my talk. I just wish to highlight that various rules of the draft EU Directive find a statutory precursor in Title II of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the DoddFrank Act). For instance, the Dodd-Frank Act, as does the EU draft Directive, provides for bail-in, for contingency planning and for a resolution strategy for banking groups.

38 Press Release of the European Commission of 12 September 2012, ‘Commission Proposes New ECB Powers for Banking Supervision as Part of Banking Union’, IP/12/953. 39 See for all the contributions to the consultation document or the ‘Summary of the Replies to the Consultation of the Internal Market and Services Directorate General on a Possible Recovery and Resolution Framework for Financial Institutions Other Than Banks’ from March 2013 by the EC for a summary of these consultations. 40 On the Single Resolution Mechanism and Single Supervisory Mechanism, para. 1.2 and note 2.

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2.4

Work of International Organizations on Bank Recovery and Resolution: an Overview National

Driven, in part, by the exhortations of the above international organizations, various national legislatures have amended their banking insolvency regimes. I will certainly list, not discuss, them all, but could not resist naming four.41 2.4.1 United Kingdom First, the United Kingdom has seen a series of legislative initiatives on the subject of bank insolvency law since 2009. In that year a Special Resolution Regime for UK banks was introduced in the Banking Act, while 2010 saw the introduction of the Financial Services Act. The last Act requires banks to have and maintain recovery and resolution plans (to be discussed in para. 3.3). In August 2012, the UK Treasury issued a consultation paper for legislation on systemically important non-banks and Financial Market Infrastructures such as settlement systems and central counterparties. 2.4.2 Germany In Germany, the Restrukturierungsgesetz came into force in 2011. This Act, among other things, confers on the resolution authority the power to transfer a bank’s assets and create a bridge bank. Additionally, under this Act, a restructuring fund was established and a two-stage recovery and reorganization procedure for banks introduced. 2.4.3 Spain Since 2012, the powers of Spanish resolution authorities have been significantly expanded, and a new legal framework for the resolution of banks has been established. Importantly, the Fund for Orderly Restructuring of Banks (FROB) may impose losses on subordinated claims by turning them into equity. Such limited bail-in was effectuated recently as regards four nationalized banks (Bankia, Catalunya Banc, Banco Gallego and NCG Banco) and resulted in up to 61% haircuts.42 The same FROB may organize bank assets to be sold to a third party, or have them transferred to a bridge bank or asset management company. Non-performing real estate portfolios have already been transferred to an asset management company.43

41 The following is based on FSB, ‘Resolution of Systemically Important Financial Institutions Progress Report’, November 2012, p. 6. 42 The Economist, 30 March 2013, p. 64. 43 See, e.g., .

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Matthias Haentjens

2.4.4 The Netherlands Last year, the Netherlands legislature adopted the Interventiewet.44 This Act confers on the Dutch Central Bank (de Nederlandsche Bank) the power to have a bank’s or an insurer’s shares, assets and liabilities transferred to a third party or bridge institution. Also, it confers on the Minister of Finance the power to expropriate holders of securities issued by the institution in distress. This expropriation measure was intended as a measure of last resort – the legislature itself thought it might never have to be used, as the Minister’s power may only be employed when the situation of a financial company forms a serious and immediate threat to the stability of the financial system. The Minister argued that exactly this had happened on 1 February 2013, which also was the first time the Intervention Act was put into practice. As a result, banking conglomerate SNS Reaal, the fourth largest bank in the Netherlands, was nationalized and its shareholders and subordinated debt holders wiped out.45

3

3.1

Thematic

General

The FSB Key Attributes identify nine norms, which – according to the FSB – every resolution regime should meet so as to be effective. Many of these norms reappear in similar form in other initiatives, including the EU draft Directive. I will now discuss the most important ones and thus turn to the thematic organization of our conference.

3.2

Scope

First, however, a word on scope. The initiatives discussed above do not take the same approach with regard to the categories of institutions that should be subject to a modernized insolvency regime.

44 In full: Wet van 24 mei 2012 tot wijziging van de Wet op het financieel toezicht en de Faillissementswet, alsmede enige andere wetten in verband met de introductie van aanvullende bevoegdheden tot interventie bij financiële ondernemingen in problemen (Wet bijzondere maatregelen financiële ondernemingen), Stb. 241. This Act was enacted retroactively as of 20 January 2012. 45 Expropriation decision of Finance Minister, 1 February 2013 (in full: Besluit tot onteigening van effecten en vermogensbestanddelen SNS REAAL NV en SNS Bank NV in verband met de stabiliteit van het financiële stelsel, alsmede tot het treffen van onmiddellijke voorzieningen ten aanzien van SNS REAAL NV, 1 February 2013).

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Work of International Organizations on Bank Recovery and Resolution: an Overview

As a matter of course, global institutions have concerned themselves with global financial institutions, while regional initiatives have focused on other categories of firms. In its latest report of April 2013, for instance, the FSB has focused on G-SIFIs. The FSB Key Attributes of 2011, on the other hand, address all kinds of financial institutions: banks, insurers, securities and investment firms and Financial Market Infrastructures (FMIs), such as securities settlement systems and central counterparties. More generally, the FSB is of the opinion that resolution powers and tools should be extended to non-bank financial institutions.46 Also, Dodd-Frank Act Title II, for instance, applies to both systemically significant banks and nonbank financial institutions.47 3.2.1 Insurance companies The FSB recognized that many of its Key Attributes would also apply to insurance companies, but that a forced transfer of the insurance portfolio and a ‘run-off’ would be specific resolution tools to be used in regard to insurance companies. In contrast, under the recent Dutch Intervention Act, not only banks but also insurance firms may be made subject to a forced transfer of assets.48 In October 2011, the International Association of Insurance Supervisors published its own consultation on a global systemically important insurers’ version of the FSB Key Attributes. 3.2.2 Financial Market Infrastructures The FSB has stressed that specific rules should be developed for Financial Market Infrastructures. As stated earlier, para. 2.3, the EU has already taken up this task and published a consultation on this subject.49 3.2.3 Securities and investment firms The EU draft Directive covers not only credit institutions, but also investment firms. The FSB has argued that the effective resolution of securities and investment firms would require ‘clear rules requiring the segregation and identification of client assets’, so that resolution authorities may have client assets transferred to performing third parties or a bridge institution.50 In my view, however, this requirement of clear rules on asset segregation should apply not to securities and investment firms alone, but to any financial institution

46 FSB Progress Report (2013), p. 5. 47 Section 201. 48 The expropriation power of the Minister of Finance discussed earlier may even be applied against all financial companies (financiële ondernemingen) with a corporate seat in the Netherlands and their holding company (as long as its corporate seat is located in the Netherlands). 49 As did the CPSS-IOSCO in July 2012. 50 FSB Progress Report (2012), p. 10 et seq.

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holding client assets and is particularly acute in the case assets are held in different jurisdictions. In this context, the FSB and BCBS have stressed that authorities and firms should have a clear understanding of, in short, who owns what under which law.51 Currently, however, there is diversity and legal uncertainty in regard to both conflict of laws regimes and substantive law on securities held in a securities account. Conflict of laws regime diversity has been addressed by the Hague Securities Convention of 2006, which provides for a uniform conflict of laws rule.52 Also in the area of substantive securities law, several supra-national initiatives have already been undertaken, such as the UNIDROIT Geneva Convention of 200953 and the European Securities Law Legislation.54 However, neither the Hague Securities Convention nor the UNIDROIT Geneva Convention has obtained the force of law, while the European harmonization initiative has not even produced a draft instrument.

3.3

Recovery and resolution plans

Already under the ‘Principles for cross-border cooperation on crisis management’ published in April 2009 by the Financial Stability Forum, firms were encouraged to maintain contingency plans, which must be regularly reviewed to ensure that they remain accurate and adequate. These contingency plans should contain ‘funding plans that are practical to use in stressed market scenarios’. Also in its Key Attributes of 2011, the FSB recommended all global SIFIs to have ‘recovery and resolution plans’ in place, and provided a list of ‘essential elements’ of these plans.55 The BCBS recommended the same.56 Recovery plans concern an early stage of a financial institution in difficulties; it is the stage in which a turnaround could be accomplished so as to stave off insolvency. Under the draft Directive, financial institutions should prepare these recovery plans. In contrast, under the same Directive, resolution authorities should prepare resolution plans. These plans

51 FSB Progress Report (2012), pp. 10-12 and BCBS Report (2010), p. 32. Cf. also BCBS Report (2010), p. 40, where national authorities are advised to clarify how customer funds and securities are segregated in insolvency. 52 In full: Convention of 5 July 2006 on the Law Applicable to Certain Rights in Respect of Securities held with an Intermediary. See . 53 In full: UNIDROIT Convention on Substantive Rules for Intermediated Securities. See . 54 See . 55 FSB Key Attributes 11 and Annex III to the Key Attributes, respectively. 56 BCBS Report (2010), Recommendation 6.

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Work of International Organizations on Bank Recovery and Resolution: an Overview

should provide a road map for resolving the financial institution once the point has been reached that the institution can no longer be deemed to be viable.57 In its latest Progress Report of last month, the FSB found that most jurisdictions lack the powers to require firms to make changes to their structures to improve resolvability.58 For the EU, this will change when the draft Directive will be adopted and implemented in national laws, as under the same Directive, resolution authorities may require financial institutions to remove, in short, any impediments to their resolvability.59 In workshop 1, Prof. Adriaanse of Leiden Law School will discuss whether and under what circumstances a recovery plan could prove to be beneficial, while Prof. Madaus of the University of Regensburg, Germany, will focus on the resolution plan.60

3.4

Bail-in

As a matter of course, banks in difficulty need funding. The FSB found that in most jurisdictions, arrangements are in place under which failed banks are supplied with private funds to solve the deficits, but that these private funds are not always enough, so injections of public funds – albeit temporary – remain necessary.61 In its Key Attributes, the FSB argued that the private funds just referred to should include debt – besides equity, uninsured deposits and investor protection funds under deposit guarantee schemes. Thus, the FSB argued that resolution authorities should have the power to carry out bail-in, that is, to write down unsecured and uninsured creditor claims and convert these claims into equity.62 This accords with the BCBS recommendations.63 In its latest report of April 2013, the FSB found that Brazil, Australia, Indonesia, Singapore and South Africa are planning to implement bail-in, but that this is not yet a fact in most jurisdictions.64 The draft Directive provides that all Member States may write down bonds, convert them into shares, and reduce them to zero.65 Indeed, this bail-in tool is one of the most important 57 58 59 60 61 62 63 64 65

Articles 5-13 of the draft Directive. FSB Progress Report (2013), p. 6. Articles 13-15 of the draft Directive. See below, Chapters 2.4 and 2.5, respectively. FSB Progress Report (2013), p. 6. Cf. also Key Attributes 6. FSB Key Attributes 3.5-3.6. BCBS Report (2010), p. 23. FSB Progress Report (2013), p. 5. Articles 37-51 of the draft Directive.

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aspects of the draft Directive. When enacted and implemented, this will probably lead to higher funding costs for banks, as bondholders would thus hold riskier claims and therefore demand a higher interest rate on their bonds. Therefore, to allow for a smooth transition, the draft Directive does not require that the bail-in tool be implemented in national laws before 2018, but this date is controversial.66 Also controversial is the hierarchy between bondholders and uninsured depositors; it is hotly debated whether bondholders should always be fully wiped out before the depositors are touched or not. In workshop 4, Prof. Garcimartín of the University Autónoma of Madrid, and Prof. De Serière of Radboud University will discuss these issues.67

3.5

Counterparties/contractual early termination

As regards counterparty rights, the international initiatives discussed above take a nuanced approach. On the one hand, recent insolvencies have shown that contractual termination rights may have a procyclical effect: where recovery or resolution measures were taken, this fact in itself triggered contractual termination rights, thus worsening the bank’s situation and causing market instability. Consequently, the FSB’s Key Attributes recommended a temporary stay, so that entry into resolution and the exercise of any resolution power should not trigger acceleration of a loan, termination rights or set-off rights.68 On the other hand, the FSB Key Attributes recommend a temporary stay on the exercise of acceleration, termination and set-off rights only where these rights arise by reason of entry into resolution or any resolution powers, and provided that substantive obligations under the contract continue to be performed. The stay should respect ‘the integrity of financial contracts’ so that termination and netting under collateralized transactions such as repos remain allowed when such termination follows from the counterparties’ default under the contract (and not by the exercise of resolution powers).69 Moreover, when such contracts are transferred to another entity, these contracts should be transferred in their entirety.70 In its Recommendation 9, the BCBS even proposes to grant national authorities the power to effectuate a (forced) transfer of these financial contracts to a solvent third party, rather than have them terminated and subject to close-out netting by counterparties.71

66 67 68 69 70 71

Recital (52) of the draft Directive. See below, Chapters 5.10 and 5.11, respectively. FSB Key Attributes 4.2. Cf. also BCBS Report (2010), p. 23. FSB Key Attributes 4.3 and Annex IV, and also BCBS Report (2010), Recommendation 9. BCBS Report (2010), p. 40.

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In its 2013 Progress Report, the FSB found that most jurisdictions lack either the temporary stay or safeguards to minimize disruption to counterparty rights.72 But in the EU draft Directive, both the conditional temporary stay and protection against partial transfer as recommended by the FSB have been implemented.73 Also on these issues, we refer you to workshop 4, of Prof. Garcimartín and Prof. De Serière.74

3.6

Cooperation/cross-border groups

As regards the resolution of cross-border banking groups, resolution strategies can be distinguished in two main categories: single point of entry and multiple point of entry. Under the single point of entry strategy, resolution measures will be directed against the top holding or parent company of the relevant banking group, while the subsidiaries will be preserved on a going concern basis. Under the multiple point of entry strategy, the group is broken up along, for instance, territorial lines, and subjected to measures by two or more resolution authorities. The single point of entry approach has been explicitly chosen in the bilateral memorandum of the Bank of England and US Federal Deposit Insurance Company, for instance.75 In the Draft Directive, a coordinated multiple point of entry approach was chosen.76 As regards Global SIFIs, FSB recommends the creation of cross-border crisis management groups (CMGs) per G-SIFI. These CMGs should consist of the supervisory authorities, central banks, resolution authorities, finance ministries and the public authorities responsible for guarantee schemes of jurisdictions that are home or host to entities of the group. Also, FSB recommends conclusion of institution-specific cross-border cooperation agreements (COAGs) between the most relevant home and relevant host authorities.77 Whereas CMGs have been concluded for all G-SIFIs, as of 13 April 2013, no COAG has yet been agreed.78 The draft Directive also provides for the creation of resolution colleges per financial institution under leadership of the group-level resolution authority, as well as for supervision thereof by the European Banking Authority.79

72 73 74 75 76 77 78 79

FSB Progress Report (2013), p. 6. Articles 63 (temporary stay) and 69 (protection against partial transfer) of the draft Directive. See below, Chapters 5.10 and 5.11, respectively. Federal Deposit Insurance Corporation and Bank of England, ‘Resolving Globally Active, Systemically Important, Financial Institutions’, 10 December 2010, pp. 6-9. Articles 80-83 of the draft Directive. FSB Key Attributes 8 and 9, respectively. See FSB Progress Report (2013). Article 80 of the draft Directive.

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An important aspect of cross-border cooperation is, of course, information sharing. The BCBS recommended that authorities should conclude agreements on that issue.80 The FSB found, however, that few jurisdictions have clear rules on the sharing of confidential information for resolution purposes with foreign authorities.81 The draft Directive, on the other hand, explicitly requires – and thus provides a legal basis for – such information sharing between the different authorities involved.82 For a discussion on these topics, I refer you to workshop 3 of Prof. Davies of Oxford University and Ms. Vallar, Ph.D. researcher at the University of Milan.83 I might add that this is a fine example of the nature of our conference, where younger scholars may guide experienced practitioners on their path to knowledge of future European bank insolvency law.

3.7

Rule of law

Many of the above themes, when enacted as black letter law, will confer larger discretionary powers on authorities. The draft Directive, for instance, confers far-reaching powers on resolution authorities so that they may force institutions to take all kinds of recovery and resolvability measures. Also, they may decide on far-reaching resolution tools that involve not only the institution to be resolved itself, but also third parties such as shareholders and debt holders (vide bail-in). In its Key Attributes, the FSB recognizes that resolution authorities should have these discretionary powers, but that these should be subject to ‘constitutionally protected legal remedies and due process’. However, when redress is due, the FSB favours ex post compensation rather than ex ante possibilities to constrain the implementation of, or result in a reversal of, resolution measures.84 Yet it may be questioned whether the contemplated measures would result in an infringement of fundamental human rights, such as the right of peaceful enjoyment of property under the EU Charter of Fundamental Rights. In workshop 2, Mr. Bornemann of the German Ministry of Justice and Dr. Schild of the Dutch Supreme Court’s Academic Service will discuss these matters.85

80 81 82 83 84 85

BCBS Report (2010), Recommendation 7. FSB Progress Report (2013), p. 6. Article 82 of the draft Directive. See below, Chapters 4.8 and 4.9, respectively. FSB Key Attribute 5. See below, Chapters 3.6 and 3.7, respectively.

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Work of International Organizations on Bank Recovery and Resolution: an Overview Conclusion

Ladies and gentlemen, I now come to a conclusion. When in 1576, the Pisani-Tiepolo bank failed and had to be bailed out by the government, Senator Tommaso Contarini lamented the success-rate of Venetian banks. Moreover, he proposed that bank examiners would exercise daily oversight over the banking system and that bankers would have to take oaths each year to uphold the provisions of the law. In 1576 Venice, this proposal got only two votes.86 In our times, it is different. Daily oversight has become a fact of life. Last year, the Dutch legislator passed a bill under which bankers have to take the very same oath as proposed by a Venetian senator 437 years ago. Which laws bankers must swear to uphold, and, more specifically, which laws should be enforced in the bank’s insolvency, is the subject of today’s conference. I hope my overview has given you some starting points on which to build further thinking.

5

Chronological overview

Documents of international organizations referred to above, in chronological order: UNCITRAL Legislative Guide (2004) United Nations Commission on International Trade Law, Legislative Guide on Insolvency Law FSF Principles (2009) Financial Stability Forum, Principles for Cross-border Cooperation on Crisis Management IMF Overview (2009) International Monetary Fund and The World Bank, An Overview of the Legal, Institutional, and Regulatory Framework for Bank Insolvency BCBS Report (2010)

86 Mueller (1997), p. 152.

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Basel Committee on Banking Supervision, Report and Recommendations of the Crossborder Bank Resolution Group IMF Resolution (2010) IMF Resolution of Cross-Border Banks – A proposed Framework for Enhanced Coordination IMF Resolution (2011) International Monetary Fund, Resolution of Cross-Border Banks CPSS-IOSCO Principles (2012) The Committee on Payment and Settlement Systems and the International Organization of Securities Commissions, The new CPSS-IOSCO Principles for financial market infrastructures FSB Progress Report (2012) Financial Stability Board, Increasing the Intensity and Effectiveness of SIFI Supervision, Progress Report to the G20 Ministers and Governors FSB Progress Report (2013) Financial Stability Board, Implementing the FSB Key Attributes of Effective Resolution Regimes – how far have we come?

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Part 2 Recovery Plans

2

Bank Recovery Plans: Strengths and Weaknesses

How to Make a Boiling Banker Frog Jump Tim Verdoes, Jan Adriaanse and Anthon Verweij*

1

General introduction

Legislators and regulatory bodies are searching for new ways to mitigate the risks of failure of financial institutions. The banking industry is nonetheless already a heavily regulated industry. A 2012 report by KPMG1 identified 38 new regulations with which Dutch banks will be confronted between 2012 and 2015. These will (further) influence the banking industry enormously. Apart from the huge consequences for the balance sheets and income statements of banks, financial institutions and banks in particular will have to adapt their business model. As a result, new regulations can evoke reactions that can be detrimental for society; for example increasing the stability of the banking industry (by regulations) can decrease economic growth as banks would then probably want to lend less money and/or charge higher credit costs to borrowers (firms and households).2 Supervision, regulations, prohibitions, capital and liquidity requirements, and specific deposit taxes are a mix of tools regulatory bodies use to mitigate systemic risk of financial institutions. These tools force financial institutions to internalize the (social) costs and risks of their activities. A relatively new tool is the requirement of drawing up ‘living wills’, which consist of an ex-ante contingency ‘recovery plan’ and ‘resolution plan’. This can be seen as a kind of ‘crisis management’ or ‘turnaround management’, but in this specific case it is written beforehand, which is in contrast to most ‘normal’ companies that only start developing turnaround plans when faced with (looming) financial distress. So these living wills are to be designed upfront, and are to be executed when a financial institution gets into (financial) trouble. But will it work? We don’t know. Is it the ‘Eureka solution’ to prevent banking crises from happening ever again, or is it just another set of rules for * 1 2

The authors are associated with the Department of Business Studies of the Leiden Law School. The research agenda of the department is named: ‘Turnarounds and Insolvency Law: a business research perspective’. They call it ‘stacking of regulations’ [translated from Dutch]. There are other dilemmas too; stabilizing the banking sector can be detrimental to competition and innovation and thus the performance of the financial sector in general.

25

Tim Verdoes, Jan Adriaanse and Anthon Verweij the banking industry to be put in the category (useless) ‘additional paperwork’?3 Time will tell. What does the living will concept mean? Is it related to other regulatory tools? What are its purposes, elements, content, relations, incentives, (dis)advantages and requirements? Are there guidelines, problems and dilemmas? Living wills contain both recovery and resolution plans, although in this paper we will primarily focus on recovery plans.4 And while regulatory bodies have executed resolution plans in the past, the new element is that recovery plans now have to be drawn up by financial institutions ex ante. Still, although the recovery plan concept is currently rather uncultivated, we are already wondering: is it possible to draw up a rescue plan for a rescue situation that doesn’t exist (yet)? It is not easy to quantify the benefits and costs of living wills. Normally, turnaround and bankruptcy tools can be viewed from two perspectives: ex-ante and ex-post. These views are usually focused on the business itself and not on society: the ex-post efficient outcome maximizes the value that can be distributed to creditors and the ex-ante efficient outcome aligns the right incentives to directors so that the bonding role of debt is preserved. By analogy, we can distinguish the ex-post (‘using’) and ex-ante (‘preventing and incentive’) role of recovery plans for financial institutions. We believe that, in general, the ex-ante perspective seems to be the most promising. Its primary function should then be to improve the information, strategy, risk, stress, scenario, compliance, governance and monitoring systems of a financial institution. This role demands that recovery planning is an integral part of bank businesses’ operational, strategic, risk, and information systems. A holistic view towards recovery planning is thus that it must not be seen as a mere appendix. However, we do feel that recovery plans will not prevent banks from any moral hazard5 or from possible failure. The latter is possible only when a recovery plan is 100% credible and reliable, which is doubtful as it is nearly impossible to think about the unthinkable; or to quote former US Secretary of Defense, Donald Rumsfeld, from a 2002 press statement: ‘[…] there are [also] unknown unknowns – there are things we do not know we don’t know […]’. This, in itself, already undermines the ex-ante function (and probably also its ex-post function). Besides that, financial institutions could still have an incentive to underinvest in such systems owing to governmental guarantees. Why invest in systems that do not work under unthinkable situations when government guarantees deposits anyway? Additional strong supervision is therefore still needed (in drawing up these plans) and should be supplemented with other rules, capital requirements and prohibition.6 3 4 5 6

Some authors qualify living wills as a disclosure requirement (Packin, 2012, p. 7). Although living will is a broader term than recovery plan, we will use both terms, meaning the same. Does it stop ‘perverse’ incentives to gamble with other people’s money? (Roberts, 2010). See among others Haldane (2010) and Boot (2011).

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Bank Recovery Plans: Strengths and Weaknesses

Recovery plans must not be seen as the ultimate ‘panacea’ for preventing failure of financial institutions, but still they could make valuable contributions to it. In the next section (section 2) we will discuss business failure in other industries, as well as some turnaround perspectives. The central tenets of these perspectives show findings that could be taken into account regarding recovery plans of financial institutions: usually there are early warning signs of imminent financial distress. Following that, we will focus on the peculiarities of banks (section 3). What are specific characteristics of the banking industry? Do they complicate turnaround (recovery) plans? The answer is: yes they do. And the key word is: complexity. This complicates and undermines recovery. It is difficult to cope with that, but it seems that transparency, simplicity and modularity are important criteria for recovery plans. In section 4 relevant aspects of the new regulations are summarized. What are the considerations, causes and purposes of recovery plans? This section focuses primarily on the new directive of the European Commission (EC). In section 5 our perspective changes to more practical implications, criteria, elements, strengths and weaknesses of recovery plans. In section 6 some conclusions are drawn.

2

Early warning and recovery plans in other industries

As recovery planning in the bank industry is a relatively new concept, we first look at concepts that are associated with it. Are insights from failure and turnaround literature fruitful for bank recovery plan discussions, and can these understandings perhaps help us find clues? To start with, failure and turnaround literature is fragmented and a general (grounded) theory on turnaround planning does not exist.7 However it can be safely stated that most failure processes contain comparable stages. Yet the severity and speed with which the stages follow up, and the sequence of events differ per company, as well as specific failure factors and related failure paths. Turnaround occurs via input (identifying crisis, early warning) processes (stages) and output (content of the plan). This section contains a short overview of some relevant research in the turnaround field, which, in our opinion, is interesting to keep in mind while studying the concept of bank recovery plans.

7

For an overview of failure and turnaround literature, see among others Crutzen & Van Caillie (2008).

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2.1

Recovery plans: early warning

Financial distress and crisis never occur suddenly. In a 2005 Roland Berger Restructuring Study,8 based on 2,600 interviews with management board members and directors of large European companies who experienced a recent company crisis, the following two main conclusions could be drawn: 1. On average, the crisis reaction time of management board members and directors is 16 months. 2. 29% of companies react to what is called a strategic crisis (e.g. shrinking markets, increased competition, end-of-life-cycle of products, change in customer behaviour patterns); 54% of companies start restructuring only while in an earnings (profit) crisis (they surpass a strategic crisis probably not knowing they are experiencing such a crisis); 17% of companies (even) wait until they enter a liquidity (cash) crisis. Obviously, the longer company management waits, the more severe a crisis is and the more difficult it is to recover from a crisis, let alone to avoid bankruptcy (in the context of this paper: avoiding a ‘resolution plan’ to be implemented). This fact is visualized in Figure 1. Figure 1 Downward spiral of companies in financial distress On average European companies start restructuring 16 month too late Healthy company Strategic crisis 29%

Earnings crisis 54% Liquidity crisis 17%

Governance crisis Cause Early recovery plan needed in order to increase survival chances

8

See Blatz et al. (2006).

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Bankruptcy

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Bank Recovery Plans: Strengths and Weaknesses

With regard to early warning the following can be concluded from the same restructuring study: – Directors in the research sample acknowledge utilization of tools for ‘early detection’ of crisis symptoms to be crucial; this includes, for example, management information systems, rolling liquidity outlooks, regular review meetings, risk management systems, and, increasingly, the application of balanced score cards. – However, the research also showed that such control and early warning systems had so far been inadequately implemented; although 96% of the interviewees emphasize the importance of monthly management information systems related to early crisis detection, only 57% actually used one. – Overall, 38% of businesses in the research possessed a completely implemented management information system; and only 30% of the companies that faced a liquidity crisis used rolling liquidity forecasts. This means that the majority of companies in crisis (according to the research) remain virtually blind in terms of their future development, even when already in trouble. So, in general, it can be concluded that company directors have the tendency to start restructuring (‘recovery planning’) too late, and that they have the tendency to ignore early warning signs. In turnaround practice this phenomenon is often called: Boiling Frog Syndrome.9 Jumping to banks: a recovery plan to be drawn up beforehand could serve to prevent this so-called crisis denial stage. It could make a ‘Boiling Banker Frog’ jump in time. Still, an essential question is, what triggers the (soon to be boiled) banker frog to jump and where to? This brings us to the practice of recovery planning and execution: the turnaround process.

2.2

Recovery plans: turnaround process

A turnaround process can be seen as a reorganization route that takes place outside the statutory framework with the objective of restoring the long-term viability of a company in financial difficulties within the same legal entity. In this recovery route, a plan to reorganize the business should be drawn up to reach the objective that has been set. This will ideally consist of two processes:10 – business restructuring; – financial restructuring.

9

The boiling frog story is a widespread anecdote describing a frog slowly being boiled alive. The premise is that if a frog is placed in boiling water, it will jump out, but if it is placed in cold water that is slowly heated, it will not perceive the danger and will be cooked to death (Wikipedia, accessed 2 May 2013). 10 See among others Slatter & Lovett (1999), Adriaanse (2005) and Kazozcu (2011).

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The underlying idea is that it is impossible and undesirable to carry through financial restructuring without restructuring the business operations (which usually have led to the deteriorated financial situation within the company). Solving problems should also involve removing the causes thereof. The nature of the problems – as well as the moment action is taken in the organization – will be a decisive factor for the planned measures. Particularly important questions when restructuring business operations are the following: what concrete strategic, operational and financial plans have been made to become a viable company again; and what are the plans for the actual implementation thereof? Although the turnaround recovery plan forms a basis for a successful rationalization of the company, a big degree of financial restructuring will also often be necessary. The losses from the past have, in most cases, disturbed the balance sheet ratios to such an extent that the obligations towards the assets are excessive. A business turnaround plan has to address both kinds of restructuring. Financial restructuring alone is usually not enough. Whether this insight is relevant for bank recovery plans depends on the characteristics of banks (see section 3). For now, we move on to the (recommended) content of turnaround plans in other industries.

2.3

Recovery plans: content

Although turnaround management literature is fragmented, there is some common agreement on what turnaround (recovery) plans should look like. A turnaround plan could be described as follows:11 An integrated business plan for a company in financial difficulties that serves as a basis for a rescue operation aiming to restore the long-term viability. The plan consists of a description of the current situation as well as a detailed plan of attack – including time scheme and prognostications – with regard to operational and financial measures to be taken, on the basis of an in-depth analysis and review of the current vision and strategy. It is a written plan and as a result thereof serves as an important means in the communication and negotiating process with external stakeholders, especially financiers. Still, in turnaround practice insufficient attention is often paid to performing and writing down diagnostic analysis in a holistic turnaround plan, with all kinds of bottlenecks as a result. Additionally, turnaround failure factors and (as a result) bankruptcies can often be traced back to lack of turnaround planning. Yet by thinking of the possibilities for a turnaround in a structured manner and by writing turnaround plans, very powerful means 11 Part of this section was (partly) published by Adriaanse (2005) and Adriaanse & Lispet (2007).

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Bank Recovery Plans: Strengths and Weaknesses

are created to attack and solve problems in a systematic and methodical way, which, as a result, create a sound basis for restoration of confidence of stakeholders instead of further deteriorating their trust.12 According to Slatter & Lovett, a turnaround plan for a (non-banking) company ideally consists of 10 elements (Table 1).13 Table 1 Business turnaround plan 1

An executive summary

2

History of the business

3

An analysis of the external environment

4

A detailed description of the business’s turnaround strategies

5

A description of the business’s desired end-state (vision)

6

Operational analysis

7

Operational action plans

8

Financial projections

9

Implementation process

10

Risk assessment

The idea behind this business turnaround plan is based on general success factors of turnarounds, as well as frequently found causes of decline and early warning signals, to be summarized as: – lack of clear vision; – not enough steering on financial information; – reorganization measures not being harsh enough; – lacking attention to market developments (trends, competitive forces, threats); – unsatisfactory supply of information to external stakeholders; and – inadequate preciseness with regard to operational goals to be achieved. Hence, these elements should serve as a reference guide for company management and its stakeholders in times of financial distress, but they can also function as reference points to prevent a crisis from happening. The elements can make ‘the frog jump before the water starts boiling’. A (sound) turnaround plan thus assists company managements in crisis prevention as it embodies the following characteristics/functions:

12 Again, an ex-ante recovery plan could be useful in this respect because there is no time pressure, so it can be drawn up iterative in an orderly and systematic way. 13 See Slatter & Lovett (1999, Chapter 9: Developing the Business Plan).

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1. 2. 3. 4.

Focus – it gives a clear and integrative picture of what should be done. Compass – it avoids losing track of needed actions to be taken. Performance measurement – it provides quantitative and qualitative goals. Conviction and giving account – it helps in negotiations with financiers and other stakeholders.

As for banks, the business turnaround elements could serve as a benchmark for living wills. But the big question still remains: Is it possible to predict the causes and consequences of a (looming) banking crisis (in time)? Compared with a regular turnaround plan, the strength of a recovery plan is probably the orderly, structured and iterative manner in which it was developed (due to the relative peace in which such a plan can be written), but its weakness is that it is almost certainly not applicable ‘just like that’ because of the idiosyncrasies of a banking crisis: it is written for the ‘known unknowns’ but also for the ‘unknown unknowns’. The ex-ante function of a recovery plan thus seems more important than its ex-post function.

3

Characteristics of banks and the banking industry

A business is an entity that transforms input into output. It consists of different stakeholders being a ‘contractual nexus’. Cooperation between the stakeholders continues if the business adds value. The business is then able to compensate all the stakeholders for their contributions. A business adds value through transformations; however, this is only possible when a business fulfils societal needs. It can then appropriate customer value by charging a higher price than the costs it should make. This is called the ‘business model’: the design or architecture of the value creation, delivery, and capture mechanisms employed by the business enterprise (Teece, 2010). Yet building a business model is not enough. It is, as such, insufficient to assure long-term competitive advantage. A business strategy is therefore needed making a business able to adapt, position and defend its market position by taking into account changes in (e.g.) consumer trends and behaviour of competitors. In order to be able to successfully change a business model ‘core competencies’ but also ‘economies of scale and scope’ play a role. Is a bank in that way different from other businesses? No, it is not. After all, the primary function of a bank is transforming money or capital. Banks bridge the gap (‘fulfil needs’) between lenders and borrowers; they act as financial intermediaries.14 A bank transforms 14 This classic function description of banks stems from: Diamond (1984); see for alternatives Llewellyn (1999, pp. 16-19).

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deposits size, maturity and risk. This is the classic function of a (consumer) bank. A bank not only transforms but also increases liquidity and mitigates problems of moral hazard and adverse selection. Banks can reduce transaction, information and search costs of lenders and borrowers; by pooling these information related activities, economies of scale (and scope) can be realized. Informational advantages (which are related to market imperfections) are one of the most fundamental or ‘core competencies’ of banks.15 According to Llewellyn (1999, p. 12): ‘[…] Bank loans are in truth a bundled collection of processes, they may supply these component services without holding the ultimate asset on the balance sheet […].’ A bank is indeed a supplier of financial services. The banking industry is a dynamic, competitive, concentrated, innovative and complex industry that has shown lots of changes during the last decennium. Competition has intensified due to deregulation, financial innovation, lower entry barriers, alternative suppliers, changing consumer trends and changes in technology (that enabled deconstruction of the ‘bank services value chain’).16 Built-up competitive advantages of banks (steadily) declined, which led to responses in diverse ways. Banks diversified, adapted their business models and showed growth in such a way that overall diversity and modularity decreased. One of the aspects was the fundamental change in business models. Most banks diversified, which led to the disappearance of (genuine) differences between banks. In other words, through diversification, convergence of business models has occurred. Nevertheless, today three different (dominant) business models can still be identified: retail banks, investment banks and wholesale banks, all embedding different implications regarding risk characteristics, systemic stability, performance, efficiency and governance issues (Ayadi et al., 2011). Banks are not equal despite the diversification trend that has taken place. Did side or external effects occur because of these individual bank policies (that can be labeled as financialization)?17 Banks gradually transformed from ‘relational banking’ (the classic function) to ‘transactional banking’. The consequence was that due to securitization opportunities and marketability, banks and markets became increasingly (and more than ever) integrated.18 Securitization opened up the bank balance sheet, and a related effect became the volatility of asset value due to mark-to-market accounting. Lots of bank assets nowadays have to be valued at their current (market) values instead of their historic costs. As a result, banks are more exposed to changes in market values than ever before. This

15 Llewellyn (1999, p. 59) also mentions other core competencies. 16 See for other pressures on the banking industry (Llewellyn, 1999, pp. 25-40). 17 Ayadi et al. (2011, p. 3) also mention the manifestation of this phenomenon in numerous dimensions, i.e., a sharp rise in the assets of the banking system relative to GDP. 18 ‘So, in a modern market based financial system, banking and capital market conditions should not be viewed in isolation’ (Sing in Boot, 2011, p. 168).

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exposure shows up on the balance sheets, but also in off-balance items (special investment vehicles, contracts) making them important financial but also strategic tools; banks have in part become (heavily debt financed) investment funds. ‘[…] When markets exist for all kinds of real or financial assets of the firm, a firm can more easily change the direction of its strategy […]’ (Boot, 2011, p. 168). During the last decade lots of financial innovations occurred. Successful (financial) innovations are usually perceived as ‘wealth increasing’ because financial innovations can make markets more complete and perfect. Innovations thus help improve the allocation of capital and increase welfare. But innovations can also spring from a ‘dark’ motivation: they can be used to fool market participants. Also, innovations sometimes open up (unintended) possibilities for opportunistic and herd behavior. The key word then seems to be: complexity. This kind of density makes companies (in general) less transparent and less easy to monitor. Increased marketability (securitization) in fact has two effects for recovery plans. First of all, it creates flexibility as (in liquid markets) assets can easily be sold, so that elements (business segments, modules) can be removed (yet for this to take place interconnections with other parts of the bank should not to be too tight; also, in hard times it is most probably difficult to sell, so usually additional losses will appear). Secondly, markets that have been created by banks (e.g. the mortgage-backed securities market) can simply vanish19 so that business models as well as funding activities collapse at the same time. In other words, finance and strategy are integrated like a ‘bowl of spaghetti’; complexity and low transparency complicate monitoring, compliance, governance and supervision, and with that, it complicates the sought-after effectiveness of recovery plans. Complexity20 – due to increased marketability, changeability, globalization, deregulation, conglomeration, consolidation, and technology – seems to be an endogenous development in the bank industry. The question is whether market forces and market discipline and/or recovery plans can control this trend (see also Boot, 2011).

19 It is easier to sell in good than in bad times. Besides that, a company in financial difficulty can easier sell well-performing instead of poor-performing parts of the company. 20 Why are banks so complex at all? It might very well be regulation induced (Boot, 2011, p. 178). Banks are able to create additional subsidiaries to exploit tax loopholes and regulatory arbitrage. They can also use SPVs to ring-fence risk (Avgouleas et al., 2010, p. 3; Packin, 2012, p. 10). Besides legal perspectives, banks can use intra-group transactions and operational platforms. So legal and operational purposes are (also) mixed like spaghetti. For example, City Group once operated its business through 2,435 different legal entities. Lehman Brothers, the bankrupt US-based financial services company, existed in over 7,000 legal entities in more than 40 different jurisdictions around the world. Lehman’s bankruptcy resulted in more than 75 separate bankruptcy proceedings (Packin, 2012, pp. 10, 51).

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Bank Recovery Plans: Strengths and Weaknesses

Besides complexity, banks are also connected (and concentrated) in myriad ways. Haldane (2009) shows that connections became more intense during the last decennium; bank balance sheets show not only the concentration of assets and liabilities (and the exposures) but also the connection with other financial institutions (Haldane & May, 2011).21 This also complicates the sought-after function of recovery plans. Finally with regard to this section, when comparing banks with companies in other industries, it should be noticed that banks’ strategies, operations, business models and finance functions – which are more or less ‘modular systems’ in companies in other industries – are in fact integrated as a whole (actually, a bank itself is a bowl of spaghetti). When a bank sells part of its portfolio or divisions, it fundamentally changes as a whole at the same time – this is a further complication for bank recovery plans. The mixed and integrated aspect of banking systems increases supervising, monitoring and restructuring complexity where speed and holistic turnaround action are of utmost importance. This puts even more pressure on banks (as compared with other companies) with regard to picking up early warning signs and the start of ‘turnaround action’ (recovery) at the earliest occasion possible. The earlier banks start restructuring, the less complex recovery measures to be taken will be. In reverse, the longer banks wait, the more difficult it is to separate loss-making activities from profitable ones – which are then already ‘infected’ due to internal (spaghetti) complexity – decreasing survival chances of banks enormously.

4

EU Directive on the Recovery and Resolution of Credit Institutions and Investment Firms

The recent rapidly evolving global financial crisis, which started in August 2007, stressed the need to address shortfalls of frameworks and tools dealing with (potential) insolvencies of financial institutions. Due to fact that many financial institutions operate on an increasing global scale, it has become more difficult to secure the continuity of essential functions, and to ensure that shareholders and creditors are able ‘to [self-reliantly] bear the financial burden when such businesses are confronted with financial distress or even insolvency’.22 The impact of the global financial crisis has led to calls by, among others, the G20 to stress the need to strengthen cooperation on crisis prevention, crisis management and resolution, and, furthermore, to review resolution regimes and insolvency laws in light of recent 21 Still, lots of activities do not show up on balance sheets due to the use of off-balance financing tools. 22 See UNCITRAL Working Group V (Insolvency Law), Note by the Secretariat on Insolvency of Large and Complex Financial Institutions (A/CN.9/WG.V/WP.109), September 2012, p. 3.

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experience ‘to ensure orderly resolution of large, complex, cross-border financial institutions’.23 These calls are based upon considerations that an effective resolution framework for financial institutions is perceived to be essential to secure financial stability as well as to limit moral hazard, and that such a resolution framework is deemed ineffective unless a robust cross-border coordination mechanism is incorporated.24 The need for a properly functioning resolution framework for financial institutions within the European Union (EU) became (the more) clear as both financial institutions as well as authorities were ‘unprepared to address the issues which arose over the course of the financial crisis’.25 In other words, the financial crisis severely tested the ability to manage problems in financial institutions, and the entire system failed.26 In this light the EC set out plans for a framework for crisis management in the financial sector applicable within the EU. The EC aimed through such a framework to equip authorities with common and effective tools and powers to tackle crises within financial institutions pre-emptively, to be able to safeguard financial stability and to minimize taxpayer exposure to losses in the event of insolvency of financial institutions.27 The need for a framework within the EU in dealing with financial institutions in distress was furthermore embraced by the European Parliament (EP) in June 2010.28 In addition to the embracement by the EP the Council (ECOFIN) adopted similar conclusions calling for a framework for crisis prevention, management and resolution.29 The ECOFIN report is of particular interest as it notes three key elements that have formed the basis for the proposed EU Directive on the Recovery and Resolution of Credit Institutions and Investment Firms.30 These key elements are: 1. Preparatory and preventive measures – to minimize the risks of potential problems. 2. Early intervention – in order to intervene at an early stage to prevent insolvency.

23 See Declaration on Strengthening the Financial System (London Summit, April 2009); Leader’s Statement of the Pittsburgh Summit (October 2009). 24 See IMF Report on Resolution of Cross-border Banks – A Proposed Framework for Enhanced Coordination, June 2010, p. 5. 25 See UNCITRAL Working Group V (Insolvency Law), Note by the Secretariat on Insolvency of Large and Complex Financial Institutions (A/CN.9/WG.V/WP.109), September 2012, p. 13. 26 See Commission Document No. 280 of 2012 final, p. 2. In addition, due to the impact of the internal market, the financial markets within the EU have become so heavily integrated that domestic shocks in one Member State can easily lead to a domino effect towards other Member States. 27 See Commission Document No. 579 of 2010 final. 28 European Parliament A-series, Commission-report, fourth parliamentary term, No. 213 of 2010. 29 See European Council (ECOFIN): conclusions calling for a Union framework for crisis prevention, management and resolution, 17006/1/10, December 2010. 30 See Commission Document No. 280 of 2012 final.

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3. Resolution tools and powers – when insolvency of an institution presents a concern for the general public interest.31 In essence these three key elements constitute (at least that is what is intended) an effective framework for both recovery and, if needed, rescue (resolution) of financial institutions. The prescribed recovery plans for financial institutions, as laid down in Articles 5-8 of the proposed Directive, must therefore be seen within the context of the desire to tackle crises pre-emptively by incorporating preparatory steps and plans to minimize the risks of potential problems. It is thought that financial institutions, by undergoing the process of drawing up recovery plans, check their resilience, that is, the ability to handle ‘adverse economic developments’.32 Recovery plans for both the group and individual entities within the group, drawn up by a financial institution, must thus set out arrangements and measures that will enable an institution to undertake pre-emptive acts to restore its long-term viability in the event of a material deterioration of its financial situation. These pre-emptive actions, based upon the drawn up recovery plans, can prevent (at least that is what is intended) escalation of problems and reduce the risk of possible failure.33 The contents of recovery plans are listed in Section A of the Annex accompanying the proposed Directive.34 Among other things, information must be submitted within the recovery plan concerning: key elements of the plan, strategic analysis, a summary of the overall ability for recovery and how recovery planning is integrated into the corporate governance structure of an institution, as well as (for example) arrangements and measures to reduce risk and leverage, to restructure liabilities or business lines and to continue access to the financial markets. In addition, according to the Financial Stability Board (FSB), recovery plans must address the following three key elements: 1. Credible options – to cope with a range of scenarios, including both idiosyncratic and market-wide stress. 2. Scenarios – that address capital shortfalls and liquidity pressures.

31 Ibid., pp. 4-5. 32 See UNCITRAL Working Group V (Insolvency Law), Note by the Secretariat on Insolvency of Large and Complex Financial Institutions (A/CN.9/WG.V/WP.109), September 2012, p. 14. 33 See Commission Document No. 280 of 2012 final, p. 9. 34 Ibid., p. 148.

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3. Processes – to ensure timely implementation of recovery options in a range of stress situations.35 Recovery plans themselves are to form the basis of the ‘resolvability’ assessment by the designated resolution authorities as laid down in Article 6. Assessment of the drawn up recovery plans is based upon both the requirements laid down in Article 5 and the ‘likelihood’ that the implementation of drawn up measures within recovery plans ‘will restore the viability and financial soundness’ of the financial institution, and whether these measures can be implemented effectively in times of distress “without causing significant adverse effects” upon the financial system. To sum up, from a regulatory perspective, a recovery plan is (also) to be considered an exante approach towards tackling crises within financial institutions, making it possible (at least in theory) to address financial distress at the earliest opportunity possible, in the best possible way. As the famous expression says, prevention is better than cure. A recovery plan should make the banker frog able to jump while the water is still not too hot. The interesting question remains, of course: Will recovery plans really work in practice?

5

Recovery plans: triggers, concepts, criteria, strengths and weaknesses

Living wills, and in particular recovery plans, are relatively new concepts. A lot of NGOs currently disclose studies and views about what the concept entails, what is required and how to implement it. However, at this time the required content is still rather vague, as well as its trigger points.36 Bolzico et al. (2007) show, as visualized in Figure 2, different stages of the life of a bank: from licensing to normal operations to weaknesses to ending up as an unviable bank (this somehow resembles the crisis stages in other industries, as shown in section 2).

35 See FSB Consultative Document on Recovery and Resolution Planning: Making the Key Attributes Requirements Operational, November 2012, p. 7, as well as the FSB Report on Key Attributes of Effective Resolution Regimes for Financial Institutions, October 2011, p. 17. 36 So are the different names used: living wills, recovery and resolution plans, shelf bankruptcy plans, winddown plans, contingency plans, funeral plans (Feldman, 2010).

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Figure 2 Life cycle of banks

Point of no return

Private Solution (market-driven) Status

Measures

Licensing

Normal Operations

Some Weaknesses

Inviable Bank

Standard Supervision (Camels 1-3)

Intensive Supervision (Camels 4)

Resolution Process

• Prompt Corrective Actions

• Regularization • Resolution Plan

As stated before, in other industries crisis reaction time is often longer than it should be (16 months on average), and usually, restructuring starts in the so-called earnings crisis, and thus too late. In a living will, situation speed is absolutely vital (maybe even more than in other industries), so an essential element is the identification of (early warning) triggers. Such triggers should be closely related (at least in our opinion) to standard practices as risk management, stress testing and scenario planning. So living will planning should be an iterative process integrated in normal banking business processes, structures and systems. In this way it is different from the writing of turnaround plans in other industries, in which such plans (most of the time) are merely developed when it is identified that competitive positions have severely declined and/or losses are already made (earnings crisis). Still, as we mentioned earlier, although a recovery plan has been drawn up beforehand, the problem is whether it covers the unforeseen (aspects of a) crisis (the ‘unknown unknowns’). Nonetheless, it could (should) perfectly work as a first line defense, although we doubt it

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is useful as a second line of defense. The real strengths of recovery plans are thus to be found ex-ante.37,38 Looking at the stage of life of a bank, it is not clear when banks enter a ‘weaknesses’ stage (to be compared with ‘strategic crisis’ or ‘early earnings crisis’ in other industries; see section 2). It is simply not possible to make a sharp division between the different stages of decline. Usually, downward spirals remain unnoticed, at least at first, because they are not viewed as problematic, are not recognized, or are simply denied. Still, a too narrow focus on potential crisis could result in myopia, so a bank has to formulate a variety of triggers or (early) warning signals. With that, it is essential that these triggers contain book-values and market-values, as well as qualitative and quantitative measures (e.g. ratings downgrades, revenue reports, credit risk limits, equity ratios etc.).39 And as this is related to normal banking activities, a bank could use tools of regular SWOT-analysis (assessment of Strengths, Weaknesses, Opportunities and Threats, including risk management and stress testing). Triggers are (or should be) an extension of risk, scenarios and stress tests; credit, operational, capital and liquidity risks are thus a starting point for living wills (Packin, 2012, pp. 30-42). This brings us to an intriguing question. As SWOT-analysis, risk management and stress testing can already be performed without living will regulation, why don’t financial institutions at present execute such recovery planning? In other words, why is living will regulation even necessary? Probably because there is no (economic) incentive to do so and the costs of doing are probably (perceived) higher than the benefits it brings; living wills internalize the social costs (of systemic risk) of banking activities. Still, there are two major advantages (as compared with not doing so) to connecting recovery-planning activities to normal banking business operations: first, there are cost advantages to be obtained, and, second (when it is not an appendix but an integral part of

37 According to Packin, in essence living wills are a type of disclosure requirement (Packin, 2012, p. 7), and Huertas & Lastra state: ‘The information embedded in a living will provides a degree of certainty and predictability that addresses the information asymmetries that characterise the business of banking and finance and that are a source of its vulnerability’ (Huertas & Lastra, 2012, p. 25). 38 In this article we focus on recovery instead of resolution. Resolutions plans, however, can contain elements of recovery. There are six categories of resolution: bank closure and deposit pay-out, radical restructuring, purchase and assumption (P&A), mergers and acquisitions (M&A), bridge bank and open bank assistance. See for a review of resolution methods, among others, Bolzico et al. (2007). 39 The Financial Stability Board (2012) gives the following examples of quantitative triggers: ratings downgrades, revenue reports or P&L (or components of these) credit risk limits, equity ratios, per cent renewal of wholesale financing, withdrawal of deposits and other funding, increased collateral requirements, rise in public debt, GDP forecasts, three-month LIBOR and senior debt spreads. This publication also presents operational stress scenarios and identification possibilities of critical functions.

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a bank policy), the benefits could be higher. After all, living wills have the (ex-ante) potential to: – enhance risk management capacities; – improve risk mitigation; – help analyse and improve legal and operational structures; – identify needs to data and information which require improvements to the back-office infrastructure; and – increase market confidence.40 So again, although a recovery plan is ‘just’ a plan, it foremost has the potential to uncoverfrictions and restrictions in banking structures, processes and systems (Douglas et al., 2011, p. 2). Living will implementation may force financial institutions to: – improve their information technology infrastructure; – rationalize their corporate structure; – lead them to become less complex and more transparent; and to – (potentially) improve corporate governance structures (Fitzpatrick et al., 2011). These advantages/benefits can be obtained when recovery (living will) planning is successfully introduced and managed within individual banks, as well as in the banking industry as a whole. According to Douglas et al. (2011), there are six guiding principles to achieve that: (interpreted) 1. Living wills should be harmonized and coordinated across supervisors and jurisdictions. If there is no international cooperation, success and credibility of living wills will be very low. Banks have many cross-border activities and subsidiaries in many countries with differences in corporate law and insolvency legislation. Just as in international trade, countries want to protect their positions; but the collective result in this case is then negligible.41 2. Living wills should be risk-based and should fully consider the firm’s business model. Living wills should resemble the idiosyncratic characteristics of a specific financial institution, they should resemble the specifics of its business model and exposure (see section 3). When a bank has a high concentration of assets valued on a mark-to-market basis, as opposed to historic costs, this has implications for its living will. Understanding 40 Of course there are drawbacks too; see Douglas et al. (2011, p. 2). He mentions: managing the business for failure (taking into account that failure can demand all kinds of restrictions that prohibit prudent risk taking) increased stability (when domestic recovery and resolution occurs, immobile capital and liquidity reduces the options and flexibility needed to execute the recovery), creating a white elephant (additional costs for drawing up the plans plus the costs if living wills are inconsistent with optimal risk or information management and back-office procedures). 41 Avgoulas et al. (2010) propose a method of burden sharing to improve international cooperation.

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3.

4.

5.

6.

the source of (potential) financial distress is critical for proper recovery. The recovery plan should therefore be closely linked to an understanding of the specific vulnerabilities of a bank and to the analytical framework of other management tools and practices in place (such as risk management, stress testing, credit exposure analysis, contingency and scenario planning). Living wills should be closely integrated with other required regulatory processes and core risk management processes. If tailor-made, it should be possible to integrate a recovery plan into ‘normal banking business procedures’. The plan should build upon ongoing business and risk management procedures, should enhance the business, and cannot be in conflict with such procedures. In this way recovery planning becomes a normal (integrated) business activity. Recovery and resolution plans should be considered on a continuum with risk management and take into account the stages of a potential crisis. Recovery plan (re)writing should not be viewed as a separable activity but as part of a crisis management continuum that presents (on a regular basis) multiple risk scenarios, paths and options. Credible living wills require careful iteration. Just like normal business procedures and processes, living wills have to evolve through an iterative process. Living will planning should involve more than merely the preparation and filing of a document. Special attention is consequently needed for continuous upgrading of management data and information systems, and with that non-stop rewriting/updating of the plans. Living wills are not a panacea. Living wills are not magic bullets, nor are they likely to succeed when drawn and managed in isolation. Moreover, recovery planning is far removed from the (potential) actual sources of crisis. ‘[…] They cannot be expected to operate perfectly in the real world […]’ (Douglas et al., 2011, p. 5).

Living wills should include certain core elements such as critical counterparty and collateral information, triggers for activating recovery or resolution plans, and a menu of available actions related to capital (Fitzpatrick et al., 2011). A living will should thus consist of input, processes and output, or crisis triggers, information and (financial) options. The information needed in identifying and analysing the crisis, and in choosing and implementing the strategic/financial option is very diverse. Douglas et al. (2011, p. 16) distinguish two broad categories of information within living will plans: – Static information – which includes descriptions of the company’s business (e.g., major business lines and legal entities, mid- and back office functions, ownership

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Bank Recovery Plans: Strengths and Weaknesses

information, jurisdictional and supervisory information, and financial and operational interdependencies between affiliates). – Dynamic information – which includes information that changes in real time, such as exposures to major counterparties (and vice versa) intercompany lending between core and critical businesses, funding and liquidity, assets and liabilities, an unconsolidated balance sheet and a consolidating schedule, available lines of credit and current positions with exchanges, clearinghouses and custodians and other significant financial companies.42 Which brings us to the recommended core elements (‘templates’) for ‘credible’ living will plans (derived from Douglas et al., 2011; summed up in Table 2). Table 2 Core elements of recovery and resolution plans 1

Institution overview

2

Business strategy and risk management

3

Governance and oversight

4

Information and counterparty management and availability

5

Stress testing and scenario planning

6

Triggers and thresholds

7

Detailed recovery plan (Business actions, Contingent capital actions, Contingent liquidity actions & Other contingent actions)

8

Detailed resolution plan (Internal and external impediments to resolution, Applicability of different legal regimes & Cross-border resolution actions)

To conclude this section, the added value of recovery planning, based on the criteria, categories and elements as shown above, is that a financial institution continuously assesses its strengths and weaknesses in order to be able to pre-emptively intervene to restore shortand long-term viability in the event of a (looming) material deterioration. The assessment of strengths and weaknesses should be considered to be a non-stop process, which should not merely be incorporated in the corporate governance structure of a financial institution, as mentioned in point nine of Annex A of the proposed Directive. Moreover, by making the process of recovery planning part of risk assessment and compliance procedures, it will create further embracement of thinking in possible failures in day-to-day operations. In this way an effective tool is institutionalized that already tackles a crisis before it is a

42 See Packin (2012, pp. 11-14) for a more elaborate overview of types of information that have to be readily available, properly organized and updated.

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Tim Verdoes, Jan Adriaanse and Anthon Verweij

crisis. And with that, the risk of boiling a Banker Frog is further mitigated. But the question still remains: at what costs?

6

Conclusions […] Essentially, what society has to do is to decide what should be the level of risk to society at which it wishes the banking system to operate […]. (Huertas, 2010)

One of the tenets of turnaround management is that the right corrective measures can be implemented only when the root causes of decline have been identified and analysed. What are the main causes of a financial crisis, and will living wills really prevent banks from collapsing in such a situation? Time will tell. Winston Churchill once said: ‘[…] Now this is not the end. It is not even the beginning of the end. But it is, perhaps, the end of the beginning […].’ The EC directive on living wills can be seen as an end of the beginning, living wills have to evolve and should develop in practice. Guidelines have been formulated for successful implementation. The most essential one? Recovery plans should be integrated in normal business processes pertaining to strategic, financial, risk and information management. Expected costs of living wills will then be lower, and benefits will be higher as compared with isolated living wills. A system of analysis and benchmarking should be set up to come to best practices. Regulators, bankers and academics have to study how living wills fit in the cluster of all the (prevention) tools already available. Still, the ‘proof of the pudding is in the eating’. The best test is probably a new financial crisis of great magnitude. And although this may sound cynical, that will definitely prove whether Boiling Banker Frogs jump out of the water in time. Up till then, it is to be hoped that banks primarily use the concept of recovery planning for continuous learning and ex-ante turnaround management. If so, then that is already a jump forward.

Documents Communication on a New EU Framework for Crisis Management in the Financial Sector COM(2010) 579 final, European Commission (EC), October 2010. Conclusions Calling for a Union Framework for Crisis Prevention, Management and Resolution (17006/1/10), European Council (ECOFIN), December 2010.

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Declaration on Strengthening the Financial System, London Summit, Group of Twenty (G20), April 2009. Draft Regulatory Technical Standards on the Content of Recovery Plans Under the Draft Directive Establishing a Framework for the Recovery and Resolution of Credit Institutions and Investment Firms EBA/CP/2013/01, Consultation Paper, European Banking Authority (EBA), March 2013. Insolvency of Large and Complex Financial Institutions (A/CN.9/WG.V/WP.109), Note by the Secretariat, United Nations Commission on International Trade Law (UNCITRAL), September 2012. Key Attributes of Effective Resolution Regimes for Financial Institutions, Financial Stability Board (FSB), October 2011. Leader’s Statement, Pittsburg Summit, Group of Twenty (G20), October 2009. Proposal for a Directive of the European Parliament and of the Council Establishing a Framework for the Recovery and Resolution of Credit Institutions and Investment Firms COM(2012) 280 final, European Commission (EC), June 2012. Recommendations to the Commission on Cross-border Crisis Management in the Banking Sector (A7-0213/2010), Report, Committee on Economic and Monetary Affairs European Parliament (EP), June 2010. Recovery and Resolution of Financial Market Infrastructures, Consultative report, Committee on Payment and Settlement Systems, Board of the International Organization of Securities Commissions (IOSCO), July 2012. Recovery and Resolution Planning: Making the Key Attributes Requirements Operational, Consultative Document, Financial Stability Board (FSB), November 2012. Resolution of Cross-border Banks – A Proposed Framework for Enhanced Coordination, International Monetary Fund (IMF), June 2010.

Literature Adriaanse J.A.A., Restructuring in the Shadow of the Law, diss., Kluwer, Leiden, Deventer, 2005. Adriaanse J.A.A., L. Lispet, Entrepreneurship and Financial Distress; A Framework for Business Planning in a Turnaround Situation, conference proceedings, G-Forum, Aachen, 2007. Avgouleas E., C. Goodhart, D. Schoenmaker, Living wills as a catalyst for action, DSF Policy Paper, No.4, Duisenberg School of Finance, 2010. Ayadi R., E.W. Arbak, W.P. de Groen, Business Models in European Banking, a Preand Post Crisis Screening, Centre for European Policy Studies, Brussels, 2011.

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Blatz M., K.J. Kraus, S. Haghani, Corporate Restructuring. Finance in Times of Crisis, Springer, Berlin, 2006, 77-87. Bolzico J., Y. Mascaró, P. Granata, Practical Guidelines for Effective Bank Resolution, Policy Research Working Paper 4389, The World Bank, 2007. Boot A.W.A., ‘Banking at the Crossroads: How to Deal with Marketability and Complexity?’, Review of Development Finance, 2011, 167-183. Costner R.C., Living Will: a Flexible Final Rule, North Carolina Banking Institute, 2012, 133-160. Crutzen N., D. van Caillie, ‘The Business Failure Process: an Integrative Model of Literature’, Review of Business and Economics, 2008, 288-316. Diamond D.W., ‘Financial Intermediation and Delegated Monitoring’, Review of Economic Studies, 1984, 393-414. Douglas J.L. et al., Credible Living Wills: the First Generation, Davis Polk/McKinsey & Company, 2011. Feldman R., Forcing Financial Institution Change Through Credible Recovery/Resolution Plans, an Alternative to Plan-Now/Implement-Later Living Wills, Federal Reserve Bank of Minneapolis, 2010. Fitzpatrick T.J., M.B. Greenlee, J.B. Thomson, Resolving Large, Complex Financial Firms, Federal Reserve Bank of Cleveland, 2011. Haldane A.G., ‘Rethinking the Financial Network’, speech delivered at the Financial Student Association, Amsterdam, 2009. Haldane A.G., ‘Regulation or Prohibition: the $100 billion Question’, Comments given at the Institute of Regulation & Risk, Hong Kong, 2010. Haldane A.G., R. May, ‘Systemic Risk in Banking Ecosystems’, Nature, 2011, 351-355. Huertas T.F., ‘Living Wills: How Can the Concept Be Implemented?’, speech Wharton School of Management, University of Pennsylvania, Philadelphia, 2010. Huertas T.F., R.M. Lastra, Living Wills, Estabilidad Financiera, Banco de Espana, 2012. Kazozcu S.B., ‘Role of Strategic Flexibility in the Choice of Turnaround Strategies: a Resource Based Approach’, Procedia Social and Behavioral Sciences, 2011, 444-459. KPMG (The Netherlands), ‘Stapeling Regelgeving’ (‘Stacking Regulations’), September 2012. Landier A., K. Ueda, ‘The Economics of Bank Restructuring: Understanding the Options’, International Monetary Fund (IMF), 2009. Llewellyn D.T., The New Economics of Banking, société Universitaire Européenne de Recherches Financières, Amsterdam, 1999. Packin N.G., ‘The Case Against the Dodd-Frank Act’s Living Wills, Contingency Planning Following the Financial Crisis’, Preliminary draft, 9 Berkeley Business Law Review, 2012, 1.

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Roberts R., Gambling with Other People’s Money, How Perverted Incentives Caused the Financial Crisis, Mercatus Center, George Mason University, 2010. Slatter S., D. Lovett, Corporate Turnaround: Managing Companies in Distress, Penguin Books, London, 1999. Teece D.J., ‘Business Models, Business Strategy and Innovation’, Longe Range Planning, 2010, 172-194. Wallison P.J., ‘The Error at the Heart of the Dodd-Frank Act’, AEI Financial Services Outlook, 2011.

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3

Bank Failure and Pre-emptive Planning

Stephan Madaus*

1

Introduction

When companies fail, they enter bankruptcy proceedings to reorganize their finances and business or liquidate their assets. When banks had failed prior to 2009, they were supposed to undergo the same proceedings in most Member States. However, the financial crisis that followed the bankruptcy of Lehman Brothers Holdings Inc. proved that state leaders and government authorities were not willing to repeat a Lehman scenario by using insolvency proceedings to handle failing banks and other financial institutions in their respective states. Instead, they prevented troubled banks from failing by financing their reorganization or resolution with public funds (the ‘bail-out’ strategy). This experience has spurred special legislation on bank resolutions in some Member States (such as Germany or the United Kingdom), while in others there has been no comparable action. In 2012, the EU Commission proposed a Directive to ensure a minimum harmonization of bank resolution tools across the EU. This conference and this workshop, in particular, will assess the tools and mechanisms of the Directive proposal. This report will first outline the special needs of a bank resolution regime and where it differs from the principles of common insolvency proceedings (2). Following a close assessment of the proposed mechanism of pre-emptive planning, authorities’ intervention, and bank resolution tools (3), the report will briefly discuss recovery planning and early intervention by supervisors (4) in addition to the special needs of banking groups (5). It will then conclude with an evaluation of the proposed regime (6) and considerations concerning a model bank resolution (7).

2

The special purpose of a bank resolution regime

The reason for exempting banks from common insolvency law has become obvious within the past few years: they are ‘too big to fail’. Due to their size and interconnections with other banks, many financial institutions seem irreplaceable for governments and authorities.

*

Professor of Civil Law, Civil Procedure and Insolvency Law, University of Regensburg.

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2.1

‘Too big to fail’

A closer look at financial institutions reveals that it is not only size that matters; it is the banking sector and its special role in our economy that calls for a special regime because financial services are vital for any economic activity.1 We need banks to collect and manage funds (deposits and savings) and provide loans, manage payment transactions and assist the issuance of securities. At the same time, the banking sector is particularly vulnerable in times of crisis as it is based on the trust of stakeholders. If depositors lose trust in a bank and withdraw their funds, bank failure and insolvency is inevitable. This again may lead to a loss of confidence in other and possibly all financial institutions, which can cause a bank run of depositors as well as a credit freeze between banks. In such a scenario, credit supplies to businesses and individuals also freeze and hit the real world economy. These fatal domino effects were on display in 2007-2009 as the U.S. housing market collapsed and a worldwide banking crisis subsequently spread.2 In the EU, a number of large banks needed help in the United Kingdom3 while virtually all major banks in Belgium4 and Ireland5 were failing. It led authorities to believe that troubled financial institutions were too important to be left without government-funded rescue or resolutions. Even if they were not too big to fail, every bank seemed too interconnected to fail.6 If we assume that most banks in the EU are potentially too interconnected to fail, the common sense response would be to prevent them from failing. The current EU financial stability framework is addressing this task by ensuring that banks are adequately capitalised and supervised. The Capital Requirements Directive (CRD) provides for an 8% minimum

1 2

3

4

5

6

See M. Schilling, ‘Bank Resolution Regimes in Europe I – Recovery and Resolution Planning, Early Intervention’, 25 August 2012, available at SSRN: , at 4 (with further references). For an analysis of this crisis see D. Furceri & A. Mourougane, ‘Financial Crises: Past Lessons and Policy Implications’, OECD Economics Department Working Paper No. 668 (2009), available at:

(last visited 8 April 2013). For a closer examination of 12 banking crises that occurred in developed countries between the 1970s and 1990s see E. Connolly, ‘Banking Crises and Economic Activity: Observations from Past Crises in Developed Countries’, 28 Economic Papers (2009), pp. 206-216. For the failure of Northern Rock see F. Bruni & D. Llewellyn (eds.), The Failure of Northern Rock: a Multidimensional Case Study, SUERF – The European Money and Finance Forum (2009), available at: (last visited 8 April 2013). For the rescue of Bradford & Bingley see (last visited 8 April 2013). See the report from the National Bank of Belgium (June 2012), at 14-16, available at: (last visited 8 April 2013). See K. Regling & M. Watson, ‘A Preliminary Report on the Sources of Ireland’s Banking Crisis’, available at: (last visited 8 April 2013). See Schilling (2012), at 6.

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capital threshold. The Basel III accord will further increase these requirements by forcing banks to hold more and better quality capital to achieve a higher ability to absorb losses without failing. A new European System of Financial Supervision (ESFS) was established in 2010 and led to the creation of new European Supervisory Authorities (ESAs): – a European Systemic Risk Board (ESRB) under the responsibility of the European Central Bank;7 – the European Banking Authority (EBA);8 – the European Insurance and Occupational Pensions Authority;9 – European Securities and Markets Authority.10 Their supervision is intended to contribute to the prevention and mitigation of systemic risks to financial stability. In contrast, a bank resolution regime does not aim to prevent failure. Instead, its objective is to reduce the impact of failure.11 As capital buffers and government supervision may prevent certain troubles in a robust market, they can be ineffective, as was proven during the recent crisis. Major bank failures in Belgium, Greece, Portugal, the United Kingdom and recently Cyprus illustrate that bank resolution regimes are required to supplement the legal framework of the banking industry. Although it may not be its main purpose, an efficient bank resolution regime contributes to the prevention of bank failure by reducing a moral hazard as this may keep a bank’s management and executives from engaging in excessive risk in cases where they can no longer count on the government to use public funds to offset bad speculation. Under an efficient bank resolution regime, a failing bank would be subject to a resolution process, and its management and owners would have to face the consequences and suffer losses for taking disproportionate risks. 2.1.1 Special requirements in a bank failure scenario Bank failures present particular challenges to the legal system. First, with regard to the special role of banks in our economy, even a failing bank must continue the services that are essential for maintaining financial stability: – payment service; 7 8 9 10 11

Established by Regulation (EU) No. 1092/2010. Established by Regulation (EU) No. 1093/2010. Established by Regulation (EU) No. 1094/2010. Established by Regulation (EU) No. 1095/2010. Impact Assessment, SWD(2012) 166 final, at 17. The same purpose is served by Deposit Guarantee Schemes.

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– loan service; – preservation of and access to (insured) deposits. Secondly, depositors, financial markets and the general public expect quick decision making concerning the future of a failing bank with systemic relevance, preferably within days or a weekend, as certainty is essential to calm stakeholders and ensure stability. Thirdly, losses resulting from bank failure must be allocated to those responsible: bank management/executives, bank owners and bondholders. Special proceedings, in recognition of systemic risks involved in the banking sector, should also be financed by their respective industry, not taxpayers’ money. Finally and perhaps most importantly, it is essential to have predictable decisions and solutions in a marketplace as volatile as our modern financial system, something especially true in times of crisis and bank failure. Therefore, decisions about the future of a bank’s failing business must not only be made quickly, but their outcomes must not come as a surprise. At the same time, fearful state leaders and authorities will find the courage to actually waive a ‘bail-out’ option in favour of a bank resolution without taxpayers’ money, only if they know the resulting course of action and feel confident to take that road. 2.1.2 The shortcomings of insolvency proceedings in bank failure Insolvency proceedings face difficulties when confronted with the special needs of a bank failure, with the Lehman case providing an impressive example. a. First, the urge for a quick decision on a bank’s future is difficult to achieve under insolvency law. As in the Lehman case, courts are likely to be confronted with a request for the sale of virtually all viable assets of a failing bank within the first (two)12 days. Such a request is underscored by the fact that the value of assets may decrease drastically within days if uncertainty continues and a bank’s failure is to spur a financial crisis.13 Accordingly, an orderly reorganization under insolvency law would be rendered impossible owing to the time required for such proceedings, as a bank would be ask to set up a rescue plan and solicit its acceptance. Even an alternative request for a sale of the debtors’ valuable assets within the first days would stretch the limits of insolvency law in many jurisdictions. Under German insolvency law, for instance, such sales require the prior opening of insolvency proceedings by the court and the approval of 12 The Sale Motion of Lehman Brothers Holdings Inc., dated 17 September 2008, (Docket No. 60) was filed only two days after the commencement of the case. 13 See the Sale Motion of Lehman Brothers Holdings Inc., dated 17 September 2008, (Docket No. 60) at 4, available at: (last visited 8 April 2013).

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the sale by the creditors’ committee that had to be constituted and summoned beforehand. In the Lehman case, Judge Peck was able to authorize the sales proceedings only by stretching the limits of the powers of the court under the Bankruptcy Code (11 U.S.C. § 363) to allow for a sale of the debtors’ estate14 despite the fact that it would predetermine any later plan solution and impair opportunities to object. He justified his approval with the ‘exigent circumstances’ of the case and found that ‘the Debtors’ estates will suffer immediate and irreparable harm if the relief requested in the Motion is not granted on an expedited basis’.15 In every jurisdiction, such sales demand the impairment of procedural rights of creditors to approve or at least object to the sale after a reasonable time to prepare. b. Secondly, insolvency law insufficiently reflects the importance of the need for financial stability. The purpose of insolvency law has always been the orderly liquidation of the insufficient estate of a failing debtor and the equal distribution of the respective proceeds among all creditors. Insolvency proceedings aim to maximize creditors’ payoff while respecting the hierarchy of non-bankruptcy entitlements. Both fundamental aspects of insolvency law do not fit the needs of a bank resolution regime where the idea of equal treatment of creditors is dominated by the need to favour some (unsecured) creditors (depositors) in order to prevent a ‘bank run’. And the purpose of maximizing creditors’ payoff is set aside by the macroeconomic need to maintain financial stability and prevent a contagion of mistrust and ‘domino effects’. Regarding commercial banks in particular, a bank resolution regime must provide for continuing essential services while managing the dissolution of the bank. In insolvency proceedings aiming at the dissolution of the debtor, the costly continuation of parts of the debtors’ business cannot be guaranteed as this decreases creditors’ payoff. c. Thirdly, insolvency proceedings typically put all asset distribution options on the table initially, and then creditors or administrators decide how to reallocate the debtors’ assets. It is only in the special case of a pre-packaged bankruptcy that proceedings start with a proposed plan solution and allow for a short and predictable bankruptcy (‘expedited proceedings’)16. In the case of a bank failure, the need for a predictable structure to crisis management only allows for pre-packaged cases.17

14 Following In re Lionel Corp., 722 F.2d 1063, 1069-1071 (2d Cir. 1983), a good business reason is required for authorizing the sale in most judicial circuits while some circuits still deny the approval of sales that comprise a ‘sub rosa plan’ – see In re Braniff Airways, Inc., 700 F.2d 935, 940 (5th Cir. 1983); In re Continental Air Lines, Inc., 780 F.2d 1223, 1226 (5th Cir. 1986). 15 See the Sale Order, dated 20 September 2008, (Docket No. 258) at 3-4, available at (last visited 8 April 2013). 16 See UNCITRAL Legislative Guide on Insolvency Law, 2005, at 238-247. 17 The case of Bradford & Bingley, a UK bank that failed in September 2008 and went through a pre-pack sale, is a good example.

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d. To sum up, bank failures call for pre-packaged proceedings that allow for quick decisionmaking and focus on the overall goal to maintain financial stability. Common insolvency proceedings could be adapted to be adequately equipped for handling bank failures; the Lehman case serves as an example for this. On the other hand, the special circumstances of such cases make a compelling argument for creating a special bank resolution regime.

3

The proposed EU bank resolution mechanism

On 6 June 2012, the EU Commission published its ‘Proposal for a Directive of the European Parliament and of the Council establishing a framework for the recovery and resolution of credit institutions and investment firms’ (Bank Recovery and Resolution Directive; hereinafter RRD).18 The framework is intended to ‘equip the relevant authorities with common and effective tools and powers to address banking crises pre-emptively, safeguarding financial stability and minimising taxpayers’ exposure to losses.’19

3.1

The scope: financial institutions

The scope of the proposal is identical to that of the CRD as it addresses the same problem: systemic risks incurred in bank failures. Therefore, its resolution regime should not only apply to credit institutions but also to investment firms, financial holding companies, mixed financial holding companies and mixed-activity holding companies20 because the recent crisis has demonstrated that ‘the insolvency of an entity affiliated to a group can rapidly impact the solvency of the whole group and, thus, even have its own systemic implications.’21 Such an expanded scope provides authorities with broad competence to respond to systemic risks from actual or pending failures of relevant participants in the financial market.

3.2

The decision: made by resolution authorities

The proposal does not favour a bank resolution mechanism similar to insolvency proceedings. Instead it prefers prospective decisions on resolution tools and powers to be made by special ‘resolution authorities’ in each Member State, which will accordingly be required

18 19 20 21

COM(2012) 280 final. Id., at 4. See Article 1 (a)-(e) RRD. See Recital 8 of the proposed directive.

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to cooperate with the authorities for supervision22 and consult with the competent ministry in the same Member State (Article 3). The reason for administrative decision-making rather than a court ruling or a courtsupervised decision-making by the parties involved (creditors, shareholders), as can be seen in regular insolvency proceedings or in the German bank resolution law (Restrukturierungsgesetz), is ‘to ensure the required speed of action, to guarantee independence from economic actors and to avoid conflicts of interest’.23 3.2.1 Reasons for a ‘dictated’ resolution plan The proposed allocation of powers with the authorities seems convincing. First, the decision-making by the parties involved is based on the fact that insolvency proceedings are only conducted to ensure a maximized and equal creditors payoff. This purpose is reflected in the creditors’ right to decide about the way to use and distribute debtors’ assets in a liquidation scenario. In contrast, a bank resolution regime does not pursue the common interests of creditors but instead macroeconomic interests for financial stability. It is therefore justified to allocate the decision-making on a bank’s future to government authorities instead of a bank’s creditors (or shareholders). Secondly, the decision of a group of people like creditors or shareholders requires voting on a proposed measure. Such voting takes time, the one factor that cannot be wasted in the instance of a banking failure. In contrast, decisions by a single person or authority can be arrived at within hours, thus making such agents more appropriate for a bank resolution regime. Thirdly, the allocation of decision-making with special government authorities instead of a judge promises more certainty that the expertise required to decide complex and sensitive issues like the resolution of a financial institution in the environment of a looming financial crisis is at hand. A special authority would establish expertise, resources and operational capacity in this very narrow field of the financial industry in a manner that no court could. It needs to be stated, however, that courts are very well able to handle cases with major implications for transnational policy or the economy (as was especially demonstrated by Judge Peck in his handling of the Lehman case). The tipping point in favour of an administrative decision against a judge’s may be seen in the need for cooperation with other

22 There needs to be a strict separation between resolution and supervision authorities as there is a clear potential for a conflict of interest; see Schilling (2012), at 14-16. 23 Recital 11 of the proposed directive.

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government agencies (supervising authorities, ministries, state leaders, government authorities in other Member States) when preparing resolution decisions. Governing banks and (international) groups of financial institutions do not appear to be a judicial task but one of administrative nature, and joint decisions taken by several agencies are less irritating to the legal system than joint decisions reached by several courts regarding the very same case. 3.2.2 The indispensable involvement of courts Court proceedings on disputed resolution measures remain necessary in order to guarantee fundamental rights and due process. Whenever a resolution authority applies its resolution tools against a financial institution, it might impair the property rights of creditors and shareholders as well as the right of shareholders to approve structural changes to their corporation, especially changes to their capital structure as they dilute the value of their shares. These rights are guaranteed by the European Convention of Human Rights and the constitutions of individual Member States, so access to justice is required when government authorities affect these legal entitlements. Here, courts need to decide whether the resolution actions in question observe the legal boundaries set by legislation. In addition, the measures need to be adequate and proportionate to maintain financial stability. These legal requirements lead to safeguards in order to protect stakeholders from infringements of their fundamental rights: – Shareholders must principally decide about the way their corporation (e.g. bank, credit institution) does business, and creditors decide on the execution of their rights without government intervention until their actions could create a situation in which the failure of the financial institution involved is imminent, no private sector solution is viable, and such failure may present an immediate threat to the stability of the financial system that requires government intervention. These preconditions for resolution actions are reflected in Article 27 (1) RRD. – The property rights of creditors and shareholders guarantee that they receive at least the amount payable in an alternative orderly liquidation of the bank’s assets under insolvency proceedings. The required valuation would reflect a piecemeal liquidation unless a sale of the bank’s business or parts of it is possible. These principles are reflected by the ‘best interest of all creditors test’ in the law of insolvency reorganization, and they should be applied here. The proposal takes account of these principles in safeguards provided by Articles 29 (1) (f) and 65 (1) (a) RRD. They do not, however, require a preliminary valuation as it is proposed in Article 30 RRD. Such a preterm valuation at the very moment of crisis would not be able to reflect a value and would thereby cause unnecessary delay. Instead, the authorities must act as soon as possible, and the question of the compensation of shareholders and creditors due to the impairment of their rights

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by authorities’ resolution actions should be discussed (in court) at a later stage, so valuation (if at all necessary)24 may be postponed to that later day, too. – The right to a judicial review must be effective25 and therefore principally includes the right to stay the execution of the act in question pending appeal as well as the right to revoke illegal excessive acts. However, the right to an effective remedy is not absolute. It may be limited by law if such limitation serves a legitimate purpose and observes the demands of proportionality.26 At the same time, it is owing to the particular nature of property rights that every person may be deprived of their possessions in the public interest and subject to the conditions provided for by law.27 After all, property rights do not guarantee the indefeasible possession of particular assets but only their liquidation value. Overall, the Rule of Law allows for a limited effect of the full judicial review as well as the impairment of property rights with regard to the overwhelming importance of financial stability to the wealth of nations as a public interest. As time is of the essence in a bank resolution, a judicial review in the interest of an individual or a small group of individuals should not interfere with the immediate implementation of resolution acts to stabilise the financial system. A bank resolution regime may therefore waive a stay pending appeal as well as a cassation of an excessive act and instead reduce the effects of judicial reviews to a full assessment of legality and, in case of an act ultra vires, a declaration of its illegality with damages awarded to the appellant. These opportunities provide the background for the rules on judicial review in Article 78 (2) RRD. Allocating the decision on resolution acts to government authorities interferes with shareholders’ rights to decide on the capital structure of their public limited liability company provided by the Second Company Law Directive28 if a resolution arranges for a reorganization opposed to the dissolution of a company. If a resolution plan provides for a financial restructuring by a debt-to-equity swap (bail-in tool), the company needs to increase its capital, and this decision is reserved for the general shareholders meeting. The proposal reacts to this conflict by allowing for the derogation of the respective shareholders’ rights (Article 104 RRD). In my view, the conflict would be better resolved by waiving the reorganization option (and therefore the bail-in tool) for failing financial institutions – an approach that will be addressed below.

24 Under some model resolution strategy, a valuation might be dispensable. See section 7. 25 Article 47 Fundamental Rights Charter; Article 13 Convention for the Protection of Human Rights and Fundamental Freedoms (ECHR). 26 Camberrow MM5 AD v. Bulgaria (dec.), No. 50357/99, ECHR 1 April 2004. 27 See for instance Article 17 (1) Fundamental Rights Charter, Article 1 of the First Additional Protocol to the ECHR or Article 14 of the German Constitution. 28 Directive 77/91/EEC.

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3.3

Decision content: pre-packaged

If the decision regarding a failing bank’s fate is to be assigned to a special resolution authority, it is essential that this authority (to as great a degree as possible) make the right decision. As the probability of such ‘correct reaction’ making increases when all available and relevant information on a situation and possible scenarios are at hand, it is necessary to ensure that resolution authorities have sufficient information. There are principally two ways of ensuring an information transfer. First, the task to set up a resolution plan could be assigned to a failing bank (perhaps supported by an expert such as a supervisor or administrator) as is the case in insolvency plan proceedings. In this instance, a failing bank has all the facts on its financial status, strategic market position and risk exposure at hand, and is capable of providing decision-makers with a detailed plan proposal to resolve a crisis. The other option is to require a failing bank to deliver all relevant information to the decision-makers involved, so that they are capable of designing a solution (plan) and making informed decisions. In contrast to a regular insolvency situation, where a rescue plan is set up by debtors themselves, the bank’s role in such cases is reduced to deliver the information required for a bank resolution that is not immediately available for the authorities as the actual plan designers. The proposed EU bank resolution regime uses both options: the first for recovery plans and the latter for resolution plans. As time is of the essence in a bank failure and a bank’s assets and financial structure are quite complex, there is not much time for preparing a plan in the moment of crisis. Instead, a pre-packaged plan seems ideal as it both provides for a ready-to-use solution if it is up to date and prepares a response to (if possible) all scenarios of possible failure. The EU proposal therefore requires all (recovery and resolution) plans to be prepared in good times and updated annually (Articles 5 (2) and 9 (3) RRD). According to Articles 5 (5) and 9 (2) RRD, they must also cover a range of scenarios and response options. 3.3.1 (Pre-packaged) resolution plans The core of the proposed EU bank resolution regime is resolution planning. In order to make a bank resolution available as an option in bank failures, authorities and state leaders need to know what happens to a failing bank’s business should they decide to let it fail instead of bailing it out. The proposal addresses this key problem by requiring special

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resolution authorities to prepare an individual resolution plan for each financial institution in their respective area of authority. 3.3.1.1 Right to set up a plan In contrast to regular insolvency proceedings, it is not the failing debtor (the bank or financial institution) but a government agency that is responsible for designing a resolution plan (Article 9 (1) RRD). The reason can be found in the special case of a bank failure as each of such failures may threaten the stability of the financial system. A resolution plan must ensure financial stability at the disadvantage of the bank’s future. Neither a bank’s management nor its shareholders are responsible for putting financial stability ahead of their individual interest of maintaining management positions or valuable investments. They are therefore not ideally incentivised to design a resolution plan that does not focus on the bank’s future and management interests but is instead aligned only to financial stability. It must therefore be the task for authorities to design a resolution plan in advance while financial institutions are required to transfer and duly update information required for feasible plans. Such an allocation of duties is provided for in Articles 9 (1) and 10 (1) RRD. 3.3.1.2 Duties to report Any resolution planning starts with a report from each financial institution to its respective resolution authority containing all the information required to design a resolution plan. Consequently, Article 10 (1) RRD commits all Member States to ‘ensure that resolution authorities have the power to require institutions to provide them with all of the information necessary to draw up and implement resolution plans.’ Section B of the RRD Annex specifies which information and analysis is deemed necessary and to be delivered. At this time, Section B contains a list of 21 facts and topics on which each financial institution must report when requested, ranging from detailed descriptions of an institution’s organizational structure or booking practices to the identification of potential risk exposures and liquidity sources for supporting resolution. In order to comply with these reporting duties, each financial institution would have to establish respective departments or offices and file update reports at least annually. This could result in imposing a considerable amount of costs on these institutions. The use of standard forms, templates and procedures29 could not decrease these costs significantly. With respect to the diversity in size of financial institutions in the EU financial market, a small business exception should be considered that would exempt small banks from costly

29 The EBA shall develop draft implementing technical standards on standard forms, templates and procedures according to Article 10 (3) RRD.

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Stephan Madaus reporting duties that would burden them disproportionately.30 Instead, resolution planning for these national non-SIFIs (systemically important financial institutions) should be based on the information available from these institutions’ reports to the capital market and supervising authorities. A duty to report for resolution purpose could be reduced to any remaining specific questions required from resolution authorities. In addition, the introduction of a ‘default resolution option’ (see section 7) could rationalize resolution planning for non-SIFIs. 3.3.1.3 Resolution planning and the core issue of resolvability Based on the reported information, resolutions authorities, in consultation with competent authorities, shall draw up a resolution plan for each financial institution.31 The required content of such plans is laid out in Article 9 (4) RRD: each plan must provide for a detailed description of the measures and tools that are part of the plan as well as the timeframe and impact of their execution. In addition, Article 9 (2) RRD provides that a ‘resolution plan shall take into consideration a range of scenarios including that the event of failure may be idiosyncratic or occur at a time of broader financial instability or system wide events.’32 Resolution planning starts with an in-depth analysis of the respective financial institution searching for the most efficient way to resolve it in different scenarios. Thus, a resolution plan may provide for a very different approach to a failure in a healthy market than in a market troubled by a spreading financial crisis. It remains to be seen whether this task proves to be too complex to be completed for effective outcome.33 If the analysis concludes that no resolution measure would efficiently prevent a threat to financial stability if the respective financial institution fails, no resolution plan may achieve its purpose. The institution is non-resolvable or ‘too big to fail’. It must therefore be restructured or even ‘downsized’ in order to adapt it to the requirements of an efficient resolution plan. Article 14 RRD provides for the power of the resolution authority to demand every measure necessary to allow for a resolution without a potential threat to financial stability. Such a power directly impairs the independence of business decisions and the strategies of major financial institutions in order to not only stop them from being too big to fail but to downsize and cease activities. It is the most critical tool to stop financial institutions from taking taxpayers hostage for its risk exposure. It would not only

30 See also T. Dohrn, ‘Der Richtlinienvorschlag zur Festlegung eines Rahmens für die Sanierung und Abwicklung von Kreditinstituten und Wertpapierfirmen’, (2012) WM, pp. 2033-2040, at 2034. 31 Article 9 (1) RRD. 32 According to Article 9 (5) RRD, the EBA, in consultation with the ESRB, shall develop draft regulatory technical standards specifying a range of scenarios for the event of failure. 33 See Schilling (2012), at 21.

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empower but also require authorities to scale down their most important financial institutions. As action to establish resolvability would be taken in times where a bank’s business is doing well, considerable effort will be required to execute this essential power against the ambition of big national financial players and the fear of politicians to eviscerate Europe’s financial institutions and market places in a worldwide competition.34 3.3.1.4 Resolution tools For resolvable financial institutions, a resolution plan may provide for the following tools, depending on the crisis scenario: – sale of business (Articles 32-33 RRD); – bridge institution (Articles 34-35 RRD); – asset separation (Article 36 RRD); – bail-in (Article 37 RRD). 3.3.1.4.1 Sale of business (and asset separation) In a scenario of a healthy M&A market, a smaller failing bank (non-SIFI) would be subject to a quick sale of its business (assets) or shares as this would not create issues of antitrust law or SIFI-creation. Resolution authorities would market such an institution (Article 33 (1) RRD), prepare a sale on commercial terms and act on behalf of the seller.35 The sale would not require the consent of the shareholders of the institution under resolution or any third party other than the purchaser (Article 32 (1) RRD). Assets of the failing bank that are non-marketable would be subject to regular insolvency proceedings (Article 31 (5) RRD) unless such proceedings are deemed to pose a threat to financial stability (Article 36 (4) RRD). Only such a threat would allow for the transfer of such toxic assets to an ‘asset management vehicle’, established by resolution authorities and wholly owned by public authorities (‘bad bank’) (Article 36 (1)-(2) RRD), in order to ‘maximise their value through eventual sale or otherwise ensuring that the business is wound down in an orderly manner’ (Article 36 (3) RRD). 3.3.1.4.2 Bridge institution (and asset separation) In the scenario of a dysfunctional M&A market or a failing bank too big to merge with competitors (SIFI), (such) a failing bank cannot be sold quickly. Resolution authorities may handle such a situation by transferring valuable assets to a ‘bridge institution without obtaining the consent of the shareholders of the institution under resolution or any third party, and without complying with any procedural requirements under company or securities law that would otherwise apply’ (Article 34 (1) RRD). The bridge institution

34 See also Schilling (2012), at 22. 35 See Article 32 (2)-(11) RRD for details.

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shall be ‘a legal entity that is wholly or partially owned by one or more public authorities (which may include the resolution authority) and that is created for the purpose of carrying out some or all of the functions of an institution under resolution and for holding some or all of the assets and liabilities of an institution under resolution’ (Article 34 (2) RRD). Non-marketable assets would be subject to regular insolvency proceedings or transferred to a ‘bad bank’ according to Article 36 RRD. It is important to emphasise that the bridge institution is principally an auxiliary tool, a makeshift, established only because there is no market interest or marketability in the failing bank’s assets or business. It may therefore not impede a liquidation for longer. If there is no sale, merger or consolidation of a bridge institution within a reasonable period of time, resolution authorities must terminate its operations and wind up its business. Article 35 (5) and (6) RRD provide for a two-year period that may be extended three times for an additional year each provided there is sufficient hope. Today, the cases provided for in Article 35 (3) RRD do not reflect the possibility of a bridge institution to continue permanently. Although such an option seems very likely, especially following a debt to equity swap that issues shares to the creditors of the failing bank, such a swap could not be deemed an ‘acquisition […] by a third party’.36 As such a swap would also be possible in a bridge institution according to Article 37 (2) (b) RRD, the draft RRD seems inconsistent here. 3.3.1.4.3 Who shall wind up a failing bank’s business and assets? Because the RRD-proposal is focussed on resolution tools, it seems flawed when it addresses the responsibilities and procedures to wind up a failing bank. While Article 31 (5) RRD states that the ‘residual part of the institution from which the assets, rights or liabilities have been transferred, shall be wound up under normal insolvency proceedings’, it is held in Article 35 (7) RRD that a failing bridge institution should be wound up by resolution authorities and Article 36 (3) RRD assigns the liquidation of toxic assets transferred to an asset management vehicle to special asset managers appointed by resolution authorities. Such inconsistency should be resolved by keeping a bank failure out of insolvency proceedings. As demonstrated above, the needs of a bank failure regime cannot be easily satisfied by regular insolvency proceedings, so it seems inappropriate to use such proceedings. Instead, the task to terminate and wind up a failing bank’s business should principally be assigned to resolution authorities as well because they are well informed and equipped to perform that task with due consideration of systemic risks. In carrying out its responsibilities in the management and disposition of assets, the resolution authority may, of course, utilize the services of private persons, including real estate and loan portfolio asset man36 Article 35 (3) (b) RRD.

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agement, property management, auction marketing, legal, and brokerage services. Thus, the appointment of special asset managers as provided in Article 36 (3) is consistent with the recommendation to vest all wind-up powers with the resolution authorities in a revised Article 31 (5) RRD.37 3.3.1.4.4 The bail-in tool – reorganization efforts in a bank failure regime? The most discussed measure of the EU proposal for a bank resolution regime is the bailin tool provided for in Section 5 of the RRD. It is intended to give resolution authorities the power to recapitalise a failing financial institution ‘to restore its ability to comply with the conditions for authorisation and to carry on the activities for which it is authorised’ (Article 37 (2) (a) RRD) or ‘to convert to equity or reduce the principal amount of claims or debt instruments that are transferred to a bridge institution with a view to providing capital for that bridge institution’ (Article 37 (2) (b) RRD). While the latter power only provides for the capitalization of bridge institutions, the first power would introduce a reorganization option to the bank resolution regime as the failing entity would survive its ‘resolution’. In my view, there is no room for a reorganization under such a regime. – A reorganization option has become a standard tool in insolvency proceedings, as it is common knowledge that a reorganization may increase creditors’ payoff while saving jobs as well as debtors’ knowledge and interconnections. In a bank resolution regime, however, maximizing creditors’ payoff or saving jobs is not the main purpose. In order to maintain financial stability despite a (major) bank’s failure, quick and predictable solutions are required to calm the financial system. This cannot be achieved by a reorganization as even a quick recapitalization of a failing bank cannot ensure that a business model is sound. It takes time and is very uncertain that restructuring a bank’s business model according to a business reorganization plan38 would be successful and prevent another failure within a short period of time. Regarding the significant rate of unsuccessful reorganizations despite successfully confirmed reorganization plans, financial stability cannot be guaranteed by a reorganization of financial institutions – especially if a considerable number of liabilities remain intact.39 – A reorganization option that is almost guaranteed as the preferred option in a future bank failure because it is a key element of a bank’s resolution plan weakens the incentive of a bank resolution regime to avoid moral hazard. If the only consequences that a 37 The question whether the resolution process itself is to be managed by a special manager, administrator or direct executive powers is not addressed in the RRD proposal and left to the discretion of each member state. See Impact Assessment, SWD(2012) 166 final, at 19. 38 Article 47 RRD. 39 See Article 38 RRD.

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–

–

–

–

financial institution has to fear are the mandatory replacement of senior management (Article 29 (1) (c) RRD) and the dilution of shares (Article 42 (1) (b) RRD), any decision to enter into risky business would not mean to risk the very existence of the company. Such a bank resolution regime would seriously miss its chief political purpose. It is a next-to-impossible task to seriously plan for a reorganization of a financial institution by setting up a pre-packaged plan based solely on crisis scenarios. Even in a moment of crisis, it is complex and difficult to design and negotiate a rescue plan. As all the precautions in Section 5 of the RRD demonstrate, the preparation of a resolution plan with a bail-in tool would absorb a huge part of the capacity of resolutions authorities and still not guarantee a quick and successful reorganization, especially in case of an unforeseen development. A reorganization option is not necessary to achieve the aims of a bank resolution regime: maintaining financial stability despite the failure of a financial institution. There are less extensive and costly tools available that ensure financial stability in every bank failure than the attempt of a reorganization. If there is no market interest in a failing bank, the solution must be to immediately wind up its business or to transfer valuable parts to a bridge institution to be sold in a better market. In the case of the latter, the bridge institution may be capitalised by a debt-to-equity swap, but this could be done under company law and would not interfere with the principal dissolution of the entity of a failing financial institution. A reorganization of a failing bank would be financed by funds acquired from competing financial institutions (Article 94 RRD). In contrast to regular insolvency proceedings where the stakeholders of an insolvent company or private investors need to fund a reorganization process by contributing loans, the funding of a bank resolution would be enabled by loans (Article 92 (1) (b) RRD) sponsored by amounts raised by ex-ante contributions from all financial institutions. Such mandatory financial support of a competitors’ rescue is hardly consistent with the principles of our economy. Finally, if a resolution regime does not arrange for a reorganization, but only for dissolution of a failing company, there would be no interfering with shareholders’ rights to decide about the capital structure of their public limited liability company provided by the Second Company Law Directive.40 Changes to the Directive, as intended in Article 104 RRD, would not be necessary.

40 Directive 77/91/EEC.

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The EU Commission should therefore not take chances and hope for late rescues of failing banks41 but instead follow the U.S. example42 and provide for the mandatory liquidation of a failing financial institution by ensuring a transfer of valuable assets and contracts. 3.3.1.5 Implementing a resolution plan As the implementation of a resolution plan impairs the fundamental rights of the financial institution involved, its creditors and shareholders, such implementation must only occur when necessary to maintain financial stability. It should be a last resort option. Article 27 RRD reflects these conditions by only allowing resolution authorities to take a resolution action if: – ‘the competent authority or resolution authority determines that the institution is failing or likely to fail; – having regard to timing and other relevant circumstances, there is no reasonable prospect that any alternative private sector or supervisory action, other than a resolution action taken in respect of the institution, would prevent the failure of the institution within reasonable timeframe; – a resolution action is necessary in the public interest’. These provisions resemble the triggers defined in the Dodd-Frank-Act43 and appear to be adequate, especially after the EBA develops guidelines to promote the convergence of supervisory and resolution practices regarding the interpretation of the different circumstances when an institution shall be considered as failing or likely to fail (Article 27 (4) RRD). 3.3.2 Side-effect: recovery plans In its proposal for a EU bank resolution regime, the EU Commission does not only address the problem of handling a failing financial institution. The Commission included provisions

41 This means turning away from the approach pursued in the United Kingdom or Germany. The aim of the UK procedure is to restore the failing financial institution to a going concern by writing-down the debt of unsecured creditors and, probably, converting it into equity, but without liquidating the entity or transferring its businesses; see the Federal Deposit Insurance Corporation and Bank of England Memorandum on Resolving Globally Active, Systemically Important Financial Institutions, December 2012, available at: . In Germany, the bank resolution regime (Restrukturierungsgesetz) is focused on rescuing a trouble financial institution with an ‘ad-hoc’ recovery plan (Sanierungsplan) and a failing institution with a rescue plan (Reorganisationsplan). Only as a last resort (§ 48c KWG), the supervisor (BaFin) may order a sale or a transfer of (parts of) the banks’ business to a bridge company (§ 48a KWG). 42 See section 214 (a) of the Dodd-Frank-Act: ‘All financial companies put into receivership under this title shall be liquidated.’ 43 See section 203 (b).

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for recovery plans (Articles 5-8 RRD) and early intervention means (Articles 23-26 RRD), all of which are not intended to assist in handling bank failures but to prevent banks from failing. Thus, they add to the current EU financial stability framework, which ensures that banks are adequately capitalised (CRD) and supervised (ESFS) by extending the powers of bank supervisors to intervene in bank operations if a bank is likely to breach the requirements of the CRD. Under the proposed bank resolution regime, a covered financial institution would be required to collect, report and update relevant information to resolution authorities, so that they are capable of designing a resolution plan. It seems effective to use the information and resources, a financial institution would have set up to meet the requirements of a bank resolution regime, to design a recovery plan that does not address a bank’s failure but a situation where a bank is unable to meet CRD requirements. To use information and resources at hand for early intervention planning and to prevent a failure may be seen as a side effect of the proposed bank resolution regime, but could prove to be very useful.

4

Early intervention by supervisors and recovery plans

Early intervention tools are not designed to address bank failures as they happen. Therefore, they are not assigned to resolution authorities but to supervisors who could use them as soon as an institution appears to be in serious crisis.

4.1

When should a supervisor intervene?

The trigger is defined in Article 23 (1) as the moment when a financial institution ‘does not meet or is likely to breach’ the requirements of the CRD. Although the EBA shall develop technical standards, a ‘likely breach’ is a financial status that could describe a larger part of the financial industry at any point in time. It seems preferable to require an actual breach of CRD requirements as the ultimate trigger while allowing for specific soft triggers in recovery plans where they would be adapted to the strategy and specific risks of a given financial institution. Such a trigger combination would allow for a proportionate yet still timely intervention to prevent failure.

4.2

What may a supervisor do?

As all early intervention tools would be aligned to the CRD requirements, they aim to reestablish a minimum capitalization of a financial institution. This aim may be achieved

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by measures on both sides of the balance sheet. An institution could be recapitalised with new funds by a capital increase; it could also terminate and wind up unsuccessful parts of its business or subsidiaries. A debt to equity swap would affect both sides. Early intervention measures would limit the freedom of management and shareholders to decide on managing the business at a time when failure is not yet imminent and a threat to financial stability is vague. Therefore, measures dictated by supervising authorities need to be appropriate and proportionate. The softest way to intervene is to mandate financial institutions to ‘implement one or more of the arrangements and measures’ they had set out themselves in their recovery plan (Article 23 (1) (a) RRD). This option must be the preferential tool in any early intervention. It calls for anticipatory planning using all the information needed to design a ‘custom-made’ reaction to a pre-defined crisis for each financial institution regarding their specific business model and risk profile. The EU proposal provides for such planning in Articles 5-8 RRD. It would mandate a financial institution to consider a multitude of data44 and ‘stress tests’45 and to submit recovery plans to their supervising authority for review and assessment.46 If a recovery plan does not provide for a solution to an unexpected crisis, the supervisor may, of course, ‘require the management of the institution to examine the situation, identify measures to overcome any problems identified and draw up an action program to overcome those problems and a timetable for its implementation’ (Article 23 (1) (b) RRD), as such management action would be required by company law anyway. The very same is true for the power to require the convocation of a shareholders meeting (Article 23 (1) (c) RRD), the replacement of incapable directors (Article 23 (1) (d) RRD), the preparation of a debt restructuring (Article 23 (1) (e) RRD), a resolution (Article 23 (1) (f) RRD) or a sale (Article 23 (1) (g) RRD) of a company’s business. Other, more intrusive early intervention tools would require special reasons as they would exceed the limits of the company’s own will or its management’s duties under company law. The nomination of a special manager, in particular, only seems appropriate when a financial institution fails to act on its own responsibility and a management takeover is justified by the systemic risks posed by a possible failure of such an institution.47 44 Article 5 (4) RRD demands for all the information listed in Section A of the Annex, which especially contains information on the company’s risk management arrangements and proposed recovery measures. 45 The EBA, in consultation with the ESRB, develops draft technical standards specifying the range of scenarios according to Article 5 (6) RRD. The EBA consultation paper is available at: (last visited 8 April 2013). 46 Article 6 RRD. Insufficient plans would need to be revised within three months. 47 As provided for in Article 24 (1) RRD.

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5

Addressing banking groups

According to the ECB, in 2011, 4,713 credit institutions operated in the EU, but 417 banking groups were also identified,48 which, as a result of industry consolidation over recent years, dominate the European banking landscape. Any bank resolution regime seems incomplete without addressing this very fact. Consequently, the proposed RRD contains special provisions and proceedings regarding the special requirements of bank groups in failure.

5.1

Group recovery plans and group financial support agreement

The RRD proposal provides for a consolidated treatment of banking groups under its regime. First, parent undertakings are required to ‘draw up and submit to the consolidating supervisor49 a group recovery plan that includes a recovery plan for the whole group […] as well as a recovery plan for each institution that is part of the group’ (Article 7 (1) RRD). Thus, recovery planning in a banking group is assigned to its parent undertaking only. A resulting single group recovery plan will ‘aim to achieve the stabilisation of the group as a whole, or any institution of the group’ and ‘include arrangements to ensure the coordination and consistency of measures’ (Article 7 (3) RRD) at each level of the group. A group recovery plan is to be approved by the management of all affected companies of the group (Article 7 (6) RRD) and submitted to the relevant consolidating supervisor for assessment. In such a case, the consolidating supervisor makes a joint decision with all the competent supervisors of affected institutions, so consultations and cooperation are required (Article 8 (1) RRD).50 As a conflict of interest between a group recovery and a recovery of single subsidiaries of the group is to be expected quite frequently, the consent required for a joint decision may not always be achievable. In order to avoid a deadlock, the consolidating supervisor may act independently after a period of four months unless a resolution authority refers the matter to the EBA for mediation and final decision (Article 8 (2)-(5) RRD).

48 ECB press release, 23 August 2012, on consolidated banking data 2011, available at: (last visited 8 April 2013). 49 A ‘consolidating supervisor’ was introduced into the CRD in 2009 (Directive 2009/111/EC) and means ‘the competent authority responsible for the exercise of supervision on a consolidated basis of EU parent credit institutions and credit institutions controlled by EU parent financial holding companies’; Article 4 (48) CRD. Article 2 (31) RRD refers to that provision. 50 In an international context, colleges of supervisors, which have already been established for 44 cross-border banking groups, would facilitate cooperation. See Impact Assessment, SWD(2012) 166 final, at 65.

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Secondly, the new regime would allow for voluntary intra group financial support agreements in order to provide for a very effective quick fix to a temporary liquidity problem.51 The content of such an agreement may cover one or more subsidiaries of the group and provide for any kind of financial support from a parent undertaking or other subsidiaries (Article 16 (2) RRD). Such agreements would require the approval of the shareholders of each covered institution under national law (Article 18 RRD) as well as the authorization of the consolidating supervisor (deciding jointly again with all competent supervisors) (Article 17 RRD). Authorization is granted on a fair and reasonable standard as defined in Article 19 RRD. Approved support arrangements are to be included into a group recovery plan (Article 7 (4) RRD) and may subsequently be enforced by supervisors as part of an early intervention.

5.2

Group resolution plans

If a financial institution is the head or part of a group of companies, resolution authorities will respond to the special demands of a possible group failure and set up a ‘group resolution plan’ that includes both a plan for resolution at the level of the parent undertaking or institution and the resolution plans for each of the individual subsidiary institutions (Article 11 (1) RRD). The transfer of information is ensured by a report from the parent undertaking to its respective ‘group level resolution authority’, who transmits the information to the EBA and resolution authorities of the subsidiaries (Article 12 (1) RRD). Subsequently, the group level resolution authority can draw up the group resolution plan, acting jointly with all resolution authorities involved. Eventually, resolution authorities will establish ‘resolution colleges’ for all cross-border banking groups (analogous to existing colleges of supervisors).52 If a joint decision cannot be reached in this college, the grouplevel authority may act on its own unless a resolution authority refers the matter to the EBA for mediation and final decision (Article 12 (2)-(7) RRD). As soon as a group failure occurs, the respective group-level resolution authority will propose a group resolution scheme and submit this to the resolution college (Article 83 (4) RRD). If consent on a proposed scheme is not granted within the college, the EBA is asked to decide within 24 hours. At this stage, a deadlock may render the resolution process futile as the EBA’s decision is to be made by its Board of Supervisors. This Board is composed of the heads of the relevant competent authorities in each Member State and ‘should

51 Impact Assessment, SWD(2012) 166 final, at 23. 52 See Impact Assessment, SWD(2012) 166 final, at 65. Competent ministries would also be a member of such colleges according to Article 80 (2) RRD.

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Stephan Madaus act independently and only in the Union’s interest.’53 A conflict between national authorities over the appropriate resolution scheme may, however, lead to a situation, where the best scheme fails to receive majority support or may even gain such support but become subject to a blocking minority under Article 44 (1) subsection 3 of Regulation (EU) No. 1093/2010. To avoid such a deadlock, the RRD should refer to Articles 19 (3) and 44 (1) of Regulation (EU) No. 1093/2010 in Article 83 (6) with the additional condition of suspending blocking minority rights for such decisions.

6

Evaluation

Overall, the proposed RRD presents both an effective bank resolution regime and a wellbalanced addition to the EU financial stability framework. The effectiveness of a bank resolution option will strongly depend on mastering the task of handling, restructuring and possibly even downsizing major financial institution, often even too big to be saved, in a financial market dominated by such ‘big players’. It needs to be emphasised that only a resolvable financial institution may be subject to a resolution regime in case of its failure. A reorganization should not be an option in a bank resolution regime as it interferes with the special characteristics of bank failures. The bail-in tool should therefore be marginalised in the proposal and applied only in cases where a bridge institution is to be established. An early intervention by supervising authorities to implement a recovery plan or company law duties is a useful addition to the EU financial stability framework but should only be triggered by an actual breach of CRD requirements or specific indicators provided for in recovery plans. However, early intervention tools do not diminish the need for a resolution regime as many of the recent bank failures have been caused by reporting manipulations,54 and such behaviour prevents the triggering of early intervention. A possible failure of a bank group is well addressed by the requirements to set up group recovery and group resolution plans at the top level of a group. Such a procedural consolidation respects the special economic situation of a group of companies without undermining the traditional legal approach to treat each legal entity of a group separately. Conflicts of interest between a parent undertaking and its subsidiaries in recovery and resolution 53 Recital 52 of Regulation (EU) No. 1093/2010. 54 See J. Sarra, ‘Prudential, Pragmatic, and Prescient, Reform of Bank Resolution Schemes’, 21 Int. Insolv. Rev. (2012), pp. 17-66, at 52.

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scenarios are addressed by the requirement of a joint decision of all supervisors and the voluntary nature of group financial support arrangements. It remains to be seen whether the EBA will be able to mediate a joint decision between disputing authorities trying to achieve the best possible outcome or protection for institutions in their respective responsibility. In this regard, the RRD proposal does not contain any standards for the EBA to grant priority, neither to a group interest nor to a subsidiaries’ interest.

7

Outlining a ‘default resolution option’

Having reflected on the results, this report concludes with a draft of a type of resolution that seems adequate to serve as a ‘default option’. It is based on the presumption that the resolution of a failing financial institution should consist of a quick and pre-packaged transfer of such institution’s valuable assets in addition to systemically relevant services and financial contracts, thus liquidating the failing entity.

7.1

Resolution planning and resolvability

In order to enable a quick transfer in the case of failure, a financial institution must inform both its resolution authority about the marketability of its core business and update its marketability assessment on a regular basis. Such an analysis cannot only focus on potential buyers from the ranks of competing financial institutions as such an acquisition may raise serious questions in terms of antitrust policy and lead to a financial group that is too big to fail from the moment of the acquisition. The marketability assessment should instead focus on potential investors for a bridge entity that would be established in a resolution and require fresh money. A quick transfer also requires preparation regarding those assets, services, and financial contracts that would be the object of such a transfer. A resolution plan must therefore identify and document the relevant assets, service units, and types of contracts in an inventory. It must also ensure that despite a transfer, all relevant services (such as accounting or payment services) would continue without interruption. Here, the issue of funding needs to be addressed as well. Deficiencies in the organizational structure of a financial institution that interfere with the need for a quick transfer are to be considered impediments to resolvability in accordance with Article 14 RRD and must be addressed by resolution authorities by requiring the institution’s restructuring. In cases where a banking group is concerned, the concept of a pre-packaged transfer falls into place with the ‘SPE approach’ (‘single point of entry’), which is held to be the preferred

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approach in the Federal Deposit Insurance Corporation and Bank of England Memorandum on Resolving Globally Active, Systemically Important Financial Institutions from December 2012.55 Here, the focus is on resolving the parent company (‘topco’) while leaving all other group companies with their regular business. This approach is particularly useful where topco is not an operating company but only a holding company that holds shares and loans to the operating subsidiaries. With such a group structure, a topco-only resolution could guarantee the continuation of services to the financial market and thus limit risks for financial stability while quickly restructuring the debts of the group at the top level. The transfer of assets would also provide for the replacement of management, while the difficult task of restructuring the groups’ business operations and long-term funding is assigned to the new management of the bridge entity. If banking groups do not have a pure holding topco at the moment of resolution planning, the probable costs, delays and (above all) risks to financial stability deriving from a parallel resolution of multiple or even of all group companies should be weighed against the costs of an opportune restructuring of the group. In cases where there is a preference for creating a holding topco, resolution agencies could require such restructuring of banking groups, as this would be considered an act to remove impediments to resolvability according to Article 14 RRD.

7.2

Resolution of a failing financial institution

As soon as a financial institution fails, the appropriate resolution authority should arrange the transfer of all assets, services and financial contracts, specified in the resolution plan, as well as all unsecured creditors’ claims to a bridge institution. By doing so, the failure would be resolved quickly and risks to financial stability would be contained promptly. The management of the institution would be assigned to business professionals. Following this quick action, resolution authorities would write down the transferred claims of unsecured creditors and convert them to equity; according to each creditor’s pro-rata share of the total amount of unsecured claims, shares would be issued. Thus, unsecured creditors retain exactly those assets that they were entitled to liquidate under insolvency proceedings with exactly the same amount of pro-rata share of potential pay-off. Such a debt to equity swap would not only spare any valuation of the transferred assets to determine a liquidation value, but also save payment to the failing entity in return for transferred value.

55 , at 2.

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The treatment of secured or preferred creditors depends mostly on pending political decisions. Basically, secured creditors could keep their liens on transferred property and would therefore not be impaired by a resolution. If depositors are to be protected regardless of a deposit guarantee scheme, deposits would be transferred and served by the bridge institution, so no impairment would be incurred on their part, too. If, on the other hand, depositors are not protected, they would be treated as unsecured creditors and their claims swapped to equity.56 If the transfer of assets is to be free and clean of all interest in the property, secured creditors are to be covered ahead of unsecured creditors. This would result in a transfer and write-down of all secured and unsecured claims, while only secured claims would be converted to equity. Creditors who do not receive equity in the bridge institution – junior creditors or unsecured creditors where secured creditors are to be impaired – could be integrated into the recovery process by being provided with an option to buy shares at their nominal value. They would thereby participate in the recovery of the financial institution only after higher ranked creditors have received full payment for their pro-rata claims.57

7.3

Post-failure activities

After the bridge institution has been established and its equity distributed, the resolution authorities’ focus may shift to the management of the assets and liabilities that remained with the failed entity. This entity may be handed over to common insolvency proceedings as Article 31 (5) RRD proposes. As the remaining assets may contain assets that could regain value over a longer period of time, it should also be possible to set up an asset management vehicle according to Article 36 RRD. The future of the former bridge institution lies in the hands of its new management and owners. They have to make sure that the institution meets all regulatory requirements. Any increase in capital in order to meet capital requirements or debt issuance to fund business operations or restructuring measures must be conducted according to company

56 If depositors would receive payments under a deposit guarantee scheme, their claims would be assumed by the deposit guarantee institution, who would therefore receive the respective shares in the bridge institution. 57 The idea to use options to overcome corporate insolvency without valuation was introduced by L.A. Bebchuk, ‘A New Approach to Corporate Reorganizations’, 101 Harv. L. R. (1987-1988), pp. 775, 785 et seq., and further developed by P. Aghion, O. Hart & J. Moore, ‘The Economics of Bankruptcy Reform’, 8 J. L. Econ. & Org. (1992), p. 523; O. Hart, R. La Porta Drago, F. Lopez-de-Silanes & J. Moore, ‘A New Bankruptcy Procedure That Uses Multiple Auctions’, 41 Eur. Econ. Rev. (1997), p. 461; B. Branch, ‘Streamlining the Bankruptcy Process’, 27 Fin. Mgmt. (1998), p. 57 and D. Hahn, ‘When Bankruptcy Meets Antitrust: the Case for Non-cash Auctions in Concentrated Banking Markets’, 11 Stan. J.L. Bus. & Fin. (2005), p. 28.

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law. Hence, capital measures must be decided upon by the general meeting of shareholders. In short, company law takes over again.

8

Conclusion

The proposal for a directive of the European Parliament and of the Council establishing a framework for the recovery and resolution of credit institutions and investment firms contains the appropriate tools to establish a pan-European bank resolution regime that is actually able to relieve the member states from bailing out failing financial institutions, even if systemically important. This effect would be enhanced if the European Commission gave up the wish to rescue a failing bank by reorganizing the failing entity and instead focused on proposing a bank resolution regime based on a pre-packaged sale. Restructuring practitioners are very familiar with such regimes. Such a proposal would enable both a quick and a safe solution to a bank’s failure while leaving disputes for later and, thus, seems to be a particularly suitable resolution tool.

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Part 3 Rule of Law v. Authorities Discretion

4

Does the Directive on the Recovery and Resolution of Credit Institutions Provide Sufficient Fundamental Rights Protection?

Alexander Schild

1

Introduction

The financial crisis has made clear the need for a Union-wide framework to manage banks in financial distress. To further integration and coherence in the resolution requirements and arrangements applicable to cross-border institutions the Commission has proposed the directive for establishing a framework for the recovery and resolution of credit institutions and investment firms (RRD).1 Its aims are to tackle bank crises pre-emptively, while safeguarding financial stability and minimising taxpayer exposure to losses in insolvency. The RRD requires Member States to confer specific resolution powers on public administrative authorities. In case an institution has failed or is about to fail, the resolution authorities will have the power to apply the following resolution tools: a. the sale of business-tool; b. the bridge institution-tool; c. the asset separation-tool; d. the bail-in-tool. Inevitably, such measures will interfere with the property rights of the institution, its creditors and shareholders. The right of the peaceful enjoyment of property is guaranteed by Article 17 of the EU Charter of Fundamental Rights (the Charter). Furthermore, the concerned parties have a right to a due process and to having an effective remedy against the measures affecting them in accordance with Article 47 of the Charter.

1

Proposal of the Commission, COM(2012) 280/3.

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In this paper the question that will be discussed is to what extent the resolution tools as proposed in the RRD are compatible with the obligations of the Member States regarding the right of peaceful enjoyment of property and the right to an effective remedy. Pursuant to Article 52 (3) of the Charter, the meaning and scope of the rights that correspond to rights guaranteed by the Convention for the Protection of Human Rights and Fundamental Freedoms (the Convention) shall be the same as those laid down by the Convention.2 Owing to the lack of case law on the above-mentioned articles of the Charter, it will be assumed that the scope and meaning of the aforementioned articles in the Charter is the same as Article 1 Protocol No. 1 to the Convention and Article 13 Convention, respectively. This paper will therefore examine whether the RRD meets the obligations imposed upon the Member States to the Convention pursuant to Article 1 Protocol No. 1 (right to property) and Article 13 of the Convention (effective remedy).

2

The right to the peaceful enjoyment of property

Pursuant to Article 1 of Protocol No. 1, the Contracting States are entitled to control the use of property in accordance with the general interest. However, certain conditions should be met. The term property is to be interpreted autonomously for purposes of the Convention. It may encompass interests that do not fall within the scope of property in the legal systems of the states that have acceded to the Convention. The ECtHR tends to take a broad view of what can be considered a ‘property’ right. Not only physical goods, but also certain rights and interests constituting assets may be regarded as ‘possessions’ for the purposes of this provision.3 The ECtHR has established three main principles applying to the protection of property. Any interference with a possession should be (i) lawful, (ii) based on a legitimate aim in the public interest, and (iii) a fair balance must be maintained between the demands of the general interest and protection of the right to the peaceful enjoyment of possessions.

2 3

According to Article 52(3), Union law may offer more extensive protection, but not less than the protection offered by the Convention. ECtHR 27 May 2010 (Saghinadze v. Georgia), No. 18768/05, § 103.

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2.1

Does the Directive on the Recovery and Resolution of Credit Institutions Provide Sufficient Fundamental Rights Protection? Principle of lawfulness

The ECtHR has reiterated that the first and most important requirement of Article 1 is that any interference by a public authority with the right to peaceful enjoyment of possessions should be lawful.4 The principle of lawfulness requires that each infringement upon the right to property has a basis in domestic law. This legal basis has to be (i) accessible, (ii) sufficiently precise and (iii) foreseeable. The principle of lawfulness is derived from the rule of law.5 All governmental powers need to have a sufficient basis in the law. In order to prevent the arbitrary use of power, legal provisions should be drafted with sufficient clarity and precision.6 The RRD describes a clear framework that is to be achieved by the member states. Furthermore, it should be noted that the use of broadly drafted powers in provisions is in itself not deemed problematic by the ECtHR.7 The Convention aims to prevent the use of power by national authorities without a sufficient legal basis. All the powers to be conferred upon the national resolution authority are clearly prescribed in the RRD. The resolution authority shall be able to take action when an institution is insolvent or very close to insolvency. In itself, this norm cannot be deemed insufficiently clear or precise. Thus, no issues are to be expected in regard to the principle of lawfulness when the RRD is dutifully implemented.

2.2

Principle of a legitimate aim

According to the second sentence of Article 1, deprivations of property are only allowed if they are in the public interest. The second paragraph provides that the control of the use of property has to be in accordance with the general interest. The ECtHR reads these provisions together as establishing one principle: interferences with a property right have 4 5 6 7

ECtHR 20 May 2010 (Lelas v. Croatia), No. 55555/08, § 71. T. Bingham, The Rule of Law, Allen Lane, London (2010). ECtHR 24 May 2005 (Sildedzis v. Poland), No. 45214/99. ECtHR 20 September 2011 (Yukos v. Russia), No. 14902/04, (§ 598: ‘In order to avoid excessive rigidity, many laws are inevitably couched in terms which, to a greater or lesser extent, are vague and whose interpretation and application are questions of practice (see, among other authorities, Sunday Times v. United Kingdom (Appl. No. 6538/74), cited above, § 49 and Kokkinakis v. Greece (Appl. No. 14307/88), cited above, § 40). On the facts, it would be impossible to expect from a statutory provision to describe in detail all possible ways in which a given taxpayer could abuse a legal system and defraud the tax authorities. At the same time, the applicable legal norms made it quite clear that, if uncovered, a taxpayer faced the risk of tax reassessment of its actual economic activity in the light of the relevant findings of the competent authorities. And this is precisely what happened to the applicant company in the case at hand.’

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to serve a legitimate aim. Member states enjoy a wide margin of appreciation when deciding what can be considered a legitimate aim in the general interest.8 The ECtHR will respect decisions – especially in the context of macroeconomic policy – unless it finds them to be ‘manifestly without reasonable foundation’.9 The objective of the RRD is to maintain financial stability and minimize losses for society, and in particular taxpayers, while ensuring similar results to those of normal insolvency proceedings in terms of allocation of losses to shareholders and creditors. The RRD is clearly beneficial towards these goals, so no issues in relation to this requirement are to be expected.

2.3

Principle of fair balance

It is well established in the case law of the ECtHR that any interference with the right to the peaceful enjoyment of possessions must strike a ‘fair balance’ between the demands of the general interest of the community and the requirements of the protection of the individual’s fundamental rights.10 Hence, a reasonable relationship of proportionality should exist between the means employed and the aim sought to be realized.11 A fair balance is absent in case the interference with the right of property creates an ‘individual and excessive burden’.12 Whether the principle of fair balance will be met shall ultimately depend on the particulars of each case in which the resolution authority will decide to act.13 The circumstances need to justify both the decision to act and the chosen instruments the resolution authority shall deploy. Notwithstanding the fact that the particulars of the case will determine the outcome of the fair balance test, some general observations can be made. Often one of the key factors that determine whether the fair balance-principle has been met is the issue of the amount of compensation that has been provided. As to the amount of compensation that needs to be offered, the ECtHR usually establishes whether the measure in question constitutes a ‘deprivation of property’ or rather falls in the ‘ambit of control of use’.14 A deprivation of 8 9 10 11 12 13

ECtHR 29 April 1999 (Chassagnou v. France), Nos. 25088/94, 28331/95 and 28443/95, § 75. ECtHR 10 July 2012 (Grainger v. The United Kingdom), No. 34940/10, § 39. ECtHR 10 July 2012 (Grainger v. The United Kingdom), No. 34940/10, § 35. ECtHR 5 January 2000 (Beyeler v. Italy), No. 33202/96, § 114. ECtHR 23 September 1982 (Sporrong and Lïnnroth v. Zweden), Series A, No. 52, p. 26, § 69. Legitimate expectations raised by the State may be a relevant factor: ECtHR 19 October 2000 (Ambruosi v. Italië), No. 31227/96, § 32. 14 In some cases, however, the ECtHR does not draw this distinction but simply states that it will scrutinize the measure in light of Article 1 of Protocol 1 and the principles that govern the right to property. For instance, in the case of Sovtransavto Holding v. Ukraine the ECtHR held that dilution of a stake in a company

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Does the Directive on the Recovery and Resolution of Credit Institutions Provide Sufficient Fundamental Rights Protection?

property without payment of an amount reasonably related to its value will normally constitute a disproportionate interference that cannot be justified under Article 1 Protocol No. 1. Before discussing how the RRD provides for certain safeguards to ensure a reasonable compensation is offered in the case of deprivation of property, it is useful to establish how the ECtHR has dealt with the complaint of former shareholders of Northern Rock regarding their deprivation of property due to the nationalization of Northern Rock in February 2008 by the United Kingdom. Immediately before nationalization, the market price of Northern Rock shares was 90 pence.15 Pursuant to the Northern Rock plc Compensation Scheme Order 2008, the independent valuer, when calculating the amount of compensation to be paid by the Treasury to the former shareholders, had to assume that Northern Rock was unable to continue as a going concern and was in administration. On the basis of this assumption, the valuer held that there would be no residual value in the company and therefore no compensation would have to be paid. The former shareholders of Northern Rock complained in Strasbourg that because of the lack of compensation the British government had failed to strike a fair balance between the public interest and the interest of the shareholders, when expropriating the shares. The general consideration of the ECtHR in the Grainger-case in response to this complaint reads as follows: 37. Compensation terms under the relevant legislation are material to the assessment of whether the contested measure respects the requisite fair balance and, notably, whether it does not impose a disproportionate burden on the applicants. It is clear that Article 1 of Protocol No. 1 does not guarantee a right to full compensation in all circumstances […]. Legitimate objectives in the ‘public interest’, such as those pursued in measures of economic reform or measures designed to achieve greater social justice, may call for less than reimbursement of the full market value. Furthermore, the Court’s power of review is limited to ascertaining whether the choice of compensation terms falls outside the State’s wide margin of appreciation in this domain (see James and Others, cited above, § 54). The Court has, however, previously indicated constitutes an interference with a property right, without further qualifying the dilution as a deprivation of property or as a control of use. ECtHR 25 July 2002 (Sovtransavto Holding v. Ukraine), No. 48553/99, §§ 9192. 15 ECtHR 10 July 2012 (Grainger v. The United Kingdom), No. 34940/10, § 15.

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that the taking of property without payment of an amount reasonably related to its value will normally constitute a disproportionate interference and a total lack of compensation can be considered justifiable under Article 1 of Protocol No. 1 only in exceptional circumstances […]. The ECtHR furthermore acknowledged that: The Court of Appeal took the view that the Government should be afforded a wide margin of appreciation in this case, since the impugned action arose in the context of macro-economic policy. The Court agrees that given the exceptional circumstances prevailing in the financial sector, both domestically and internationally, at the relevant time, a wide margin of appreciation is appropriate.16 It further held that Northern Rock had survived only because of the temporary financial report provided by the State, which the United Kingdom was under no obligation to continue. The complaint was declared manifestly ill-founded and inadmissible. Two things are noteworthy. First, in order to pass the fair balance-test in case of a deprivation of property, a payment of an amount reasonably related to its value suffices.17 Second, the ECtHR has made it clear in Grainger v. The United Kingdom that it does not want to become another instance were complaints can be brought about the valuation of the deprived assets. The review by the ECtHR is limited ‘to ascertaining whether the choice of compensation terms falls outside the State’s wide margin of appreciation in this domain’.18 This approach will make it very difficult for deprived shareholders who complain about the absence or amount of compensation offered after an interference with their property right to be declared admissible in Strasbourg. It seems safe to assume that the review exercised by the ECtHR will be mostly, if not only, in relation to procedural matters, that is whether the valuation has been according to the rules and whether the affected parties had the opportunity to seek judicial review in their national courts.

16 ECtHR 10 July 2012 (Grainger v. The United Kingdom), No. 34940/10, § 39. 17 See also ECtHR 8 July 1986 (Lithgow and Others v. The United Kingdom), Series A, No. 102. 18 ECtHR 10 July 2012 (Grainger v. The United Kingdom), No. 34940/10, § 37.

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3

Safeguards under the RRD

The RRD does provide for several safeguards to ensure that deprived creditors and shareholders will receive no less than they would have received under normal insolvency proceedings.19 The first safeguard provided for in the RRD is the requirement (in Article 30) of a preliminary valuation of a (legal) person who is independent of any public authority, before resolution action may be taken.20 The resolution authority will have to endorse that valuation. The valuation by an independent expert will make an important defense for the resolution authority against the claim that the action taken was not required because of the sufficient financial soundness of the financial institution.21 Next, I shall shortly discuss the way the RRD establishes further safeguards in respect of the various resolution tools that may be used by the resolution authority.

3.1

Safeguards for counterparties in partial transfers

In case a resolution authority decides to sell assets or parts of the business of a financial institution to another entity, it is under the obligation to create a level playing field for potential purchasers (Article 33 (2)). The RRD assumes that this will generate a fair market price. There is no obligation to have the business to be sold, valued specifically by an independent person.22 It is questionable whether the creation of a level playing field will ensure a fair market price. The risk exists that the resolution authority will agree to a ‘fire sale’ price – which might be considered the right price at the time of transfer – and the financial institution will complain that the resolution authority – by agreeing to a fire sale price – has agreed to a price below the real market value. This risk may be enhanced by the fact that the primary interest of the resolution authority will be to do what is required to keep the financial system going. This may also provide for an incentive to sell parts of the business or certain 19 This principle is laid down in Article 65. 20 Article 30 (1). 21 In the legal disputes that followed the nationalization of SNS Bank in The Netherlands, the valuation by an independent expert proved to be an important element in the discussion between the State and the shareholders and creditors that were ‘bailed in’ whether the action taken was indeed necessary. 22 Article 30 (1) – which requires a general independent valuation of the assets and liabilities of the institution – does not contain a specific reference. But see article 32(4). Article 66 (1) prescribes an independent valuation for the value of the financial institution after partial transfers have been effected for the remaining creditors and shareholders.

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assets of a bank in financial distress quickly and not necessarily for the highest price. A financial institution will have to rely on judicial review of the decision (Article 78) to be compensated. An annulment of a decision shall not be able to reverse the sale. Compensation for the loss is the only possible redress, under the RRD (Article 78 (2)(d)). Pursuant to Article 13 of the Convention, the availability of a remedy must include the determination of the claim as well as the possibility of redress. The nature of the remedy required will depend upon the nature of the alleged violation.23 The nature of any complaints made pursuant to the use of resolution tools will be such that compensation will suffice to meet the obligations under Article 13.

3.2

Safeguards for the bridge institution and the asset separation-tool

The RRD does not provide for specific safeguards in respect of the bridge institution and the asset separation-tool. Persons affected by these tools have the ability to ask for judicial review of the decision and to be compensated for their loss (Article 78).

3.3

Safeguards for the bail-in instrument

The ‘bail-in’ instrument under the RRD can be used to recapitalize a financial institution. The resolution authorities will have the power to write down the claims of unsecured creditors and to write off the existing shareholders.24 Unsecured debt may be converted into equity. The RRD stipulates that shareholders and creditors whose claims have been written down or converted to equity receive in payment of their claims at least as much as what they would have received if the institution had been wound up under normal insolvency proceedings immediately before the writing down or the conversion (Article 65 (1)(b)). Furthermore, an independent valuation needs to be carried out (Article 66 (1)). The RRD acknowledges that shareholders and creditors whose claims are bailed in are entitled to compensation reasonably related to the value of their claims. The case of Grainger v. The United Kingdom has demonstrated that as long as the ECtHR is convinced that a certain valuation is arguable, it is not willing to review the correctness of a valuation in any detail. When the RRD is implemented as envisaged, complaints of creditors and shareholders in this respect to the ECtHR after a future bail-in will most likely be declared manifestly ill-founded and inadmissible.

23 Aksoy v. Turkey (1996), 23 EHRR 553. 24 Article 42 RRD.

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4

The right to an effective remedy

The Member States have to ensure that all persons affected by the decisions of the resolution authority shall have the right to apply for judicial review (Article 78). This right is, however, subject to certain limitations. The lodging of an application for judicial review shall not entail an automatic suspension of the challenged decision. The review is also restricted to the questions of (i) legality of the decision, (ii) the legality of the way it was implemented, and (iii) the adequacy of any compensation granted. These limitations are of such nature that the requirements of Article 13 are still fulfilled. As noted above, Article 13 of the Convention requires the availability of a remedy, leaving the nature of the remedy up to the nature of the alleged violation.25 In the case of a violation of property rights, a right to financial compensation can be deemed sufficient.

5

Conclusion

As long as the member states will dutifully implement the safeguards as set forth in the relevant provisions of the RRD, it is difficult to envisage a situation in which either Article 1 Protocol No. 1 or Article 13 of the Convention will be violated.

25 Aksoy v. Turkey (1996), 23 EHRR 553.

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Resolution Regimes for Financial Institutions and the Rule of Law

Alexander Bornemann* When I am speaking on crisis resolution I often end by saying – Do something! Do anything! Goran Lind1 Aucune justice ne s’exerce, comme droit, sans une décision qui tranche. Jacques Derrida2

1

1.1

Rule of law issues relating to resolution regimes for financial institutions

Role and functions of resolution regimes

When used in relation to financial institutions the term ‘resolution’ denotes a set of governmental powers and procedures designed to resolve such institutions’ failure.3 Unlike insolvency proceedings, resolution regimes do not serve the purpose of maximizing returns to creditors but aim at preserving the stability of the financial system in the public interest.4 Owing to this regulatory focus, resolution regimes involve sovereign powers of administrative ‘resolution authorities’.5 In order to avoid the use of public funds that would burden taxpayers and distort competition, resolution regimes require that the costs of the institu-

* 1 2 3 4 5

Views and opinions herein are those of the author and not reflective of the position of the German Federal Ministry of Justice or any other person, body or entity. Comments on Alternatives to Blanket Guarantees for Containing a Systemic Crisis, . ‘Justice, as law, is never exercised without a decision that cuts, that divides’, J. Derrida, ‘Force de Loi: Le Fondement Mystique de L’ Autorité’, 11 Cardozo L. Rev. (1990), p. 920 (962). See Recital 4a of the BRRD-Proposal (infra footnote 16, describing ‘recovery and resolution’ as a tool that includes ‘mechanisms that allow authorities to deal with failing or likely to fail institutions’). See Recital 14 of the BRRD-Proposal (infra footnote 16, positing that resolution action is permissible only if it is ‘necessary in the public interest’). Article 3 of the BRRD-Proposal (infra footnote 16, defining ‘resolution authorities’ as authorities that are empowered to apply ‘resolution tools’ and to exercise ‘resolution powers’).

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Alexander Bornemann tion’s failure be internalized.6 Interferences with the rights of the institution and its stakeholders are thus unavoidable, and corresponding powers of the resolution authority form the heart of any resolution regime. According to the FSB Key Attributes for Effective Resolution Regimes (hereinafter ‘FSB Key Attributes’),7 which form the international benchmark for legislation at the national and regional levels,8 resolution authorities are expected to have the power, inter alia, to remove and replace the institution’s management, to take control of, and manage, the affected institution, to terminate, continue, transfer or assign contracts, to transfer assets and liabilities, to merge the institution with a solvent institution, to write down share capital and creditors’ claims and to convert creditor’s claims into share capital.9 The effects of such actions on the rights of the stakeholders of an affected institution may appear to be comparable to the potential outcomes of a hypothetical insolvency proceeding. However, as resolution takes place in the public interest and as resolution authorities are not bound by general insolvency laws, stakeholders may be differently affected than in the course of a hypothetical insolvency proceeding.10 Vesting an administrative authority with such wide-ranging powers raises concerns in terms of the rule of law, in particular with a view to the formal, procedural and substantive requirements for governmental interventions in private rights as embodied in constitutional law and other higher-ranking norms and principles.

1.2

Illustration: debate over constitutionality of the ‘orderly liquidation authority’ under the U.S. Dodd-Frank Act

Illustrative examples of the issues that resolution regimes raise in terms of the norms and principles emanating from, and associated with, the rule of law are provided by a legal

6

See Recitals 4 and 4b of the BRRD-Proposal (infra footnote 6, positing that shareholders and creditors should bear losses and that public intervention by way of government stabilization tools be used exclusively as a ‘last resort’). 7 Financial Stability Board, ‘Key Attributes for Effective Resolution Regimes’ of October 2011, , endorsed at the G 20 Cannes Summit on 4 November 2011. 8 For an overview of the implementation efforts across FSB members see Financial Stability Board, ‘Thematic Review on Resolution Regimes – Peer Review Report’, April 2013, ; Financial Stability Board, ‘Implementing the FSB Key Attributes of Effective Resolution Regimes – How Far Have We Come?’, April 2013, . Some jurisdictions have already introduced legislation that to a large extent meets the requirements of the FSB Key attributes. See, e.g., the U.K. Banking Act 2008, the Orderly Liquidation Authority under Title II of the U.S. Dodd-Frank Wall Street Reform and Consumer Protection Act 2010, the Dutch Wet bijzondere maatregelen financiële ondernemingen of 2012, the German Restrukturierungsgesetz of 2010 and the French loi n° 2013-672 de séparation et de régulation des activités bancaires of 2013. 9 FSB Key Attributes 3.1-3.9. 10 See Recital 9 of the BRRD-Proposal (infra footnote 16, recognizing that the BBRD provisions may affect the rights of creditors and, in particular, the equal treatment of creditors).

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dispute before the District Court for the District of Columbia11 regarding the constitutionality of the resolution regime introduced in the U.S. under Title II of the Dodd-Frank Act,12 the so-called Orderly Liquidation Authority.13 Plaintiffs, including eight States, allege, inter alia, that the resolution powers conferred on government bodies are insufficiently constrained through adequate due process-safeguards and thus violate the due process clause of the U.S. Constitution.14 Complaining a lack of specificity in the statutory language, it is also claimed that the powers conferred on the resolution authorities are not sufficiently constrained and thus violate the separation of governmental powers mandated by the U.S. Constitution.15

1.3

The European perspective

1.3.1 Proposal for a recovery and resolution directive Looking at the issue from a European perspective, the primary subject of analysis is the proposal for a Directive on the Recovery and Resolution of Credit Institutions and Investment Firms (hereinafter ‘BRRD-Proposal’)16 by which the legislative bodies of the European Union intend to coordinate among the Member States the implementation of the FSB Key Attributes, while providing a minimum level of harmonization for national resolution regimes.17 As regards the relevant standard of review of the BRRD-Proposal in terms of the norms and principles emanating from, and associated with, the rule of law, the provisions of the BRRD-Proposal are to be measured not only against the respective constitutional laws but also, and particularly, against the Treaty on European Union,18 the Treaty on the Functioning of the European Union19 (hereinafter collectively referred to as the ‘EU 11 See Second Amended Complaint dated 13 February 2013, Case No. 1:12‐cv‐01032. 12 Dodd‐Frank Wall Street Reform and Consumer Protection Act of 2010, Publ. L. 111‐203 signed into Federal law on 21 July 2010. 13 12 U.S.C. 5381 et seqq. 14 Second Amended Complaint (footnote 11), ¶¶ 226-243. 15 Second Amended Complaint (footnote 11), ¶¶ 244-250. 16 Proposal for a Directive of the European Parliament and the Council establishing a framework for the recovery and resolution of credit institutions and investment firms and amending Council Directives 2001/24/EC, 2002/47/EC, 2004/25/EC, 2005/56/EC, 2007/36/EC and 2011/35/EC and Regulation (EU) No. 1093/2010, COM(2012) 280. Since the final approval of the BRRD-Proposal is still pending as of the date of delivery of the manuscript, reference is made to the final compromise text informally agreed upon among the European Parliament and the Council in December 2013 and published in Council document 17958/13 dated 18 December 2013 . 17 Article 1 (2) of the BRRD-Proposal: ‘Member States may adopt or maintain stricter or additional rules’; cf. Recital 10 [6] of the BRRD-Proposal: ‘common minimum harmonization rules.’ 18 Treaty on European Union (a consolidated version of which is published in OJ C 326/13 of 26 October 2012). 19 Treaty on the Functioning of the European Union (a consolidated version of which is published in OJ C 326/47).

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Founding Treaties’) as well as the Charter of Fundamental Rights of the European Union (hereinafter ‘Charter’),20 which are applicable in all situations governed by EU law,21 including where national legislation falls within the scope of a EU directive.22 Considering that many of the rights guaranteed under the Charter correspond to rights guaranteed under the Convention for the Protection of Human Rights and Fundamental Freedoms (hereinafter ‘Convention’),23 Article 52 (3) of the Charter provides that the meaning and scope of such rights shall be the same as the meaning of the respective right under the Convention. To that extent, the Convention and the extensive jurisprudence of the European Court of Human Rights (hereinafter ‘ECtHR’) provide authoritative guidance for the interpretation of the Charter.24 1.3.2 Rule of law in EU law The rule of law belongs to the fundamental principles upon which the European Union is founded (Article 2 of the Treaty on European Union).25 Lacking a definition in the EU Founding Treaties and the Charter, the concept of the ‘rule of law’ at first sight appears to be unspecific and not actionable as such.26 It is undisputed, however, that it serves as a conceptual nexus for a set of normatively potent and justiciable sub-concepts, which jointly and severally constrain the exercise of public powers in order to protect private parties

20 OJ C 83/389 of 30 March 2010. 21 Article 51 of the Charter in connection with Article 6 of the Treaty on European Union (TEU). 22 ECJ, case C-418/11 – Textdata Software, § 73 (‘the fundamental rights guaranteed by the Charter must be respected where national legislation falls within the scope of EU law’); case C-617/10 – Åklagaren (‘The applicability of European Union law entails the applicability of the fundamental rights guaranteed by the Charter’). 23 As amended by Protocols Nos. 11 and 14 and supplemented by Protocols Nos. 1, 4, 6, 7, 12 and 13. 24 ECJ, case 279/09 – DEB, § 35 (‘the meaning and the scope of the guaranteed rights are to be determined not only by reference to the text of the ECHR, but also, inter alia, by reference to the case-law of the European Court of Human Rights’); cf. case C-400/10 PPU – McB, § 53 (giving a Charter provision the same meaning and the same scope as the corresponding provision in the Convention, ‘as interpreted by the European Court of Human Rights’); cf. De Schutter, Commentary of the Charter of Fundamental Rights of the European Union, 2006, Article 52 (p. 401) ‘L’article 52 § 3 de la Charte prescrit d’interpréter les dispositions de la Charte qui correspondent à des droits et libertés de la Convention européenne des droits de l’homme ou de ses protocols additionnels en tenant compte de l’interprétation qui en est donnée par la Cour européenne des droits de l’homme.’ 25 Article 2 Treaty on European Union (in connection with the second and fourth Preamble); see, for a historic account and for further details, L. Pech, The Rule of Law as a Constitutional Principle of the European Union, Jean Monnet Working Paper 04/09 (2009). 26 L. Pech, ‘‘A Union Founded on the Rule of Law’: Meaning and Reality of the Rule of Law as a Constitutional Principle of EU Law’, 6 European Constitutional Law Review (2010), p. 359, at 376: ‘It would be difficult to deny that the Court of Justice does not view the rule of law as a rule of law actionable before a court. This means, for instance, that parties in legal proceedings cannot directly rely on the principle of the rule of law to seek annulment of the acts of Union institutions’; F. Amtenbrink, ‘Observing the Rule of Law in the European Union’, 2 Erasmus L. Rev. (2009), p. 1: ‘The concept of the ‘rule of law’ is anything but well-defined, despite its wide acceptance and application.’

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against arbitrary or unjustified interventions.27 When substantiating the rule of law and deriving concrete legal consequences from it, the European Court of Justice (hereinafter: ‘ECJ’) and the European General Court (hereinafter: ‘EGC’) have historically relied on constitutional traditions common to all Member States.28 As the rule of law and comparable concepts forming part of each of the Member States’ constitutional orders are not only open and vague but differ from one another, it has been difficult to reach agreement as to the concrete classification, relative weight and normative reach of the sub-concepts of the rule of law that belong to the relevant common constitutional traditions and, thus, to the rule of law as a constitutional principle of the European Union.29 The ECJ and EGC (hereinafter ‘European Courts’) have, however, identified a set of common traits. According to that case law, the rule of law guarantees the availability of judicial review of EU institutions’ acts30 and includes a ‘principle of sound administration’ obliging EU institutions, inter alia, to conduct a diligent and impartial assessment of the facts before taking a decision,31 to provide affected parties an opportunity to deliver their views on those facts32 and to respect the principle of equal treatment.33 Lately, the rule of law has 27 Pech (supra footnote 25), at 373: ‘the Union rule of law is also construed by the Court of Justice as a “metaprinciple” which provides the foundation for an independent and effective judiciary and essentially describes and justifies the subjection of public power to formal and substantive legal constraints with a view to guaranteeing the primacy of the individual and its protection against the arbitrary or unlawful exercise of public power’; Pech (supra footnote 25), at 52 (‘umbrella principle with formal and substantive components’); Amtenbrink (2009, citing H. Yu & A. Guernsey, ‘What Is the Rule of Law’, who describe the rule of law as ‘a system that attempts to protect the rights of citizens from arbitrary and abusive use of government power’). 28 Pech (supra footnote 25), at 48–69 (showing that the formula of the ‘Community based on the rule of law’ has first been developed by the ECJ before it was codified in Article 6 (1) Treaty on European Union, which reads: ‘The Union is founded on the principles of liberty, democracy, respect for human rights and fundamental freedoms, and the rule of law, principles which are common to the Member States’). 29 See, for an overview of the commonalities, nuances and differences in the conception of the rule of law in European jurisdictions, Pech (supra footnote 25), at 22 et seq. (referring to the Rule of Law in the English legal tradition, the German Rechtsstaatsprinzip and the French État de droit); cf. Pech (2010), at 373 et seq. (noting that ‘the precise list of principles, standards and values the rule of law entails may naturally vary in each legal system’, while stressing that ‘most if not all European legal systems share in common the use of formal and substantive legal standards and have all known an “intensification of judicial review”’). 30 ECJ, case C-521/06 P – Athinaki Techniki AE, § 54; joint cases C-402/05 P and C-415/05 – Kadi and Barakaat, §§ 281, 285; case C-354/04 P – Gestoras Pro Amnistla, §§ 34, 51; case C-50/00-P – UPA, §§ 38-39 and (the landmark) case C-294/83 – Les Verts v. Parliament, § 23: ‘the European Economic Community is a Community based on the rule of law, inasmuch as neither its Member States nor its institutions can avoid a review of the question whether the measures adopted by them are in conformity with the basic constitutional charter, the Treaty’; ECJ, case T-411/06 – Sogelma, §§ 36-37; case T-141/03 – Sniace v. Commission, § 39; case T-2/04 – Korkmaz, § 55. 31 ECJ, case C-269/90 – TU München, § 14; ECJ, case 54/99 – max.mobil Telekommunikation Service GmbH, § 48 (‘diligent and impartial treatment of a complaint is associated with the right to sound administration which is one of the general principles that are observed in a State governed by the rule of law and are common to the constitutional traditions of the Member States’). 32 ECJ, case C-232/02 P(R) – Technische Glaswerke Illmenau, § 85. 33 ECJ, case C-232/02 P(R) – Technische Glaswerke Illmenau, § 85 (‘right to sound administration, which is one of the general principles that are observed in a State governed by the rule of law and are common to the consti-

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been increasingly related to the protection of fundamental rights and, thus, with another principle that Article 2 of the Treaty on European Union refers to as a founding principle of the EU. Seen in this light, it is appropriate to relate the rule of law with the European Courts’ case law that, although making no reference to the term ‘rule of law’, brings to bear principles that form part of the rule of law as contained in the Member States’ constitutional orders.34 Considering, in particular, the functions attributed to the rule of law in the context of the protection of fundamental rights, it can be said that the supremacy of law intends to prevent the arbitrary exercise of public powers, while enabling private parties to plan their behaviour and predict the type and extent of potential governmental interventions.35

tutional traditions of the Member States’); ECJ, joint cases T-270/00 and T-277/00 – Hotel Cipriani, §§ 210211; case T-198/01 R – Technische Glaswerke Ilmenau v. Commission, § 85; cf. case T-229/02 – PKK et al., § 44. 34 ECJ, joint cases 46/87 and 227/88 – Hoechst, § 19: ‘[I]n all the legal systems of the Member States, any intervention by the public authorities in the sphere of private activities of any person, whether natural or legal, must have a legal basis and be justified on the grounds laid down by law, and, consequently, those systems provide, albeit in different forms, protection against arbitrary or disproportionate intervention. The need for such protection must be recognized as a general principle of Community law.’ 35 A popular reformulation of the rule of law has been delivered by F.A. von Hayek, The Road to Serfdom (cited after the condensed version as published in the April 1945 version of Reader’s Digest), at 57: ‘Stripped of all technicalities, this means that government in all its actions is bound by rules fixed and announced beforehand – rules that make it possible to foresee with fair certainty how the authority will use its coercive powers in given circumstances and to plan one’s individual affairs on the basis of this knowledge. Thus, within the known rules of the game, the individual is free to pursue his personal ends, certain that the powers of government will not be used deliberately to frustrate his efforts.’ Cf. P. Craig, The Rule of Law, Appendix 5 to House of Lords Select Committee on the Constitution, 6th Report of Session 2006-2007, Relations between the executive, the judiciary and Parliament (HL Paper 151), p. 97, at 99: ‘A further important aspect of the rule of law is that the laws thus promulgated should be capable of guiding one’s conduct in order that one can plan one’s life’; cf. ECtHR, Malone v. The United Kingdom (Appl. No. 8691/79), § 67 (principle of legality as a ‘measure of legal protection in domestic law against arbitrary interferences by public authorities with the rights safeguarded. [The] law must be sufficiently clear in its terms to give citizens an adequate indication as to the circumstances in which and the conditions on which public authorities are empowered to resort to this secret and potentially dangerous interference with the right’); Halford v. United Kingdom (Appl. No. 28341/95), § 55: ‘As regards the requirement of foreseeability, the Court reiterates that the rule is “foreseeable” if it is formulated with sufficient precision to enable any individual, if need be with appropriate advice, to regulate his conduct’. Hashman and Harrup v. United Kingdom (Appl. No. 25594/94), § 31 (‘The Court recalls that one of the requirements flowing from the expression “prescribed by law” is foreseeability. A norm cannot be regarded as a ‘law’ unless it is formulated with sufficient precision to enable the citizen to regulate his conduct’). Specek v. Czech Republic (Appl. No. 26449/95), § 54 (concept of law includes qualitative requirements, notably those of accessibility and foreseeability). ECJ, cases 46/87 and 227/88 – Hoechst, § 19 (‘any intervention by the public authorities in the sphere of private activities of any person, whether natural or legal, must have a legal basis and be justified on the grounds laid down by law, and, consequently, those systems provide, albeit in different forms, protection against arbitrary or disproportionate intervention’).

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Important elements of the rule of law are thus: – the principle of legality, requiring a pre-existing legal basis authorizing administrative interferences with private rights and allowing private parties to foresee with fair certainty, if, when and how the administration will use its coercive powers;36 – the availability of judicial review of administrative acts, such that the powers of the executive branch are not only kept under ex ante control of the legislator, but also made subject to ex post control by the judiciary;37 – the principle of sound administration, subjecting the executive branch to, largely procedural, obligations in order to ensure that affected parties are provided with an opportunity to be heard and that an impartial and diligent assessment of the facts is conducted, so that the powers are properly used.38 1.3.3

Instantiations of the rule of law in the fundamental rights guaranteed under the Charter While the protection of individual rights might not exhaust the normative reach of the rule of law,39 its protective functions certainly form its genotypic focus.40 It is thus no surprise that most of the aforementioned facets of the rule of law constitute fundamental rights guaranteed not only under national constitutional laws but also under the Charter. In this regard, the rule of law manifests itself in subjective actionable rights, which not only the EU legislator but also, to the extent EU legislation is implemented, national legislators must observe and respect (Article 51 (1) of the Charter). The supremacy of law is reflected in the Charter by virtue of the principle of legality as laid down in Article 52 (1) of the Charter, which requires that limitations to rights and freedoms guaranteed by the Charter must be based on a law that respects the essence of those rights and freedoms, in particular through observation of the principle of proportionality. Judicial review is guaranteed under Article 47 of the Charter, entitling everyone to an effective remedy before an independent and impartial tribunal. And the principle of sound administration is reflected in a right to good administration, which is guaranteed under Article 41 of the Charter and provides for procedural safeguards, including, inter alia, a right to be heard, a right to have one’s affairs handled impartially and fairly and an obligation of the administrative body to give reasons for its decisions.

36 37 38 39

See supra footnote 35. See supra footnote 30. See supra footnotes 31-34. Cf. Pech (2010), speaking, inter alia, of an ‘organizational paradigm of constitutional arrangements’ (at 48) and of a ‘politico-legal benchmark’ (at 63-67). 40 Cf. the preamble to the Convention referring, inter alia, to the rule of law as part of the common heritage, upon which the Convention builds.

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1.4

Rule of law issues – overview

Aiming at preventing, or at least mitigating, adverse effects that the failure of a financial institution is expected to impose on the stability of the financial system,41 resolution regimes generally build on a systemic risk test, requiring in substance that the resolution authority may act only if the (impending) failure of a financial institution poses a threat to financial stability.42 The administration of such systemic risk tests is burdened with the difficulty that ‘financial stability’ and thus ‘threat to financial stability’ are indeterminate terms. Consequently, resolution authorities must be vested with wide-ranging margins of assessment when applying the test in practice or when specifying the test through administrative rulemaking. Additionally, resolution authorities are vested with broad discretionary powers when deciding which resolution tool to apply to a given set of circumstances. The broader such scopes for administrative assessment and discretion are, however, the more problematic the powers appear to be in terms of the principle of legality as laid down in Article 52 (1) of the Charter, which requires, in substance, that the legislator, rather than the executive branch, shall lay down the conditions for the use of administrative powers (see section 2).43 Compared with traditional insolvency proceedings, resolution regimes provide for little, if any, procedural safeguards prior to the taking of actions that affect the rights and interests of the concerned institution and its stakeholders. Pre-intervention notice is generally not given to creditors and other ‘outsiders’, but only to the institution itself, in the latter case subject, however, to potentially harsh time-constraints.44 These constraints to the pre41 See the list of resolution objectives in Article 26 of the BRRD-Proposal (under which resolution is aimed, in particular, at – ensuring the continuity of the institution’s critical functions, including ‘activities, services or operations the discontinuance of which is likely to lead to the disruption of services that are essential to the real economy or to disrupt financial stability’ (Article 2 29 of the BRRD-Proposal); and – avoiding significant adverse effects on financial stability, in particular by preventing contagion, including to market infrastructures, and by maintaining market discipline. 42 Article 27 BRRD-Proposal, requiring in its para. 1 that the institution is failing or likely to fail (subpara. a) without any prospect of improvement by way of private sector solutions (subpara. b) and that the taking of resolution action is necessary in the public interest (subpara. c), while its para. 3 deems an action to be in the public interest if it is necessary for the achievement of, and is proportionate to, one or more of the resolution objectives as specified in Article 26 (see supra footnote 41). 43 Another issue raised by the principle of legality is whether the limitations of the affected freedoms are ‘necessary and genuinely meet objectives of general interest recognized by the Union or the need to protect the rights and freedoms of others’ as required by Article 52 (1) of the Charter. This paper will not engage in an in-depth analysis of these questions. It will thus be based on the assumption that the statutory and regulatory provisions establishing the resolution regimes meet, or could be shaped in a way that meets, the public policy test. 44 The notification requirement of Article 75 of the BRRD-Proposal relates to the institution as the addressee of the potential resolution measure and certain authorities, but not to creditors or other stakeholders of the institution; in addition, the notification requirement is not mandatory until after the taking of the resolution

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intervention rights of the institution and its stakeholders are to be measured against the right to good administration guaranteed under Article 41 of the Charter (see section 3). In addition, resolution regimes generally limit post-intervention review by excluding the availability of rescissory remedies, the execution of which would entail a reversal of the contested action’s legal and practical effects.45 These limitations raise the issue of whether the right to an effective remedy as guaranteed under Article 47 of the Charter is affected (see section 4).

2

Principle of legality

Resolution measures affect, among others,46 the property rights of the concerned institutions, their counterparties, creditors and shareholders (Article 17 of the Charter).47 According to the principle of legality, as laid down in Article 52 (1) of the Charter, such actions are permissible only if authorized by a law that sets out the conditions under which they may be taken. The principle of legality serves as a safeguard to protect fundamental rights by limiting the powers of the executive branch vis-à-vis the beneficiaries of such fundamental rights: The latter should be able to assess under which conditions the governmental powers are triggered, such that they can safely plan their behaviour without having to fear unforeseeable and excessive interventions.48 Additionally, the principle of legality

45 46 47

48

action (‘as soon as reasonably practicable after taking a resolution action’). According to Article 78 para. 0a of the BRRD-Proposal, the Member States may require that certain decisions be made subject to ex ante judicial review. Such ex ante judicial control is not mandatory, however, and it applies only to crisis management measures as defined in Article 2 para. 87a of the BRRD-Proposal. Correspondingly, current resolution regimes in Member States provide for restricted pre-intervention notice requirements. Under German law, e.g., the resolution authority is not required to notify creditors or other stakeholders, if in cases of urgency such notice would or could jeopardize the purpose of the intervention, namely to prevent systemic implications of the institution’s failure (A. Bornemann, in H. Beck, H. Samm & A. Kokemoor (eds.), Gesetz über das Kreditwesen, Kommentar, § 48a at 148-149 (2013)). Article 78 para. 2 of the BRRD-Proposal. Other fundamental rights, such as the freedom to conduct a business (Article 16 of the Charter) or the Freedom of Profession (Article 12 of the German Basic Law) may also be affected. The scope of Article 17 of the Charter covers not only property relating to tangible assets, but any other object of economic interest or value, such as shares (ECtHR, Bramelid and Malmström v. Sweden (Appl. Nos. 8588/79 and 8589/79): ‘Une action de société anonyme ayant une valeur éconornique peut étre considérée comme un bien’ and Olczak v. Poland (Appl. No. 30417/96), § 60) and creditors’ claims (ECtHR, Pressos Compania Naviera SA v. Belgium (Appl. No. 17849/91), § 31; van Marle et. al. v. the Netherlands (Appl. No. 17849/91), § 41). ECtHR, Malone v. United Kingdom (Appl. No. 8691/79), § 67 (Principle of Legality as a ‘measure of legal protection in domestic law against arbitrary interferences by public authorities with the rights safeguarded. [The] law must be sufficiently clear in its terms to give citizens an adequate indication as to the circumstances in which and the conditions on which public authorities are empowered to resort to this secret and potentially dangerous interference with the right’); Halford v. United Kingdom (28341/95), § 55: ‘As regards the requirement of foreseeability, the Court reiterates that the rule is “foreseeable” if it is formulated with sufficient precision

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ensures that the powers of the executive branch remain constrained and kept under ex ante control of the legislator and ex post control of the judiciary.49 The principle, thus, also functions as an element of the constitutional requirement of the separation of governmental powers and the concept of democracy.50 It is obvious that the functions of the principle of legality could easily run dry, if it did not require more than the mere presence of an enabling law. In order to become meaningful and functional it must rather require that the law be clear and specific enough to allow a solid determination that the law is (or is not) intended to apply to facts of the kind that constitute the case of its actual application. This implication of the principle of legality is reflected in the ECtHR’s51 doctrine of the ‘quality of the law’.52 The European Courts have

49

50

51

52

to enable any individual, if need be with appropriate advice, to regulate his conduct.’Hashman and Harrup v. United Kingdom (Appl. No. 25594/94), § 31 (‘The Court recalls that one of the requirements flowing from the expression “prescribed by law” is foreseeability. A norm cannot be regarded as a “law” unless it is formulated with sufficient precision to enable the citizen to regulate his conduct.’). Specek v. Czech Republic (Appl. No. 26449/95), § 54 (concept of law includes qualitative requirements, notably those of accessibility and foreseeability); cf. ECJ, cases 46/87 and 227/88 – Hoechst, § 19 (‘any intervention by the public authorities in the sphere of private activities of any person, whether natural or legal, must have a legal basis and be justified on the grounds laid down by law, and, consequently, those systems provide, albeit in different forms, protection against arbitrary or disproportionate intervention’). S. Greer, The Margin of Appreciation: Interpretation and Discretion under the European Convention on Human Rights, Council of Europe Publishing, Strasbourg Cedex (2000), p. 16: ‘The net effect is to limit the discretion of national executive and administrative bodies in favor of national courts.’ See for the interrelations between the rule of law and the separation of powers, P.R. Verkuil, ‘Separation of Powers, the Rule of Law and the Idea of Independence’, 30 Wm. & Mary L. Rev. (1989), p. 301, at 303 et seqq. From the perspective of German constitutional law, see Federal Constitutional Court, BVerfGE 108, 282 (310 et seqq.); 83, 130 (142); 49, 89 (126) (holding that the rule of law (Rechtsstaatsprinzip) and the command for democracy (Demokratiegebot) require the legislature to take all material and essential decisions and to refrain from delegating such decision-making to the executive branch); cf. L. Cariolou, in EU Network of Independent Experts on Fundamental Rights, Commentary of the Charter of Fundamental Rights of the European Union (2006), Article 47 (p. 359) (interpreting the right to judicial review as ‘an essential aspect of democratic accountability’). For doubts as to the competence of the ECtHR in matters relating to the separation of powers, see D. Kosar, ‘Policing Separation of Powers: A New Role for the European Court of Human Rights?’, EuConst (2012), p. 33. ECtHR, RTBF v. Belgium (Appl. No. 50084/06), §§ 103 et seqq.; Sildedzis v. Poland (Appl. No. 45214/99), § 48: ‘the principle of lawfulness also presupposes that the applicable provisions of domestic law be sufficiently accessible, precise and foreseeable’; Hentrich v. France (Appl. No. 13616/88), § 42 (stating that a legal provision that operates ‘arbitrarily and selectively’, while being ‘scarcely foreseeable’ and failing to provide ‘basic procedural safeguards’ does not ‘sufficiently satisfy the requirements of precision and foreseeability implied by the concept of law within the meaning of the Convention’); Halford v. United Kingdom (Appl. No. 28341/95), § 55 (requiring ‘sufficient precision’); Leander v. Sweden (Appl. No. 9248/81), §§ 50-51: ‘the law in question mustbe accessible to the individual concerned and its consequences for him must also be foreseeable […]the law has to be sufficiently clear in its terms to give them an adequate indication as to the circumstances in which and the conditions on which the public authorities are empowered to resort to this kind of […] dangerous interference’; Malone v. United Kingdom (supra endnote 46), § 67. The doctrine can be traced back to the ECtHR judgment in the matter of Malone (supra endnote 46), § 30, according to which the requirement of an authorizing law ‘does not merely refer back to domestic law but also relates to the quality of the law, requiring it to be compatible with the rule of law.’ See Bacquer, La calidad

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subscribed to the general idea of this doctrine,53 which has been increasingly invoked by Advocates General Villalón54 and Kokott55 in recent opinions. Certain adaptations seem appropriate, when applying the doctrine to secondary EU legislation. Where such legislation requires implementation by the Member States’ legislators, it raises the issue of whether compliance with the demands deriving from the quality of law-doctrine is to be ensured at the EU level or at the level of the implementing Member States. As has been convincingly pointed out by Advocate General Villalón, where the European Union legislator decides to introduce legislation that interferes with fundamental rights it necessarily bears responsibility for the respect of the affected fundamental rights, and it should, thus, ensure compliance, inter alia, with the quality of law-requirement.56 Thus, in case of a EU directive, the provisions of such directive must themselves be sufficiently specific and clear.

2.1

Vagueness and margins of assessment in the context of systemic risk tests

As the debate over the constitutionality of the U.S. Orderly Liquidation Authority illustrates, resolution regimes have been confronted with the allegation that the powers conferred on resolution authorities lack specificity and clarity and that the regimes thus fail to provide for meaningful and enforceable limits to authorities’ discretion.57 Given that the triggers used in most resolution regimes (including the regimes envisaged by the BRRD-Proposal) also lack detailed and comprehensive definitions, allegations of a similar kind may be relevant when measuring these regimes against the demands for specificity under the principle of legality. Resolution regimes are commonly conditional on the presence of a failureinduced threat to financial stability, that is, a situation in which the institution concerned is about to fail, whereat such failure has the potential of posing a substantial threat to financial stability.58 Such a test (hereinafter referred to as ‘Systemic Risk Test’) involves

53

54 55 56 57

58

de la ley según la jurisprudencia del Tribunal europeo de derechos humanos, Derecho Privado y Constitución (2003), at 377. ECJ, joint cases C-465/00, C-138/01 and C-139/01 – Österreichischer Rundfunk, § 77 (requiring ‘sufficient precision to enable the citizen to adjust his conduct’ and compliance with the ‘requirement of foreseeability laid down in the case-law of the European Court of Human Rights’); ECJ, case C-413/08 P – Lafarge v. Commission, § 99. Opinions of Advocate General Villalón in joint cases C-293/12, C-594/12 – Data Retention, §§ 108-132 and in case C-70/10 – Scarlet Extended, §§ 94-99. Opinions of Advocate General Kokott in case C-275/06 – Promusicae, § 53. Cf. Opinions of Advocate General Villalón in joint cases C-293/12, C-594/12 (supra endnote 52), § 117. Second Amended Complaint (supra endnote 9), ¶¶ 161, 245 (‘unlimited power’ delegated to the Treasury Secretary ‘to determine that a company should be liquidated under the Orderly Liquidation Authority’ and to deviate from bankruptcy law’s priority rules and to treat similarly situated creditors differently). Article 27 (1) & (3) in connection with Article 26 of the BRRD-Proposal (requiring that the institution ‘is failing or likely to fail’ and that the taking of action is necessary in the public interest, in particular to avoid ‘significant adverse effects to financial stability’); §§ 48a (1), 48b of the German Banking Act (Kreditwesengesetz)

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uncertainties, as the term ‘financial stability’, like any other term deriving from or building on it, including ‘systemic relevance’, ‘systemic importance’ or ‘systemic risk’, is indeterminate.59 The requirement of clarity and specificity is not absolute, however. Laws cannot always be drafted in specific terms. Acknowledging that clarity and specificity in language is only possible where the subject matter is readily accessible for a description by means of a simple combination of specific terms, the ECJ and the ECtHR have approved vagueness in laws, where the discretionary margins conferred by such laws to the administrative authorities were channelled and ring-fenced through substantive provisions contained in non-legislative sources of law (such as case law or ordinances)60 or through procedural safeguards providing protection against arbitrary and ill-founded interferences.61 Likewise, the ECJ has repeatedly held that margins of assessment and discretionary powers can, and shall, be compensated by way of procedural safeguards, such as, in particular, a sufficient reasoning that allows and facilitates the judicial review of the decision.62 Thus, ‘the fact that a law confers a discretion is not in itself inconsistent with the requirement of foreseeability, provided that the scope of the discretion and the manner of its exercise are indicated with sufficient clarity, having regard to the legitimate aim in question, to give the individual adequate protection against arbitrary interference.’63 Against this background it should be clear that the indeterminacies inherent in Systemic Risk Tests should not necessarily give rise to objections in terms of the quality of lawdoctrine. These indeterminacies are an inevitable consequence of the complexity of the

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60 61 62 63

(requiring a threat to the viability of the institution (Bestandsgefährdung), which is expected to cause a threat to financial stability (Systemgefährdung)); Sections 7-9 of the British Banking Act 2009 (requiring, inter alia, that the institution is ‘failing, or likely to fail, to satisfy the threshold conditions for the permission to carry on regulated activities’ and the taking of the action is necessary, having regard to the public interest in the stability of the financial system, the maintenance of the confidence in the stability of the banking system or the protection of depositors); Article L 612-1 (4) No. 4 in connection with Articles L 613-31-15 (1), L 613-3116 (1) of the French Code Monétaire et Financier (requiring that the institution is failing (defaillante) and that action is mandated in order to serve the public interest (finalités d’intérêt public) in preserving the financial stability (stabilité financière) and maintaining systematically critical functions (assurer la continuité des activités, des services et des opérations des établissements dont la défaillance aurait de graves conséquences pour l’économie)). Bornemann (supra footnote 44), § 48a at 5, 46-58 (pointing, inter alia, at the metaphorical character of the term systemic relevance and the terms and concepts (such as ‘contagion’, ‘domino effect’, ‘chain reaction’, ‘meltdown’) used to circumscribe or define it). ECJ, case C-501/11 P – Schindler, § 57; case C-413/08 P – Lafarge v. Commission, § 94; ECtHR, G. v. France, § 25. ECtHR, Leander v. Sweden (Appl. No. 9248/81), § 66. ECJ, case C-269/90 – TU München, § 14; case C-405/07 P – Netherlands v. Commission, § 56. ECJ, case C-501/11 P – Schindler, § 57; case C-413/08 P – Lafarge v. Commission, § 94; ECtHR, Margareta and Roger Andersson v. Sweden (Appl. No. 46544/99), § 75.

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covered subject matter. The financial system forms a dynamic and complex system. The forces and mechanisms by which it is driven cannot be captured and described in simple models and clear-cut terms. It is, thus, virtually impossible to devise a universal and exhaustive description of the nature and of all possible future instantiations of the risks to which the stability and the functioning of the financial system is exposed in case of the failure of a single institution.64 While the determination of a disruption of financial stability (and of the causal chains and conditions that led to it) might be easily made from an ex post perspective, for example when looking back to the events that took place in the late summer of 2008 (in particular, the collapse of Lehman Brothers and the bailout of AIG), it is quite a demanding task to make corresponding forecasts for all possible and conceivable future situations, in which financial institutions could fail. This is not to say that the research community and the community of regulators lack adequate concepts of systemic risk. On the contrary, based on empiric evidence and on general theoretical models, various meaningful concepts of systemic risk have been developed.65 However, the relevant communities are far away from having reached a solid and definite agreement as to an ultimate and exhaustive description of the nature and the specific instantiations of systemic risk.66 There might be no better illustration to this finding than the still unresolved and ongoing dispute as to whether Lehman’s collapse was actually in and of itself the single cause of the systemic disruptions that followed.67

64 We are reminded here of Rudolph Carnap’s philosophical insights, according to which the choice of simple and clear-cut basal term (such as within Euclidean geometry) may come at the cost of an inextricably complex description of the world, whereat the alternative choice of complex and, thus, empirically indeterminate basal terms (such as within relativity theory) may yield simple and operational descriptions of the world. (Carnap, Über die Aufgabe der Physik und die Anwendung des Grundsatzes der Einfachheit, Kant-Studien 28 (1923), 90-107); cf. Bornemann, in: Beck?Samm/Kokemoor (supra footnote 44), § 48b at 43 (claiming that an exhaustive list of all possible contagion channels that could become relevant in case of a financial institution is impossible, since it would require firm knowledge of all factors and drivers by which future crises might be governed. Bornemann (supra footnote 44), § 48b at 43 (claiming that an exhaustive list of all possible contagion channels that could become relevant in case of a financial institution is impossible, since it would require firm knowledge of all factors and drivers by which future crises might be governed). 65 See, e.g., IMF/BIS/FSB, Report to G20 Finance Ministers and Governors – Guidance to Assess the Systemic Importance of Financial Institutions, Markets and Instruments (October 2009), retrievable under ; M. Drehmann & N.A. Tarashev, ‘Systemic Importance: Some Simple Indicators’, 3 BIS Quarterly Review (2011), p. 24 et seqq.; M. Drehmann & N. Tarashev, ‘Measuring the Systemic Importance of Interconnected Banks’, BIS Working Paper (March 2011), p. 342, ; O. De Brandt & P. Hartmann, ‘Systemic Risk: A Survey’, ECB Working Paper No. 35 (2000); S.L. Schwarcz, ‘Systemic Risk’, 97 Geo. L. Rev. (2008), p. 193. 66 Bornemann (supra footnote 44), para. 46. 67 The most prominent sceptics are K. Ayotte & D.A. Skeel, ‘Bankruptcy or Bailout?’, 35 J. Corp. L. (2010), p. 469 (490 et seqq.); D.A. Skeel, Written Testimony before the Subcommittee on Commercial and Administrative Law/Committee of the Judiciary (October 2009), p. 5 (claiming that ‘Lehman’s default did not cause any more disruption in the financial markets than the government’s decision to bail out AIG two days later’).

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It follows that the conceptual and factual uncertainties associated with the phenomenon of ‘systemic risk’ cannot, and should not, prevent legislators from conditioning resolution measures on a Systemic Risk Test. On the contrary: just because the subject matter is complicated, the legislator should be allowed to use sufficiently broad language in order to be able to capture the subject matter adequately. To hold otherwise would be to force legislators to capitulate before complex subject matters.68 Although it is certainly desirable that the legislator provides some guidance by way of describing exemplary instances of systemic risk,69 it must be clear that such descriptions cannot exhaust the concept of systemic risk, and that therefore any such list of descriptions would necessarily have to be supplemented by a broad, open and unspecific catch-all provision.70 As long as the legislation – in connection with the complementing regulations and case law – makes clear in a conceptional and functional perspective, for what purposes the powers have been created, the command for specificity and clarity is met, since it provides a sufficient foundation for a rational inter-subjective discourse on whether an action taken was covered by the legal authority upon which it was based.71 In this respect, it becomes understandable why the ECJ and the ECtHR have both held that the use of discretionary margins is not objectionable as long as compliance with certain procedural safeguards, such as in particular the obligation to give verifiable and reviewable reasons for its interpretation of the law, provides adequate protection against arbitrary or ill-founded interference.72 Another issue deserves careful attention, however: some resolution regimes provide that the taking of a resolution action is lawful if based on the information available and reason68 For an economic analysis of vagueness in law and its implications G.K. Hadfield, ‘Weighting the Value of Vagueness: An Economic Perspective on Precision in Law’, 88 Cal. L. Rev. (1994), p. 541. 69 See § 48b (2) of the German Banking Act (Kreditwesengesetz), listing factors that, in the light of the practical experiences and the current research findings at the time of the legislation might be relevant in determining the existence of a threat to financial stability (Bornemann (supra footnote 44), § 48b at 43); cf. the public commentary to the draft bill for the Restrukturierungsgesetz, BT-Drucks. 17/3024, at 64 (referring to the common and typical contagion channels that had been observable at the time of the drafting of the bill: ‘Die Aufzählung der in diesem Zusammenhang zu berücksichtigenden Faktoren ist nicht abschließend, sondern verweist vielmehr auf die nach bisherigem Erfahrungsstand gängigen Ansteckungskanäle, über welche die Stabilität des Finanzsystems durch die Schieflage eines einzelnen Instituts beeinträchtigt werden kann’). 70 Likewise, the list of factors provided by § 48b (2) of the German Banking Act (Kreditwesengesetz) is not exhaustive (Bornemann (supra footnote 44), § 48b, para. 43). 71 For the German law see Bornemann (supra footnote 44), §§ 48a, 159-162; M. Höfling, Finanzmarktregulierung – Welche Regelungen empfehlen sich für den deutschen und europäischen Finanzmarkt?, Verhandlungen des 68. Deutschen Juristentages, Gutachten F (2010), S. F-59: ‘Wichtig ist ferner eine ausführliche Dokumentation des komplexen “faktengesättigten” Evaluations – und Entscheidungsfindungsprozesses. Sie ermöglicht – und strukturiert in gewisser Weise auch – eine angemessene gerichtliche Kontrolle und sichert damit zusätzlich die Rechtsstaatlichkeit der Intervention’. 72 Cf. ECtHR, Yukos v. Russia (Appl. No. 14902/04), § 598; Sunday Times v. United Kingdom (Appl. No. 6538/74), § 49; Kokkinakis v. Greece (Appl. No. 14307/88), § 40; ECJ, case 55/75, § 8 – Balkan Import-Export GmbH; case C-120/97 – Upjohn, §§ 27 et seq.; case C-55/06 – Arcor, §§ 160 et seqq.; case C-269/90 – TU München, §§ 13-14; C-405/07 P – Netherlands v. Commission, § 54.

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ably ascertainable by the resolution authority at the time of the taking of such action, the threshold conditions for an intervention were met.73 One consequence of this approach is that an action taken by the resolution authority cannot be challenged ex post on the ground that – based on the knowledge of additional factors having become ascertainable after the fact – the original determination was incorrect. Some commentators interpret this approach as a problematic subjectification of the systemic risk trigger and claim that such subjectification is incompatible with the commands of the principle of legality.74 The criticism is unfounded, however. It fails to recognize that it is neither the purpose nor the effect of such subjectificating language to make the resolution authorities’ subjective views authoritative and to vest the resolution authority with unfettered discretion. The reference to information ascertainable by the resolution authority is rather intended to give consideration to the hypothetical and prospective character of systemic risk determinations: whether a danger for financial stability exists is always a matter of a prognosis of the effects the breakdown of the institution in question is expected to have. Such forecasts are necessarily based on a variety of assumptions, take place under circumstances that are subject to quick and dynamic change and must be conducted within a limited period of time that sets limits to the possibilities of determining all relevant facts.75 Given these objective (!) constraints to the possibility of determining all relevant facts at the time the action is to be taken, the systemic risk determination is, as a matter of principle, probabilistic, rather than deterministic in nature.76 A determination based on ex ante available and reasonably (i.e. objectively) ascertainable information at the time of the taking of the decision remains, thus, correct regardless of whether from an ex post perspective the determination can be falsified on the basis of after-acquired knowledge.77 As long as the standard to be applied remains an objective one and builds on the information objectively available and ascertainable at time of the taking of the decision, it is not problematic to designate the perspective of the acting authority as authoritative.78 In contrast, an unqualified subjectification, such as language that would exclusively rely on the actual view of the authority would be objectionable. It would fail to limit the margin of assessment conferred on the resolution authority and therefore violate the principle of legality, unless it can be ‘saved’ by way of

73 See § 48a (1) para. 2 German Banking Act (Kreditwesengesetz); comparable approaches are being promoted within the negotiations of the BRRD, see Article 27 (1) of the BRRD-Proposal. 74 R. Willemsen & J. Rechel, in G. Luz, W. Neus, M. Schaber, P. Schneider & M. Weber (eds.), Kreditwesengesetz (KWG) (2011), § 48a, para. 8 (referring to § 48a of the German Banking Act (Kreditwesengesetz)). 75 Bornemann (supra footnote 44), § 48a, para. 164. 76 Id. 77 Id. 78 Id.

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a restrictive interpretation that objectifies the interpretation standard along the lines unfolded above.79

2.2

Use of and choice between specific resolution tools and powers

The commands for specificity and clarity derived from the principle of legality do not only require that the intervention triggers be sufficiently clear and precise, but also that the law governs the use of the triggered powers.80 The law must thus establish the scope of the discretionary margin conferred on the administrative authority, and it must also guide the manner of exercise of authority’s discretion.81 It has been argued that the Dodd-Frank Orderly Liquidation Authority is failing to sufficiently constrain and guide the use of the powers conferred on the FDIC and, in particular, the choices between them.82 Similar allegations could be made vis-à-vis other resolution regimes to the extent they lack specific and detailed rules as to the use of, and choice between, triggered intervention powers. The BRRD-Proposal83 provides the resolution authority with broad discretion as to which powers it may use once the intervention thresholds are met: Article 26 (1) BRRD-Proposal allows the authority to choose between the various tools and powers foreseen in the BRRDProposal. Besides, the authority may combine such tools and powers (Article 31 (3) BRRDProposal) and even apply additional powers not foreseen in the BRRD-Proposal (Article 31 (7) BRRD-Proposal). Discretionary margins are not limited to these general matters, but extend to a variety of tool-specific features. The resolution authority may in particular exempt certain classes of liabilities from the application of the bail-in tool and thereby 79 In this regard, good reasons can be given that Article 27 (1) of the BRRD-Proposal (‘if the resolution authority considers’) should be subjected to a restrictive interpretation. 80 ECtHR, Malone v. United Kingdom (Appl. No. 8691/79), § 79 (requiring that the law lays down with ‘reasonable clarity the essential elements of the authorities’ powers’ and objecting that in the present case ‘it cannot be said with any reasonable certainty what elements of the powers to intercept are incorporated in legal rules and what elements remain within the discretion of the executive’ and that the law ‘does not indicate with reasonable clarity the scope and manner of exercise of the relevant discretion conferred on the public authorities’). 81 In distinguishing between margins of assessment (relating to the interpretation of the statutory triggers for intervention) and discretion (relating to the choice between the triggered powers), this paper follows the dogmatic framework of German administration law. See for the corresponding concepts of Beurteilungsspielraum (relating to the requirements of a norm) and Ermessen (relating to the legal consequences of such a norm) M. Jestaedt, in M. Burgi et al., Allgemeines Verwaltungsrecht (13th ed.) (2006), § 10, para. 10 et seqq. While it is well recognized that other jurisdictions may not make such distinctions (see, however, S.D. Sastre & K. Weyand, in J.-P. Schneider, Verwaltungsrecht in Europa, Band I (2007), p. 326 et seq., noting that Spanish law seems to also distinguish between conceptos normativos indeterminados and potesdad discretional), the distinction between margins of assessment and discretion is made here, because it also seems to provide a useful analytical framework for the discussion of particular issues (see D.J. Galligan, in Administrative Discretion and Problems of Accountability – Proceedings of the 25th Colloquy on European Law (1995), p. 11 (16)). 82 Supra footnote 12. 83 Id.

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privilege the corresponding creditors at the expense of the remaining creditors (Article 38 (3) BRRD-Proposal). Margins of discretion are not, as such, incompatible with the principle of legality. Rather, they are a useful and indispensable tool to allow for lawmaking with respect to complex subject matters.84 In many areas, including areas involving complex technical85 or economic86 matters, it is often impossible to determine in advance which specific legal consequences should attach to each of the possible combinations of facts that might characterize any possible future case of application.87 Assuming that the principle of legality is reinforced, when legislative norms are applied according to the legislative intent, it can be mandated in the spirit of the principle of legality to vest the competent authority with discretion, because the authority will be in a better position than the legislator to assess the facts in the given case and relate them to the legislative intent, provided, however, that adequate safeguards are put in place that provide protection against arbitrary or ill-founded interferences. Among the most important safeguards to consider in this respect are the procedural safeguards entailed in the right to good administration under Article 41 of the Charter, as their observance will ensure, inter alia, that the authority bases its action on adequate and complete information (which includes the views of the affected parties) and that it provides reasons for its decision. The latter aspect is a necessary prerequisite for enabling the party to establish whether the authority has used its discretion in a way that is compatible with the legislative intent and whether there are grounds for a successful judicial review of the decision (which is guaranteed under Article 47 of the Charter).88 Measured against this background, it seems appropriate to leave resolution authorities with discretion as to the choice of tools and instruments. Under the BRRD-Proposal, resolution authorities are not provided with unlimited discretion. The authorities are generally bound to choose such tools and powers that best achieve the prescribed resolution objectives (Article 26 (1) BRRD-Proposal). This brings in objective constraints to the range of tools and powers theoretically available in a given situation. It would be obviously outside the scope of discretion to apply a tool, or make use of a power, when the use of such tools or 84 D.J. Galligan, Discretionary Powers – A Legal Study of Official Discretion (1990), at 20 et seqq. 85 Cf. ECJ, case C-269/90 – TU München, §§ 13-14; case C-405/07 P – Netherlands v. Commission, § 54. 86 J. Winkler, ‘The Political Economy of Administrative Discretion’, in M. Adler & S. Asquith, Discretion and Welfare, Heinemann, London (1981). 87 ECtHR, Yukos v. Russia (Appl. No. 14902/04), § 598; ECJ, case 55/75, § 8 – Balkan Import-Export GmbH; case C-120/97 – Upjohn, §§ 27 et seq.; case C-55/06 – Arcor, §§ 160 et seqq.; case C-269/90 – TU München, §§ 13-14; C-405/07 P – Netherlands v. Commission, § 54. 88 Cf. ECtHR, Yukos v. Russia (Appl. No. 14902/04), § 598; Sunday Timesv. United Kingdom (Appl. No. 6538/74), § 49; Kokkinakis v. Greece (Appl. No. 14307/88), § 40; ECJ, case 55/75, § 8 Balkan Import-Export GmbH; case C-120/97 – Upjohn, §§ 27 et seq.; case C-55/06 – Arcor, §§ 160 et seqq.; case C-269/90 – TU München, §§ 13-14; C-405/07 P – Netherlands v. Commission, § 54.

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power is not suited in a given situation to prevent or mitigate the systemic implications of the resolution process. One might object that the answer to the question of what tool and power is suited in a given case will regularly be guided by the authority’s own systemic risk determination and that, as a result, the authority’s discretion will de facto not be meaningfully limited. Although that is not incorrect, the discretion of the authority will nevertheless be limited, since (1) the actions taken must be consistent and coherent with the factual determinations made and (2) the prospect of a judicial review of both the determinations and the decisions based on them will discipline the authority to use its powers according to the law’s intentions.89

3

Right to good administration and the due process of law

The foregoing discussion has shown that the procedural safeguards guaranteed by the right to good administration under Article 41 of the Charter are an important element in the evaluation of the compatibility of resolution regimes with the rule of law. The corresponding obligations for the interfering authority include: an obligation to provide parties who would be affected by the envisaged action both notice and an opportunity to be heard, in order to enable the authority to consider such party’s view on the case; and an obligation to give reasons for its decision (Article 41 (2) of the Charter). While resolution regimes generally meet the second requirement by subjecting resolution authorities to an obligation to give a detailed description of the underlying systemic risk analysis (Article 74a (2) (a) of the BRRD-Proposal),90 the obligation of resolution authorities to provide the institutions and its stakeholders with notice and an opportunity to be heard is substantially relaxed. The notification requirement of Article 75 of the BRRD-Proposal, for example, relates exclusively to the institution as the direct addressee of the potential resolution measure and certain authorities, but does not extend to creditors or other stakeholders of the institution; in addition, the notification requirement is not mandatory until after the taking of the resolution action (‘as soon as reasonably practicable after taking a resolution action’). According to Article 78 (0a) of the BRRD-Proposal, the Member States may require that certain decisions be made subject to ex ante judicial review. Such ex ante judicial control is not mandatory, however, and it applies only to crisis management measures as defined in Article 2 (87a) of the BRRD-Proposal. Correspondingly, current resolution regimes in Member States provide for restricted pre-intervention notice requirements. Under German law, for example, the resolution authority is not required to notify creditors or other stakeholders, if in cases of urgency such notice would or could 89 Case C-269/90 – TU München, § 14. 90 Cf. § 48b (3) German Banking Act (Kreditwesengesetz), § 203 (a) Dodd-Frank Act.

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jeopardize the purpose of the intervention, namely to prevent systemic implications of the institution’s failure.91 Although forming an important part of the ‘due process of law’ the requirement of advance notice is not absolute. Where the very purpose of the applied law would be frustrated by the provision of ex ante-notice, such notice is, if substituted by adequate guarantees and safeguards, dispensable.92 Both the ECJ and the ECtHR have, thus, accepted exceptions to the rule that notice and opportunity to state one’s view must be given prior to the taking of action.93 Resolution is intended to prevent or at least mitigate the adverse effects the failure of an institution is expected to have on financial stability. As experiences during the recent financial crisis have shown, the threat to financial stability materializes in a dynamic setting, in which the financial difficulties of the concerned institution can worsen within days or even hours. Thus, the resolution process is not only subject to severe time constraints, but additionally burdened by the fact that proliferation of information relating to the financial condition of the concerned institution can cause a run on that institution that leads to the very situation that resolution intends to avoid.94 Against this background, the provision of notice to affected parties appears to be, a limine, problematic, when put in relation to the purpose of resolution. Pre-intervention notice, thus, appears to be generally dispensable, for example in relation to the body of creditors and to holders of publicly traded shares.95 In relation to the affected institution (and its directors), notice will, however, generally be mandated, as confidentiality will be easier to ensure and as the resolution authority can expect to receive information that will help it to better understand the facts and to identify the right remedies.96

4

Right to effective remedy and fair trial

As shown, procedural safeguards that allow for, and facilitate, meaningful judicial review are an important element in helping to reconcile the award of discretion to the competent authority with the commands of the principle of legality. Since, in this perspective, the 91 Bornemann (supra footnote 44), § 48a at 148-149. 92 ECJ, case C-27/09 P – People’s Mojahedin Organization of Iran, §§ 67, 75; joint cases C-402/05 P and C-415/05 P – Kadi and Al Barakaat International Foundation v. Council and Commission, § 342. 93 ECJ, case C-27/09 P – People’s Mojahedin Organization of Iran, §§ 67, 75; Joint cases C-402/05 P and C-415/05 P – Kadi and Al Barakaat International Foundation v. Council and Commission, § 342; ECtHR, Leander v. Sweden (Appl. No. 9248/81), § 66; Margareta et al. v. Sweden (Appl. No. 12963/87), § 75. 94 Bornemann (supra footnote 44), § 48a at 147-148. 95 Id. 96 Id.

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problems associated with authorities’ discretion and with judicial review are closely linked and interconnected, the allegation of an unreasonable curtailment of judicial review made vis-à-vis the Dodd-Frank Orderly Liquidation Authority97 deserves particular attention. Other resolution regimes, including the ones envisaged under the BRRD-Proposal,98 do also limit judicial review of measures taken by resolution authorities99 and could thus be made subject to similar allegations.

4.1

Scope and standard of judicial review

The Dodd-Frank Act limits the judicial review of the systemic risk determination to two of the total of eight elements of the systemic risk determination in section 203 (b),100 namely to the issue of whether the institution is in default (or danger of default) and whether it qualifies as a covered financial company.101 The court has to take its decision within 24 hours of the filing of the petition – on a strictly confidential basis and without prior public disclosure. If the court does not take a decision, the petition (for the appointment of the FDIC as receiver) is granted by operation of law.102 Besides, the court may not review the determinations de novo, but its review is exclusively bound to an arbitrary and capricious standard.103 At the same time, post-intervention review is excluded or at least limited. This combination of the time constraints, the limited scope and the generous review standard has given rise to concerns as regards the compatibility of section 203 (b) with the U.S. constitution. From a (continental) European perspective, these concerns seem plausible, as such limitations to the reviewability of intrusive administrative acts would probably be unprecedented in Europe. And indeed, the limitations on judicial review provided for in 97 Supra footnote 12. 98 The BRRD-Proposal provides for a right to challenge the resolution authority’s decision to take resolution action, but restricts that right by excluding any (automatic or court-ordered) suspension effect and limiting the review to the legality of the decision and its implementation as well as the adequacy of the compensation. Additionally, the annulment of the decision does not affect the legal effects of that decision and its implementation, if rescinding the decision and its implementation would disadvantage parties that benefitted from the action (Article 78 (2) RRD-Proposal). 99 Under German law, the order made by the resolution authority is subject to limited judicial review: the enforcement of the order is not subject to automatic or court-ordered suspension (§ 49 German Banking Act (Kreditwesengesetz)); actions may be brought only by the institution concerned within two weeks after the order is made (§ 48r (1) German Banking Act); the order may not be invalidated merely because the compensation was inadequate, as in that case the only available remedy is an adjustment of the compensation (§ 48r (2) German Banking Act); finally, the legal consequences of the order and its implementation may not be rescinded, unless three conditions are cumulatively met: (1) the rescission would not have consequences that endanger financial stability, (2) it would not violate interests of third parties that are worthy of protection and (3) it is practicably and legally possible (§ 48s (1) German Banking Act). 100 Codified at 12 U.S.C. § 5383 (b). 101 Section 202(a)(1)(A)(iii), codified at 12 U.S.C. § 5382 (a)(1)(A)(iii). 102 Section 202(a)(1)(A)(v), codified at 12 U.S.C. § 5382 (a)(1)(A)(v). 103 Section 202(a)(1)(A)(iii), codified at 12 U.S.C. § 5382 (a)(1)(A)(iii).

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the BRRD-Proposal seem to be much more modest. However, having a closer look, the differences turn out to be much less radical. First, judicial review provided for under the Dodd-Frank Act is a remedy available ex ante, that is prior to the entering of the institution into resolution. Given the weight of the public interest at stake (financial stability) and the time constraints that will regularly be dictated by the impending systemic risk, it seems reasonable to subject the court to a time limit. Otherwise the matter could, and regularly would, resolve itself through a materialization of the impending systemic risk, a process that could be accelerated through a spreading of information or rumours in connection with the filing. In contrast, judicial review permitted under the BRRD-Proposal is available ex post and, thus, in situations in which there is no reason to limit on a substantial scale the timing or the scope of the review, given that the possibility of an actual and effective rescission of the measures and their enforcement is precluded (Article 78 (2) lit. d BRRD-Proposal). Second, the limitation of the review to the default or imminent default of the institution must be seen in conjunction with the fact that (1) under the condition of an imminent default or default the alternative to entering into resolution is the commencement of insolvency proceedings, which regularly also involve infringements of debtors’ and stakeholders’ rights, and that (2) the resolution process under the Orderly Liquidation Authority ensures every creditor at least what he would have received had the appointment of the FDIC as receiver not occurred.104 It comes to bear in this context that under most insolvency laws neither the debtor nor the creditors can contest the opening decision on grounds other than the absence of the debtor’s insolvency. Obviously, a debtor would not have standing to contest the opening decision on the ground that its failure would not have any adverse effect on financial stability. In this perspective, the exclusion of the systemic risk test from judicial review appears to be less radical than at first sight. And finally, although the arbitrary and capricious standard seems, at first glance, to be an extraordinary lax standard, it is not unprecedented in U.S. administrative law.105 And it must also be observed that the ECJ in reviewing decisions of administrative agencies has constantly accepted to a certain extent the assessments carried out by the latter.106 The difference between the U.S. approach and the approach taken in the BRRD-Proposal,

104 Section 210(d)(2), codified at 12 U.S.C. § 5390(d)(2). 105 See Administrative Procedure Act, at 5 U.S.C. § 706, c. Cf. Yakus v. United States, 321 U.S. 414, 433 (1944); Franklin Savings Association v. OTC, 934 F.2d 1127, 1142 (10th Cir. 1991). 106 ECJ, case C-272/09 P – KME, § 94; case C-386/10 P – Chalkor, § 76; case C-405/07 P – Netherlands v. Commission, § 55; case C-55/06 – Arcor, § 160 et seqq.; case C-120/97 – Upjohn, § 34; case C-269/90 – TU München, § 14; case 55/75 – Balkan Import, § 8.

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therefore, boils down to the question of whether the application of the arbitrary and capricious standard leaves the authority a broader prerogative of assessment than it enjoys according the jurisprudence of the ECJ. In determining whether such limitations to judicial review are consistent with Article 47 of the Fundamental Rights Charter, regard has to be given, inter alia, to the jurisprudence of the European Courts for Human Rights on Article 13 of the Convention, ruling that lax review standards may render a judicial remedy ineffective, in particular if they exclude any consideration of the question of whether the interference with the applicant’s rights was justified under the Convention provisions107 or if the authority is vested with unfettered discretion, so as to hinder the court entirely from reviewing substantive issues.108 The ECJ, likewise, has held that Article 47 of the Charter requires a review of the legality of the challenged act and that, where such act has involved the exercise of discretion, the review of legality includes a review of the exercise of discretion.109 This holds true even where the exercise of discretion involves complex economic assessments.110 In particular, the ECJ will not only review whether the evidence relied upon by the acting body is factually accurate, reliable and consistent but also whether that evidence contains all the information that must be taken into account in order to assess the facts and whether it is capable of substantiating the conclusions drawn from it.111 Thus, despite the often used phrase that the acting body enjoys ‘wide discretion’ or a ‘substantial margin of discretion’, courts are not precluded from carrying out the full and unrestricted review, in law and in fact, required of it under Article 47 of the Charter.112 Thus, the mere fact that resolution authorities are vested with discretionary margins when using their powers does neither mean that the courts will be prevented from reviewing the exercise of that discretion nor that such discretionary margins are in and of themselves problematic when measured against the demands of Article 47 of the Charter.

107 ECtHR, Grady v. United Kingdom (Appl. No. 33985/96), § 138; Hatton v. United Kingdom (Appl. No. 36022/97), § 141 et seq. 108 ECtHR, Hasan & Chaoush v. Bulgary (Appl. No. 30985/96), § 100. 109 ECJ, case C-386/10 P – Chalkor, § 54: ‘whilst, in areas giving rise to complex economic assessments, the Commission has a margin of discretion with regard to economic matters, that does not mean that the Courts of the European Union must refrain from reviewing the Commission’s interpretation of information of an economic nature.’ 110 Id. 111 Id.; cf. case C-12/03 P – Commission v. Tetra Laval, § 39; case C-525/04 P – Spain v. Lenzing, §§ 56 and 57. 112 ECJ, case C-386/10 P – Chalkor, § 82.

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Prohibition against a reversal of the decision’s legal consequences

Resolution regimes usually exclude the possibility of a rescission of the legal consequences of a resolution action if the action itself has been declared to be unlawful.113 The question thus arises whether an effective remedy within the meaning of Article 47 of the Fundamental Rights Charter and Article 13 of the Convention requires the possibility of reversing the consequences of unlawful acts. In this perspective, the limitation of available remedies to pecuniary compensation could be problematic, since it fails to recognize the interest of the affected parties to have the status quo ante reinstalled. However, the ECtHR has recognized that the right to objections (Article 6 of the Convention), which shares many characteristics with the right to an effective remedy under Article 13 of the Convention, is not absolute.114 Rather, it may be subjected to limitations, if such limitations serve a legitimate purpose, while observing the demands of proportionality115 and retaining the ‘very essence of the right’.116 These requirements are met with respect to the exclusion of rescissory remedies in the context of resolution action: First, due to the size, interconnectedness and complexity of the institution’s business, it will, in many cases, either be impossible or unreasonably costly to rescind the totality of the consequences of the action taken. Second, even where rescission is theoretically possible, it would frustrate legitimate interests of stakeholders and market participants having relied on the effects of the resolution measure. Third, the reversal of an action designed to prevent or mitigate systemic disruptions might by itself be prone to create a threat to financial stability. In this perspective, the exclusion of rescissory remedies seems justifiable at least, if conditioned on these reasons. Following this reasoning,117 § 48s (1) of the German Banking Act (Kreditwesengesetz) conditions the availability of rescissory remedies on the determination that such rescission is (a) objectively feasible and reasonable, (b) does not violate the rights of third parties and (c) does not give rise to a threat to financial stability. Although Article 78 (1) lit. d) of the BRRD-Proposal refers only to the legitimate interests of affected parties, it should, in practice, not fall short of the parallel provision in German law referring to all of the three cases: both the case of impossibility/unreasonableness and the case of a threat to systemic risk will in most cases involve, or require, the frustration of expectations of stakeholders or market participants. Limitations to judicial review that take account of these reasons appear to constitute proportionate limits, as the protection of legitimate 113 Article 78 (2) lit. d RRD-Proposal. Cf. § 48s (1) of the German Banking Act (Kreditwesengesetz). 114 See Opinion of Advocate General Mengozzi, case C-334/12 RX II – Jaramillo et al., § 58: ‘According to the case-law of the European Court of Human Rights relating to the interpretation of Article 6(1) ECHR, the “right to a court”[…] is not absolute.’ 115 ECtHR, Camberrow MM5 AD v. Bulgaria (Appl. No. 50357/99); cf. Olczak v. Poland (Appl. No. 30417/96). 116 Opinion of Advocate General Mengozzi (supra endnote 113), § 59. 117 See the official comment on the German Restructuring Act, BT-Drucks. 17/3024, p. 71.

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expectations of market participants and financial stability is a legitimate aim (which justifies resolution regimes and resolution action in the first place) and as the impossibility of a rescission puts objective or economic limits to the feasibility of rescissory remedies. Finally, the right to judicial review is not excluded as such, as the measures can be fully reviewed with a view to a claim for compensatory damages.

5

Conclusions

Resolution regimes come into play in emergency situations, involve complex business, financial and economic assessments and must be taken within limited time horizons. In order to make resolution regimes feasible it is thus necessary to confer on resolution authorities broad margins of assessment and of discretion, to curtail procedural rights of the affected parties and to exclude rescissory judicial remedies. Each of these features raises issues in terms of the rule of law, which is intended to protect private parties against arbitrary and ill-founded interferences with their rights. Although these issues must be taken seriously, as the supremacy of law is not dispensable as such, the regimes of the kind envisaged by the BRRD-Proposal are not in and of themselves incompatible with the demands of the rule of law. Borrowing from Justice Frankfurter a well-known dictum, it seems appropriate to say that the rule of law is not a static yardstick.118 It is rather a dynamic system of normative sub-concepts, which in their concurrence are to ensure the achievement of their objectives, namely to control government powers and to protect private rights. As the real world is not constructed in a way to fit certain configurations of the rule of law, the rule of law must, if it is to succeed, adapt to the specificities of the respective subject matter. The rule of law has proved to be adaptive and innovative, for example by requiring and emphasizing ex post participation and judicial review where ex ante participation and review is not feasible with a view to the legislative objectives pursued. The approach taken by the BRRD-Proposal and by most national regimes seems appropriate to meet the requirements deriving from the rule of law-doctrine. As the preceding analysis has shown, though, resolution authorities will have to put a particular emphasis on the provision of sufficient and comprehensive reasons for the taking of their actions and, in particular, to make explicit the factual assumptions upon which the systemic risk determination is based. In the context of resolution regimes the rule of law will be put into effect through a diligent and comprehensive documentation of the factual assessments and the exercise of discretion, so as to document that the action taken is compatible with the purposes of the legislative

118 Cf. Joint Anti-Fascist Refugee Comm. v. McGrath, 341 U.S. 123, at 162-163; cf. Pech (2010), at 376 (stating that the rule of law as a precise rule of law would ‘potentially run afoul of its own requirements, for the simple reason that the rule of law itself is not entirely clear or certain in meaning.’).

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authority. This will not only facilitate the judicial review but also discipline resolution authorities to make responsible use of their powers.

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Part 4 Treatment of Cross-Border Groups

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Federal Deposit Insurance Corporation and Bank of England Memorandum on Resolving Globally Active Systemically Important Financial Institutions

Paul Davies*

1

Introduction

In December 2012 the Federal Deposit Insurance Corporation (FDIC) in the United States and the Bank of England (BofE) in the United Kingdom reached an agreement on a memorandum for resolving globally active and systemically important financial institutions.1 Like other formal memoranda issued by sovereign states, it is a non-binding document, in this case one jointly authored by the bank resolution authorities of the United States (FDIC) and the United Kingdom (Bank of England) setting out their expectations as to how they would handle the resolution of a G-SIFI. In addition to its potential importance for the signatory authorities, it is a document of some general importance, because the memorandum explicitly identifies itself as an exercise in implementing some aspects of the Financial Stability Board’s (FSB) Key Attributes of Effective Resolution for Financial Institutions of October 2011.2 By adopting these Key Attributes the 24 state members of the FSB committed themselves to action at the national or (in Europe) the EU level to embody those attributes in legislation. The memorandum has relevance to a number of the Key Attributes, particularly to Attribute 3.2 (ix), which states: Resolution authorities should have at their disposal a broad range of resolution powers, which should include powers to do the following […]

* 1 2

Allen & Overy Professor of Corporate Law, University of Oxford. The text of the agreement is available on: . Available on: .

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Carry out bail-in within resolution as a means to achieve or help achieve continuity of essential functions either (i) by recapitalising the entity hitherto providing these functions that is no longer viable, or, alternatively, (ii) by capitalising a newly established entity or bridge institution to which these functions have been transferred following closure of the non-viable firm (the residual business of which would then be wound up and the firm liquidated). It is also of relevance to Attribute 8, which states: Home and key host authorities of all G-SIFIs should maintain CMGs [Crisis Management Groups] with the objective of enhancing preparedness for, and facilitating the management and resolution of, a cross-border financial crisis affecting the firm. CMGs should include the supervisory authorities, central banks, resolution authorities, finance ministries and the public authorities responsible for guarantee schemes of jurisdictions that are home or host to entities of the group that are material to its resolution, and should cooperate closely with authorities in other jurisdictions where firms have a systemic presence. Clearly, the FDIC/BofE memorandum is not a full-scale implementation of Attribute 8. The memorandum involves only two jurisdictions, whereas Attribute 8 anticipates the creation of CMGs in the home and all ‘key’ host authorities. Nevertheless, it is not a bad start since it appears that 88% of the international assets and operations of the top US banks are in the United Kingdom, and the top UK banks have a substantial part of their overseas operations in the United States.3 So the memorandum covers a large chunk of the territory of these jurisdictions’ globally important banks, but far from all of it. Second, it should be noted that the FDIC and the BofE are engaged in their capacity as resolution authorities only. In particular, the BofE is not engaged as prudential regulator, as supervisor of financial institutions or as a central bank, although it has both these functions.4 On the US side an extension of the scope of agreement would have involved bringing into the memorandum additional institutions, notably the Federal Reserve and Financial Stability Oversight Council. Thus, the memorandum does not cover the whole of the field envisaged by the FSB for a Crisis Management Group, but it does deal with the 3

4

Cleary Gottlieb, Alert Memo, 2 January 2013. It has also been stated that 12 of the world’s 28 G-SIFIs are headquartered in the United Kingdom or United States (Speech by Paul Tucker (BoE) and Martin Gruenberg (FDIC), Financial Times, 12 December 2012). Prudential regulation and supervision is carried out by the Prudential Regulatory Authority (PRA), which is in effect a subsidiary of the Bank of England.

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issues most likely to be controversial in a cross-national context, namely, the funding of the resolution and the co-ordination of the national resolution authorities regulators involved. Nor is this memorandum an ‘institution-specific cross-border agreement’ (COAG), as envisaged in Section 9 of the Key Attributes. The focus of the memorandum is on the general resolution mechanisms in the two countries, not on their application to a particular G-SIFI. It is much less likely that this second class of memorandum will be made public.5

2

General approach

The memorandum outlines a mechanism for resolving cross-border corporate groups containing a G-SIFI. The approach described is based on the ‘single point of entry’ (SPE); that is, the focus is on resolving the parent company. The expectation is that if this approach is successful, the other group companies will not need to be put into resolution. Indeed, it is important for the smooth running of the scheme that they should not be, even if those other group companies are based in a different jurisdiction from that in which the parent company is located (see further below). In order for this approach to work it is important that both losses in the operating subsidiaries (if they are significant) be up-streamed to the parent company pre-resolution and that liquidity be downstreamed to the operating subsidiaries in the resolution process. Both objectives can be achieved if, pre-resolution, the parent company holds all or nearly all the equity in the subsidiary or has made subordinated loans to the subsidiary and if, in the resolution process, the parent subscribes for new equity in the subsidiary or makes additional subordinated loans. The SPE approach is in contrast to the multiple points of entry (MPE) approach. Here, more than one company in the group is put into separate resolution proceedings, with the consequent splitting up of the previous unified group. This is necessarily a more complex process. Nevertheless, the memorandum accepts that in some cases the MPE approach will be appropriate, although the SPE approach is preferred (and is the only one analysed in the memo). The arrangements apply to globally systemic financial institutions, whether banks or not. The majority of the financial institutions identified as globally systemic are in fact banks.

5

The FSB’s progress report of April 2013 states that no institution-specific agreement has yet been made (FSB, ‘Implementing the FSB Key Attributes of Effective Resolution Regimes – How Far Have We Come?’, 3 April 2013).

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Paul Davies The FSB identified 28 banks as G-SIFIs as at the end of 2012,6 but only 9 insurance companies,7 and (as yet) no other type of financial institution. The FSB’s view so far has been that traditional insurance business does not generate systemic risks and so insurers are classified as systemically important only to the extent they engage in non-traditional insurance or non-insurance (NTNI) business.8 In order to limit the scope of the paper, it will proceed on the basis that the G-SIFI is in fact a bank. Four general propositions can be said to underlie the memorandum, though they are not specifically identified as such within it. 1. No post-crisis resolution procedure can be credibly proposed that does not impose losses on unsecured creditors. A taxpayer-funded bailout, from which these creditors emerge whole, is not acceptable. This does not necessarily exclude the possibility that, after unsecured creditors have been bailed in, some public money will be injected into the bank. 2. In particular, the resolved entity will need liquidity if it is to operate as a going concern and, at least initially, it is likely that this liquidity will have to be provided by the state, since private repo markets are likely to be closed to the resolved bank for a period of time. 3. The failing bank is likely to be near or even below its regulatory capital requirements. The resolved entity will thus need access to capital if it is to meet the regulatory standards. Bail-in may help the resolved entity to meet the required capital standards – though liquidity is still likely to remain a problem.9 4. The business model of the failing bank will need to be reformed if the resolved entity is not to run into the same set of problems again in the near future.

3

US and UK approaches: functional but not formal convergence

In some ways it is remarkable that the United States and the United Kingdom have been able to reach an agreement on the resolution of G-SIFIs, because their approaches to bank resolution have been divergent historically and, in relation to systemically important banks, have converged only slightly post the crisis. Although the United Kingdom has converged 6 7 8 9

FSB, ‘Update of the List of Global Systemically Important Banks’, November 2012. Three banks had been removed and two added as compared with 2011. FSB, ‘Global Systemically Important Insurers and the Policy Measures That Will Apply to Them’, July 2013. International Association of Insurance Supervisors, ‘Insurance and Financial Stability’, November 2011. For example, to the extent that the unsecured debt in the failing bank has value after a write-off to absorb losses and that residual value is mandatorily transformed from debt into equity, the demands on the bank’s cash flows will be reduced and its capital increased. However, this transformation will do nothing to improve the liquidity of the bank’s assets, which may be inadequate to permit it to function effectively (for example, where those assets consist mainly of items that cannot readily be sold or used as collateral in repo markets).

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on the US model for handling non-systemic deposit-taking banks, the two countries’ approaches to the resolution of systemically important banks and G-SIFIs more generally continue to be divergent. This divergence is mainly due to the insistence in the United States that the executive and its agencies should not have the power in any case to bail out banks (Congressional approval will be required for that) so that Dodd-Frank makes use of an ‘Orderly Liquidation Procedure’ for systemically important banks (and other financial institutions). Not under this compulsion, the United Kingdom focuses on the recapitalization of the failing bank rather than its liquidation. Thus, a remarkable amount of the content of the memorandum can be understood as each jurisdiction explaining to the other the (different) way in which it proposes to handle the resolution of failing G-SIFIs – but with the common objective of achieving, within SPE resolution, the four conditions mentioned above. The US procedure. Long before the crisis the United States had developed a rather effective mechanism for resolving deposit-taking banks (but this did not apply to bank holding companies or other non-bank financial institutions). Given the highly fragmented nature of the US retail and commercial banking sector, these powers have generally been applied to only small banks.10 Although the Federal Deposit Insurance Corporation Act gives the FDIC a wide range of powers, the most frequently used methods for handling a deposittaking bank are a transfer of the insured deposits alone (i.e. both the assets and the liabilities attached to the deposits) to a solvent third party (‘insured deposit transfer’) or a ‘purchase and assumption’, where some additional assets and liabilities are transferred as well. The third party may think it worthwhile to pay something to acquire the failing bank’s deposit book and other assets, or it may be paid a sum by the FDIC to do so. The former procedure is used in about a third of the cases and the latter in about half.11 This process happens very quickly, often over a weekend. In a successful transfer or purchase and assumption: – the depositors avoid any loss; – the functioning transferee will provide the capital and liquidity to support the transferred business; – the costs of effecting the transfer can be met out of the deposit guarantee fund constituted out of ex ante industry contributions (at least to the extent that the fund is saved expenditure by the transfer of the deposits to the solvent transferee); – the rump of the business is wound up and the non-transferred creditors (for example, bond holders) will absorb losses in the winding up in the usual way. They will benefit from the protection (usually not worth anything) that their losses in the winding up 10 In 1984 the FDIC resolved Continental Illinois, then the United States’ seventh largest bank. This was a controversial operation because the FDIC covered the deposits of all depositors, even those above the formal guarantee limit. The Continental Illinois case has been identified as the first ‘too big to fail’ bank. 11 D. Skeel, The New Financial Deal, Wiley, Hoboken (2011), pp. 122-123.

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of the rump will be no more than if the whole bank had been placed into the standard liquidation procedure (‘no creditor worse off’ rule).12 This procedure, when successfully carried out, neatly achieves all four objectives mentioned above. In addition, it means that the management responsible for the failure of the bank is displaced. Under Dodd-Frank13 (Title II) the FDIC’s powers have been extended to financial institutions which are systemically important. Formally, this was achieved not by a simple extension of the FDIC’s deposit-taker powers to systemically important financial institutions, but through the creation of a separate ‘Orderly Liquidation Authority’, of which the FDIC is the administrator.14 Systemically important banks thus now fall under Title II of Dodd Frank rather than under the FDIC Act. However, as appears very clearly from the memorandum, the FDIC anticipates using its Title II powers very much on the purchase and assumption model. Translated into the resolution of the holding company (‘topco’) in a systemically important financial institution, the procedure, the memorandum explains, would work as follows. The failing topco will be liquidated (which in itself will ensure that creditors left behind in the topco will bear losses). However, following the FDIC’s traditional procedure, the topco’s assets (mainly its shareholdings in the operating subsidiaries and intra-company loans) and its viable businesses (if it is also an operating company) will be transferred to another private sector entity. The group’s recovery and resolution plan (RRP – now required of systemically important financial institutions) should already have provided indications on which assets should be transferred and which retained within the topco. The obvious objection to the purchase and assumption model for G-SIFIs is that it is far from obvious that other financial institutions will be available in a crisis able and willing to take on the businesses of the failing topco that are thought to be viable.15 Anticipating the argument that a potential purchaser of a G-SIFI may not be readily available, the 12 The reason this protection is insubstantial is that loss of franchise value a bank suffers if it goes into liquidation so that the bank’s assets will have to sold at a large discount to their going concern value. 13 Dodd-Frank Wall Street Reform and Consumer Protection Act, 2010. 14 Title II also involves the participation of agencies other than the FDIC, both in designating the financial institution as systemically important and in the taking of the decision to trigger the resolution procedure (see Skeel, 2011, ch. 8), but these matters are outside the scope of the memorandum. 15 Though in fact substantial parts of the business of Lehman Brothers were transferred quickly after its collapse, mainly to Barclays Bank (United Kingdom) and Nomura (Japan). For an optimistic assessment of how much more of the value of Lehman’s would have been preserved had the OLA procedure been available at the time, see ‘The Orderly Liquidation of Lehman Brothers (Holdings) Inc. under the Dodd-Frank Act’, 5 FDIC Quarterly, No. 2 (2011), p. 31.

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memorandum suggests that the assets to be transferred will be held initially by a ‘bridge bank’, run by the FDIC, and transferred to a private entity later. Although the liquidation of the topco causes non-transferred creditors to bear losses, it does nothing to capitalize the bridge bank or ultimate private entity. To the extent, therefore, that the unsecured claims have value in the liquidation, these creditors will not be cashed out but instead will be given equity or subordinated debt in the transferee. However, this does not deal with the provision of liquidity to the bridge bank. Here the FDIC has the power to borrow funds from the Treasury to provide liquidity against collateral – but not for a capital injection. Any losses on the liquidity provision are to be recovered, first, in the liquidation of the topco and, second, by levy on the financial industry. The FDIC’s borrowing powers for liquidity purposes are, in fact, extensive. They are reconciled with the ‘no bailout’ rule on the basis that the bridge-bank is not insolvent, because more assets than liabilities will be transferred to it. Finally, the businesses run by the operating subsidiaries will be reorganized according to the group’s RRP.16 The UK procedure. The United Kingdom had no special resolution procedure for banks or other financial institutions until 2009. The UK Banking Act 2009 created a procedure based on the US model for deposit-taking, non-systemic banks, and in 2012 this procedure was extended to non-banks. However, in the UK procedure there is greater scepticism of the proposition that there would necessarily be a purchaser for a UK G-SIFI, even after a period in a bridge bank.17 Perhaps more important, SPE resolution is more difficult to implement in the United Kingdom because the topco usually has substantial operating businesses, unlike in the United States where the topco is typically nearer to the model of a pure holding company. The UK arrangement would considerably complicate the required rapid transfer of viable businesses to a bridge bank, which is the first step envisaged in the US procedure. It would no longer simply be a question of transferring the shareholdings of the topco in viable subsidiaries to the bridge bank. As the memorandum puts it, ‘Using the existing statutory transfer powers [under the Banking Act 2009, as extended] would involve separating and transferring large and

16 This procedure is set out in paras. 24-29 of the joint document. For more detail see also ‘The Orderly Liquidation of Lehman Brothers Holdings Inc. under the Dodd-Frank Act’, 5 FDIC Quarterly, No. 2 (2011), p. 1. In the United Kingdom, in the event that the recapitalization of the failing topco did not produce stability, the Bank of England has transfer and bridge bank powers akin to those conferred on the FDIC. 17 Grounds for this scepticism may be the history of the two banks bailed out by the UK government in the financial crisis. The Royal Bank of Scotland, in which the government holds over 70% of the shares, is not thought likely to be ready to begin the process of a return to the private sector until some date after 2015. Even Lloyd’s Bank, in which the government never held a majority stake, has only in 2013 begun to see the government-held shares being sold into the private market.

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complex businesses from within operating entities to a purchaser or bridge bank, while leaving behind the remaining liabilities and bad assets in the failed firm to be wound up through insolvency. These operating companies may have several thousand counterparties, customers, and contracts. Such a transfer would be almost impossible to achieve over a resolution weekend without destroying value and causing financial stability concerns in multiple jurisdictions.’18 The memorandum reveals that, in fact, the Bank’s preferred strategy for resolving G-SIFIs in the United Kingdom is not purchase and assumption but a recapitalization of the failing bank or other financial company. The resolution mechanism contemplated in the United Kingdom is thus, in technical terms, very different from that contemplated in the United States. It follows that in the UK strategy bail-in is absolutely central. After all, it was the recapitalization of the failing banks (by way of taxpayer injection) that allowed the creditors of banks that failed in the financial crisis to avoid taking any losses, because the taxpayer injection meant that no part of the bank entered liquidation. The aim of the UK procedure is to recapitalize the failing bank on the backs of the bank’s long-term creditors rather than via the taxpayer. In order to achieve this result, the unsecured creditors have to bear losses short of insolvency19 and probably while the shareholders’ equity in the company still has some positive value. In a little more detail, the United Kingdom’s anticipated procedure restores the failing topco to a going concern by writing-down the debt of long-term unsecured creditors20 and, in most cases, by converting it into equity, but without liquidating the topco or transferring its businesses. The now-restored topco is expected to be controlled by its former unsecured creditors, and the former managers, it is expected, will have been removed.21 The existence of a bail-in power is thus central to the UK approach. Because the topco is not liquidated, without the bail-in the unsecured creditors would not bear losses; and without the conversion of debt into equity, the recapitalization of the topco might be

18 Para. 18. 19 These losses will be approximately, but not necessarily exactly, what the unsecured creditors would have borne in a liquidation, for the bail-in procedure requires the administrator to make an ex ante estimate of the losses that need to be covered by a write-off of the debt rather than carrying out that exercise ex post, as in a liquidation. 20 In order to avoid an over-lengthy paper I will not deal with the question of which unsecured creditors should be exempted from bail-in. 21 Such recapitalization can be achieved, of course, by agreement between creditors and shareholders, as in the 2013 recapitalization of the Co-operative Bank. In order to meet regulatory capital requirements, some classes of long-term unsecured creditors swapped their debt for equity, while the previous 100% shareholder injected some extra capital but saw its shareholding fall to 30%. The move was controversial because the previous controlling shareholder was a mutual society and the converting creditors were dominated by hedge funds.

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impossible. Curiously, at the time of the memorandum the UK authorities had no bail-in powers. For that the Bank is dependent upon national transposition of the EU Recovery and Resolution Directive – still not adopted at the time of writing in November 2013.22 By contrast, under the US procedure, bail-in plays a lesser, but still significant, role. It is not needed to impose losses on the creditors (the liquidation procedure will do that), but it is needed to prevent the creditors being cashed out in relation to the residual value of their claims and to transform that residual value into equity in or subordinated loans to the transferee. As in the US procedure, the reorganisation of the group’s businesses is treated as a matter for the new management, in the UK procedure the new management of the topco, and is assumed to take place along the lines set out in the group’s recovery and resolution plan (RRP). This might involve splitting the bank into two or more smaller entities. None of the above deals with the crucial question of liquidity for the resolved topco under the UK procedure. This is not considered in detail in the memorandum, but liquidity could come via (recently extended) lender-of-last-resort facilities from the Bank of England or even directly from the Treasury.23 Overall, both systems set out in the memorandum aim to achieve the same results but through very different methods. In both cases the long-term creditors of the bank will absorb losses (because they are not transferred to a third party and rump of the bank is liquidated (US) or because of an explicit bail-in (UK)). Liquidity for the resolved entity will be provided, at least initially, by the state (through FDIC borrowing from the Treasury in the United States; through the standard mechanisms in the United Kingdom). Capital will be provided by the bail-in creditors (in both systems – though more of it is likely to be needed in the UK system, since there will be no solvent third party buying the viable parts of the business). New management in both jurisdictions will implement a recovery plan.

4

Common Issues

In order to make the above procedures work somewhat in the way envisaged, the following conditions will have to be satisfied.

22 The Financial Services (Banking Reform) Bill currently before Parliament makes extensive changes to UK law in the expectation that the RR Directive will soon be adopted. 23 See paras. 30-38 of the joint paper.

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Debt issuance in topco. Both the US and the UK procedures, in their different ways, produce a recapitalization, either of the topco itself (United Kingdom) or the replacement entity (United States). Unless there is substantial unsecured debt of the appropriate categories in the topco, (i) writing it off will not restore balance sheet solvency, (ii) converting it into equity (either of the topco or its replacement) will not give the former creditors control and (iii) likewise the conversion may not be enough to meet regulatory capital requirements. As noted above, (ii) and (iii) are particular issues in the United Kingdom because there is no assumption that a well-capitalized third party will appear on the scene to acquire all or any of the failing bank’s businesses. A senior Bank of England official has estimated that a UK bank should have an amount of debt capable of bail-in equal to the bank’s minimum capital requirement (itself substantially increased post the financial crisis) plus the amount X, where X is an estimate of the loss a bank could suffer in a stressed scenario that would not be absorbed by its existing equity. Bailing in that amount of debt would permit the bank to absorb the losses not absorbed by the prior equity and then to be recapitalized at the minimum required level.24 There is not only a question of the amount of debt capable of bail-in, but also of its location within the group. Extensive topco debt issuance is common in the United States, less so in the the United Kingdom, where operating subsidiaries may issue the debt (because this removes any structural subordination risk for creditors). So, regulatory requirements for topco debt issuance may be needed to complement this scheme. Group structure.25 The procedures described above have the great advantage that only the topco is resolved, so that, provided the resolution procedure is successful, the operating companies continue undisturbed, running the businesses that they own. Of course, the cause of the group’s weakness may be in one of the operating subsidiaries, in which case it may be necessary to recapitalize not only the topco but also the problem subsidiary (as well as to reorganize the business of the subsidiary). The most obvious ways to do this are via the forgiveness of intra-group debt or by the topco subscribing for additional equity in the subsidiary. International forbearance. Within a single jurisdiction the administrator of the resolution process can be sure that if it wants to operate only at the top level, that is what will happen. If the group has operating subsidiaries in other jurisdictions, however, that decision is not wholly in its hands. The very purpose of understandings of the type discussed in this paper

24 Bank of England, ‘Resolution and the Future of Finance’, speech by P. Tucker, 20 May 2013. 25 For an illuminating analysis of group structures in the context of bail-in see S. Gleeson, ‘Bank Resolution and Bail-ins in the Context of Bank Groups’, (2012) Law and Financial Markets Review, p. 61.

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is to give the regulators of the foreign subsidiary confidence that the resolution effected in another jurisdiction at the topco level will effectively and fairly deal with the creditors of the subsidiary. Consequently, the subsidiary’s regulator can refrain from exercising its resolution powers. Indeed, the United Kingdom expressly stated at the time of the adoption of the memorandum that it would refrain from putting a UK subsidiary of a US parent into resolution if the FDIC were dealing with the issue at the topco level – though no equivalent statement was made by the FDIC. In the financial crisis, a number of national authorities exercised their discretion in a way that favoured national creditors and national interests. Sometimes their action was egregious.26 Some jurisdictions still have specific provisions in their banking laws that favour national interests, such as depositor preference only for national depositors. The incentives for regulators and legislatures to act in this way are strong and obvious. National taxpayers and voters are the ones who keep the politicians in power and the regulators in jobs. Favouring, or appearing to favour, foreign creditors is not likely to be popular with national voters and taxpayers. Memoranda of the type discussed above are formally a weak counterweight to nationalist tendencies that may emerge if resolution procedures have to be triggered. They are not binding agreements, even in international law, but only statements of intention. They are not likely to be a strong constraint in themselves in a time of crisis. One might think they are most likely to fail at the precise point at which they are needed. One possibility is that the expectation of reciprocal benefits will provide a reason for adherence to the terms of a memorandum. ‘I will forbear now in the expectation of forbearance by you in the future.’ The question, then, becomes that of how national authorities can be expected to move from the low trust relationship, which operated by and large during the crisis, to a high trust relationship, in which forbearance is a feasible strategy. Both high trust and low trust equilibria may be conceivable, but the issue is how to move from low to high trust. Here the dense network of CMGs and COAGs envisaged under the FSB’s principles and high levels of inter-state interaction pre-failure that are contemplated may prove confidencebuilding and produce a shift from low trust to high trust. Even so, much is likely to depend on accident. If the first time the procedures are used forbearance is seen to be rewarded rather than punished, that will make it more likely forbearance will occur in the future. 26 The actions of the Icelandic government were perhaps the clearest example of this. It refrained from bailingout its insolvent deposit-insurance scheme (which would have protected all depositors) and enacted legislation that compensated domestic depositors only. Surprisingly, the EFTA court held that this was compatible with EU law. See V. Babis, ‘Abandoning Foreign Depositors in a Bank Failure? The EFTA Court Judgment in EFTS Surveillance Authority v Iceland’, 1 Global Markets Law Journal (2013).

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Forbearance may also work the other way around. If the group’s problems are seen to be located in one or more foreign subsidiaries, the topco regulator may be unwilling to put the whole group into resolution but rather regard the burden of taking action as falling on the subsidiary’s regulator. If this view is shared by the subsidiary’s regulator, all is well and good. However, if the subsidiary regulator believes the topco regulator is forbearing, not in order to advance the interests of the creditors of the group as a whole, but to advance the interests of the creditors resident in the home country, trust in the new arrangements will be undermined. In this connection, it is worth noting that although SPE is analysed in the memorandum as the resolution authorities’ preferred method of handling a failing banking group, neither the FDIC nor the Bank of England is committing itself to this form of intervention. At one level, this is clearly sensible. In a group consisting of a loosely coordinated set of national banking subsidiaries, where the problem arises only in one or some limited number of jurisdictions, national level resolution, implying the detaching of the subsidiaries from the group, may be the most efficient form of resolution. However, such possibilities also create uncertainty about how resolution will proceed in any particular case and generate scope for disagreement about how best to proceed as resolution situations actually arise. To resolve this problem, much weight will fall on the institutionspecific COAGs and their capacity to identify in advance the circumstances in which MPE should replace SPE for a particular institution.

5

Conclusion

Memoranda of understanding in the field of resolution are doubtfully reliable instruments for handling actual failures of cross-border groups. Nobody really knows at this stage whether they (and the pre-crisis coordination contemplated in the Key Attributes) will be enough to resist powerful national protection pressures that are likely to emerge with a G-SIFI failure. Both the United Kingdom and the United States can be seen to be hedging their bets about whether coordinated resolution will work by putting in place measures likely to make it more likely that group entities established within their jurisdictions will be able to survive periods of financial stress – irrespective of what happens to the group as a whole. In the United Kingdom the Vickers Commission recommended – and Parliament is currently enacting – a scheme whereby taking deposits and making loans to consumers and businesses within the European Economic Area either must be or may be included in a ring-fenced entity (RFE).27 The RFE must be separately capitalized, must not lend deposit

27 Independent Commission on Banking, ‘Final Report’, September 2011 (‘Vickers’).

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finance to other group entities, must conduct business with other group entities on an arm’s length basis and, to some degree, be separately governed. The implications of this arrangement for our purposes are two-fold. Assuming the topco is in the United Kingdom, the UK authorities might have less incentive to recapitalize the topco, as described above, if they can be certain that the core banking functions that are important for the United Kingdom can be secured by resolving only the ring-fenced entity. The Bank of England, of course, views things differently: resolving the RFE is something to be contemplated only if recapitalising the topco is impossible or impracticable.28 An example might be where the UK topco holds insufficient bail-in debt to cover the losses incurred. Here, a taxpayer injection would be necessary if the group is to survive, and it is conceivable that the UK government would decide to limit taxpayer exposure by allowing the group other than the RFE to collapse. Another example might be a situation of noncooperation from overseas regulators. There is reason to believe that the United Kingdom would not lightly allow the non-RFE parts of the banking group to collapse. That course of action assumes no social value is attached by the United Kingdom to the investment banking activities of the group. Nevertheless, the ring-fence arrangement to some extent undermines the credibility of the United Kingdom’s commitment to the action it might take under the memorandum and the Key Attributes more generally in relation to UK topcos. The other UK implication arises where the topco is not incorporated in the United Kingdom but in the United States. If the UK operations are carried on through a UK subsidiary, that subsidiary will be subject to the ring-fence requirements. There is some evidence that the Bank of England is putting pressure on non-EEA banks that wish to enter the UK market to do so via a subsidiary rather than a branch.29 The implication here is that the United Kingdom might be less strongly committed to SPE resolution by the US authorities if the United Kingdom could protect its core banking functions by resolving the UK RFE on its own. It was perhaps in order to allay such a fear that the Bank stated at the time the memorandum was adopted that the United Kingdom would not act in relation to a UK subsidiary where the FDIC took action to resolve the US topco.30 Similar concerns arise when looking at the potential weaknesses of the US resolution model. In order to avoid the statutory prohibition on agency use of taxpayer funds to 28 Tucker, 2013, at 13: ‘The introduction of ring-fenced domestic retail banks is, therefore, consistent with the broader international agenda on resolution.’ 29 ‘Bank Regulators Edge Towards ‘Protectionism’’, Financial Times, 9 December 2012. EEA banks, of course, have the right to branch into the United Kingdom. 30 ‘UK Ready to ‘Trust’ US Over Failing Banks’, Financial Times, 10 December 2012.

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recapitalize a failing bank, the businesses transferred to the bridge bank must be solvent (if short of liquidity). With a badly failing banking group, it is possible that only a small proportion of the existing businesses would be transferred and the rest liquidated (including the overseas operations of the liquidated businesses). In these circumstances it would be crucial for the host states to have in place effective procedures for handling the failing domestic operations, including possibly the prior imposition of a ring-fence. Of course, Congress might give ad hoc approval for the recapitalization of the failing topco from taxpayer resources – but the host states would not be able to count on that. Equally, the United States seems not to regard itself as being in a position in which it can rely on the resolution authorities of non-US topcos to keep the group as a whole alive, possibly because resolution memoranda are so far thin on the ground. The Dodd-Frank Act required foreign bank holding companies to be capitalized on a stand-alone basis – a change from established practice.31 When Barclays and Deutsche Bank responded by reorganising their US activities so as no longer to count as bank holding companies, the Federal Reserve responded with rules requiring foreign banks above a certain size to operate in the United States through intermediate holding companies.32 The need to hold capital (and liquidity) at intermediate rather than just at the consolidated level is likely to increase the costs of the banks subject to this requirement and to reduce their competitiveness. The rationale for this move was put explicitly on the grounds of the need to protect the financial stability of the United States in the context of reduced confidence that the home state authorities would take effective action.33 Indeed, a particular advantage of the IHC was stated to be that it would provide ‘U.S. regulators with one consolidated U.S. legal entity to place into receivership under title II of the Dodd-Frank.’34 None of this suggests any great willingness to rely on the actions of foreign regulators. While the twin-track strategy on the part of both the United Kingdom and the United States may be understandable, the preparations of national resolution of the parts of crossborder groups that lie within the jurisdiction undermines the credibility of the proposed SPE resolution strategies for multinational banking groups, since the latter requires host state regulators to refrain from taking resolution action. Unless the FSB’s Key Attributes

31 See especially sections 165, 166 and 171. 32 See ‘Deutsche Bank Avoids Capital Rules’, Financial Times, 21 March 2012 and above endnote 30; and the Board of Governors of the Federal Reserve, Enhanced Prudential Standards and Early Remediation Requirements for Foreign Banking Organizations and Foreign Nonbank Financial Companies; Proposed Rule, 28 December 2012. 33 D.K. Tarullo, ‘Regulation of Foreign Banking Organisations’, 28 November 2012, p. 9: ‘The likelihood that some home-country governments of significant international firms will backstop their banks’ foreign operations in a crisis appears to have diminished.’ 34 Ibid., p. 14.

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are comprehensively developed in short order, it would be a rash person who would bet that in the next financial crisis cross-border co-operation will prevail over the protection of more narrowly conceived national interests.

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According to the Proposal for a Directive Establishing a Framework for the Recovery and Resolution of Credit Institutions and Investment Firms Giulia Vallar

1

1.1

Introduction

The path towards a discipline of insolvent cross-border groups in the proposal for a directive establishing a framework for the recovery and resolution of credit institutions and investment firms

Insolvency of cross-border banking groups is, at the moment, not governed by any set of norms either in the European Union or at an international or other regional level. Therefore, the insolvency of each component of a group has, in principle, to be addressed by the competent courts of the different States in which the group has its companies, separately from that of the other components, as if they were independent entities. Such a situation brings about inconveniences, particularly in those cases in which the group is a highly integrated one, with its several functions spread all over its constituents.1 In the above-mentioned context, the legislative Proposal for a Directive of the European Parliament and of the Council establishing a framework for the recovery and resolution of credit institutions and investment firms and amending Council Directives 77/91/EEC and 82/891/EC, Directives 2001/24/EC, 2002/47/EC, 2004/25/EC, 2005/56/EC, 2007/36/EC and 2011/35/EC and Regulation (EU) No. 1093/2010 (hereinafter ‘the Proposal’), adopted by the Commission on 6 June 2012, is to be welcomed for various reasons, one of them being that it specifically devotes some of its provisions to the issue at hand. Besides some norms regarding groups scattered here and there throughout the entire Proposal, the latter also contains a specific Title V, encompassing Articles 80-83, which is entirely dedicated to ‘[g]roup resolution’. The first set of norms covers preparation and prevention of the crisis, namely the drawing up of recovery plans (Articles 7 and 8), of resolution plans 1

See B. Wessels, ‘Towards a European Bank Company Law?’, in W.A.K. Rank & F.G.B. Graaf (ed.), Financiële sector en internationaal privaatrecht, NIBE, Amsterdam (2011) R. 160 and E. Hüpkes, ‘Rivalry in Resolution. How to Reconcile Local Responsibilities and Global Interests?’, European Company and Financial Law Review (2010), p. 220.

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(Articles 11 and 12) and the assessment and removal of impediments to resolvability (Article 15); transfer of assets between entities affiliated to a group in times of financial distress (Articles 16-22); adoption of early intervention measures (Article 25); financing of resolution (Article 98); relations with third countries’ authorities in case of international (i.e. not merely European) groups (Articles 84, 88 and 89). Articles 80-83 contain provisions on the establishment of resolution colleges, on the exchange of information and on the enactment of resolution. The Proposal is the most recent step of a process that began in 2007, when the Commission launched a public consultation on Directive 2001/24/EC in order to investigate, inter alia, whether the scope of the said Directive should have been extended to cross-border banking groups.2 Nineteen Member States out of thirty-two, as well as the industry, broadly supported the above-mentioned extension, also pointing to a set of possible ways to address the issue.3 This was followed, in October 2009, by a Public Consultation regarding a EU framework for Cross-Border Crisis Management in the Banking Sector, which, as far as the scope of the present paper is concerned, outlined two possible options that could have been adopted in order to address the insolvency of cross-border groups. These consist in (i) developing a framework for the coordination of measures that would continue to be applied at a national level or (ii) providing for an integrated resolution of group entities by a single resolution authority.4 Finally, in October 2010, the Commission issued a Communication on a new EU framework for crisis management in the financial sector,5 whose technical details were then set forth in a public consultation of January 2011.6 The present paper is divided into two parts. The first analyses those provisions that concern the resolution of a group, from resolution plans and the assessment and removal of 2

3

4

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6

European Commission, ‘Public Consultation on the Reorganisation and Winding-up of Credit Institutions’, May 2007, available at: (last visited 21 April 2013). See European Commission, ‘Summary of the Public Consultation on the Reorganisation and Winding-up of Credit Institutions’, December 2007, available at: (last visited 21 April 2013). ‘Communication from the Commission to the European Parliament, the Council, the European Economic and Social Committee, the European Court of Justice and the European Central Bank, An EU Framework for Cross-Border Crisis Management in the Banking Sector’, 20 October 2009, COM(2009) 561, final, available at: (last visited 21 April 2013). European Commission, ‘Communication from the Commission to the European Parliament, the Council, the European Economic and Social Committee, the Committee of the Regions and the European Central Bank, An EU Framework for Crisis Management in the Financial Sector’, COM(2010) 579 final, available at: (last visited 21 April 2013). Available at: (last visited 22 April 2013).

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impediments to resolvability, to the core phase of resolution and to its main characteristics. Moreover, something will be said on groups established partially in the EU and partially outside of it. The second part comments on the system featured in the said norms, also in the light of the models endorsed, in their respective scope of application, by Directive 2001/24/EC on the reorganization and winding up of credit institutions and by the Proposal for the amendment of Council Regulation (EC) No. 1346/2000 on insolvency proceedings (hereinafter ‘the Proposal for the amendment of the EIR’). Then, other proposals recently put forward in the field of insolvency of cross-border financial institutions by certain international bodies will be mentioned. Finally, some general closing remarks on the solution envisaged by the Proposal will be made.

2

2.1

Analysis of the relevant provisions contained in the Proposal

Group resolution plans (Articles 11 and 12)

Starting with group resolution plans, Article 11 (1), first sentence, of the Proposal provides that Member States shall ensure that resolution authorities7 draw up, in times of normal business activity and therefore before the outbreak of any financial crisis,8 group resolution plans. The main role, in the drawing up as well as in the updating of the said plans, is played by the group level resolution authority, namely, according to Article 2 (38) of the Proposal, the resolution authority operating in the Member State in which the consolidating supervisor is situated.9 Such an authority is required to act jointly, within a resolution college,10 with the resolution authorities of all the other entities of a given group and in consultation with the relevant competent authorities.11 Group level resolution authorities may, at their discretion, include in the drawing up and maintaining of group resolution 7

‘Resolution authority’ means, according to Article 2 (17) of the Proposal, an authority designated by a Member State in accordance with Article 3. Article 3 (2) and (3) provides that such an authority should be a public administrative one, such as the competent authorities for supervision for the purposes of Directives 2006/48/EC and 2006/49/EC, central banks, competent ministries or other public administrative authorities. 8 See para. 4.4.3 of the Explanatory memorandum to the Proposal. 9 The consolidating supervisor is, according to Article 2(31) of the Proposal, ‘the competent authority responsible for supervision on a consolidated basis as defined in Article 4 (48) of Directive 2006/48/EC’. Article 4 (48) of Directive 2006/48/EC, in turn, states that ‘“consolidating supervisor” means the competent authority responsible for the exercise of supervision on a consolidated basis of EU parent credit institutions and credit institutions controlled by EU parent financial holding companies or EU parent mixed financial holding companies’. 10 For which see infra. 11 According to Article 2 (20) of the Proposal, ‘competent authority’ means the ‘competent authority as defined in Article 4 (4) of Directive 2006/48/EC or as defined in Article 3 (3) (c) of Directive 2006/49/EC’, namely the national authority that is empowered by law or regulation to supervise credit institutions or investment firms.

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plans resolution authorities of third countries in which the group has established subsidiaries or financial holding companies or significant branches pursuant to Article 42a of Directive 2006/48/EC12 (Article 12.2 of the Proposal). Group resolution plans, according to paragraph 3 of Article 12, shall be updated at least annually and, in any case, after any change to the legal or organizational structure of the institution or of the group, to its business or to its financial situation that could have a material effect on or require a change to the plans. Member States shall ensure that the group level resolution authority has the power to require the parent undertaking and the institutions subject to consolidated supervision pursuant to Articles 125 and 126 of Directive 2006/48/EC to submit to it all the information necessary to draw up and implement resolution plans. This information shall concern themselves, all the legal entities that are part of the group and the companies referred to in Article 1 (c) and (d) of the Proposal. In particular, reference is made to the information and analysis specified in Section B of the Annex to the Proposal.13 Information is provided through draft implementing technical standards developed by the European Banking Authority (hereinafter ‘EBA’) on standard forms, templates and procedures.14 The group level resolution authority, in turn, shall transmit the information here at stake to the resolution authorities of the subsidiary institutions, to the relevant competent authorities15 and to the resolution authorities of the Member States where the companies referred to in Article 1 (c) and (d) of the Proposal are established. The group level resolution authority and the other relevant resolution authorities shall, within four months from the transmission just referred to, make a joint decision on the drawing up of a group resolution plan. EBA may, on its own initiative, in accordance with Article 19 of Regulation (EU) No. 1093/2010,16 assist the authorities just mentioned to reach a decision. In case a resolution authority disagrees with any element of the group level resolution plan, it may, within the four months referred to above and, in any case, before the reaching of a joint decision, refer the matter to EBA in accordance with Article 19 of Regulation (EU) No. 1093/2010. In this case the group level resolution authority shall

12 Directive 2006/48/EC of the European Parliament and of the Council of 14 June 2006 relating to the taking up and pursuit of the business of credit institutions (recast). 13 This is presumably what is to be inferred by Articles 11 (2), 10 (1) and 12 (1) of the Proposal, jointly read. 14 The draft implementing technical standards are to be submitted by EBA to the Commission for adoption in accordance with Article 15 of Regulation (EU) No. 1093/2010 within 12 months from the entry into force of the proposed Directive. 15 Referred to in Articles 130 and 131a of Directive 2006/48/EC. 16 Regulation (EU) No. 1093/2010 of the European Parliament and of the Council of 24 November 2010 establishing a European Supervisory Authority (European Banking Authority), amending Decision No. 716/2009/EC and repealing Commission Decision 2009/78/EC.

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defer its decision and wait for that of the EBA, to which it should then conform. Such a decision should be taken within one month, and the four-month period is treated as the conciliation period within the meaning of the Regulation just mentioned. In case a joint decision cannot be reached within four months, the group level resolution authority shall make its own decision, which should be fully reasoned and should take into account the views and reservations expressed during the four-month period by the other competent authorities involved. Group resolution plans contain plans for the resolution of (i) the parent undertaking or institution subject to consolidated supervision pursuant to Articles 125 and 126 of Directive 2006/48/EC, (ii) individual subsidiary institutions,17 (iii) institutions referred to in points (c) and (d) of Article 1 of the Proposal and (iv) institutions with branches in other Member States in compliance with relevant provisions of Directive 2001/24/EC. Article 11 (3) states the specific content of group resolution plans. They shall (i) set out the coordinated or independent resolution actions in respect of the group as a whole or of part of it, taking into account that the crisis may occur at a time of broader financial instability or systemwide events; (ii) examine the extent to which the resolution tools and powers could be applied and exercised in a coordinated way and identify any potential impediment to a coordinated resolution; (iii) where necessary, identify arrangements for cooperation and coordination with the relevant authorities of third countries; (iv) identify measures necessary to facilitate group resolution; (v) identify how the group resolution actions could be financed and, where appropriate, set out principles for sharing responsibility between Member States, taking into account, in particular, the economic impact of the resolution in the Member States affected and the distribution of the supervisory powers between the different competent authorities. No public financial support should be relied on, except for financing arrangements entered into in accordance with Article 91 of the Proposal.

2.2

Assessment and removal of impediments to resolution (Article 15)

As to the assessment and removal of impediments to resolvability of groups, the procedure set forth in Article 15 of the Proposal is somewhat complicated and confusing as far as deadlines are concerned. However, some essential stages can be identified. Before coming to an analysis of the latter, it is necessary to clarify when a group shall be deemed resolvable. According to Article 13 of the Proposal, this condition is met if the resolution authority believes that it is feasible and credible to either liquidate the group under normal insolvency proceedings or to resolve it without giving rise to significant adverse consequences for the financial systems of the Member States concerned, having regard to the economy or 17 Resolution plans for these institutions should be drawn up in accordance with Article 9 of the Proposal.

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financial stability in that same or other Member State or the Union and with a view to ensuring the continuity of critical functions. In order to assess the resolvability, resolution authorities shall, as a minimum, examine the matters provided for in Section C of the Annex to the Proposal, as specified by EBA in consultation with the European Systemic Risk Board.18 The first step is the one in which the group level resolution authority, in cooperation with the consolidating supervisor and EBA, prepares and submits a report to the parent undertaking or institution subject to consolidating supervision and to the resolution authorities of the subsidiaries, in which it analyses the substantive impediments to the effective application of the resolution tools and the exercising of the resolution powers in relation to the group and recommends any measures that it believes necessary or appropriate to remove the said impediments.19 Under the second step, the parent undertaking or institution subject to consolidating supervision may submit observations to the group level resolution authority and propose alternative measures. Third, such measures shall be communicated by the group level resolution authority to the consolidating supervisor, EBA and the resolution authorities of the subsidiaries. Fourth, with a procedure very similar to the one described in relation to the drawing up of resolution plans, the group level resolution authority and the resolution authorities of the subsidiaries, in consultation with the competent authorities, shall do everything within their power, with possible voluntary assistance from the EBA, to reach a joint reasoned decision, within the resolution college, regarding the identification of material20 impediments and, if necessary, the assessment of the measures proposed in accordance with steps 1 and 2 above. In case any resolution authority disagrees with the main point of view, it may refer the matter to EBA, and therefore the group level resolution authority shall defer its decision. In the absence of a joint decision and of any reference to EBA, the group level resolution authority shall take its own decision, which should be fully reasoned and take into account the other participating parties’ views and observations. Such a decision will then be recognized as conclusive and applied by the competent authorities.

2.3

Resolution colleges (Article 80)

According to Article 80 (1), resolution colleges are entities, clearly parallel to supervisory colleges, that shall be established by the so-called group level resolution authority. The 18 Established under Regulation (EU) No. 1092/2010 of the European Parliament and of the Council of 24 November 2010 on European Union macro-prudential oversight of the financial system and establishing a European Systemic Risk Board. 19 For examples of measures see Article 14 (4) of the Proposal. 20 It is not clear what the difference between ‘substantive’ and ‘material’ could be in this case.

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only case in which group level resolution authorities are not required to establish resolution colleges is when an entity having exactly the same characteristics as those set forth in Article 80 in relation to resolution colleges already exists. In such a case, envisaged by Article 80 (8), all references to resolution colleges contained in the Proposal should be understood as references to the above-mentioned entity. Besides the group level resolution authority, the other members of a resolution college are, first of all and in any case, according to Article 80 (2), the resolution authorities of all the Member States in which a subsidiary covered by consolidated supervision is located and EBA. In case the resolution authorities are not the ‘competent ministries’,21 also the latter shall be members and may attend meetings, in particular those in which issues that may interfere with public funds are to be discussed. As far as EBA is concerned, Article 80 (4), however, seems to be somehow inconsistent with the above-mentioned Article 80 (2). This is because, after having assigned to the recalled institution the necessary powers in order to assure the correct functioning of the colleges, it states that EBA itself, in order to fulfil its mandate, ‘may participate in particular meetings or particular activities as it deems appropriate, but it shall not have voting rights’.22 It is submitted that this is at odds with the quality of member by full right recognized to EBA. An additional member can be the resolution authority of the Member State where a company of the kind referred to in Article 1 (d)23 is established, when the parent undertaking of one or more institutions24 is a company of such a nature. Moreover, when a parent undertaking25 or an institution established in the Union has one or more subsidiaries in a non-EU country, resolution authorities of the said third countries can be invited to participate as observers, subject to confidentiality requirements set forth in Article 76 of the Proposal. Article 80 (6) and 80 (7) of the Proposal foresee additional participants to the meetings or activities of the resolution colleges, with the aim of assuring the completion of some of the tasks provided for in Article 80 (1), second subparagraph.26 First, in order to decide on the need to establish a group resolution scheme,27 participation of the resolution authorities of each Member State in which a subsidiary is established is required; second, in order to secure an agreement on the said schemes and in order to coordinate the use of financing arrangements,28 par21 According to Article 2 (21) of the Proposal, the competent ministries are ‘the finance ministries or other ministries responsible for economic, financial and budgetary decisions according to national competencies’. 22 Emphasis added. 23 Namely, parent financial holding companies in a Member State, Union parent financial holding companies, parent mixed financial holding companies in a Member State or Union parent mixed financial holding companies. These, in turn, are defined respectively in Article 2 (11-14) of the Proposal. 24 Whereby ‘institution’ means a credit institution or an investment firm (see Article 2 (23) of the Proposal). 25 As defined in Article 4 (12) of Directive 2006/48/EC (see Article 2 (6) of the Proposal). 26 For which see infra. 27 On group resolution schemes see infra. 28 On financing arrangements see Title VII of the Proposal and infra.

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ticipation of the resolution authorities of every Member State in which a subsidiary that meets the conditions for resolution is established is required. Finally, Article 80 (3), first sentence, recommends that the public bodies participating in the colleges, presumably referring to all the several resolution authorities mentioned above and to the competent ministries, shall cooperate closely. The group level resolution authority is in charge not only of creating a college but also of coordinating its activities and of convening and chairing its meetings. In particular, in this regard, ex ante, it shall inform all the members of the college, as well as EBA, of the meetings that are going to be held and of the topics that are going to be discussed therein. Moreover, it is competent to decide which authorities and ministries are to be invited to the said meetings on a case-by-case basis. Such a choice should be made, according to Article 80 (3), second subparagraph, keeping in mind the relevance of the issues to be discussed, of the activities to be planned or coordinated and of the decisions to be taken, in particular with regard to their potential impact on the stability of the financial system of the Member States concerned. Ex post, the group level resolution authority shall inform in a timely fashion all the members of the college of all the decisions adopted and of all the actions taken during the meetings. The functioning of the resolution colleges is governed by two sets of norms. A first layer, related to the ‘operational functioning’, is represented by ‘draft regulatory standards’ developed by EBA according to Article 80 (9), for the general functioning of any resolution college. Within 12 months from the entry into force of the Directive, EBA shall submit the above-mentioned standards to the Commission, which, in turn, will adopt them according to Articles 10-14 of the EU Regulation No. 1093/2010. A second, subordinated,29 layer consists in the ‘arrangements and procedures’ established, according to Article 80 (5), by the group level resolution authority, after having consulted the other resolution authorities. These rules are meant to be designed ad hoc for each resolution college. Coming to the nature of the resolution colleges and to the purpose for which they are to be created, it must be said that, in principle, they are not a new type of decision-making bodies, vested with their own powers: they are intangible entities that work as a framework for the performance primarily by the group level resolution authorities and, more in general, by all their other members of the tasks set forth in Article 80 (1). The latter mentions, in its first subparagraph, the tasks referred to in Articles 11, 15 and 83 of the Proposal, namely the drawing up of group resolution plans, the addressing and the removing of impediments to the resolvability of a group and the resolution of a group. It also assesses that the reso29 See Article 80 (9), first subparagraph.

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lution colleges should be used as means to ensure cooperation and coordination with resolution authorities of non-EU countries. The second subparagraph of the cited norm specifies more in depth the kind of tasks the completion of which should be facilitated by the creation of resolution colleges. Besides recalling the above-mentioned Articles 11, 15 and 83, it points to the exchanging of information, which is an essential basis for carrying out all the other tasks, the assessment of the resolvability of a group, the coordination of the public communication related to group resolution strategies and schemes and the coordination of the use of financing arrangements.

2.4

European resolution colleges (Article 81)

A specific kind of resolution colleges are the European resolution colleges, addressed in Article 81 of the Proposal. They should be created if the two following conditions are met: (i) a third country institution or a third country parent undertaking has two or more subsidiary institutions established in the Union; (ii) no arrangements related to the exchange of confidential information with third country authorities are made.30 The European resolution colleges are to be created by the resolution authorities of the Member States where the domestic subsidiary institutions are established. Their activity is exclusively directed to the latter.31 They function in the same way and pursue the same tasks as the colleges regulated by Article 80 do. The sole difference relates to their chairmanship: Article 81 (3) sets the general rule and the exception. Normally, the chair is agreed to and nominated by the members of the European resolution colleges. However, in the event that the domestic subsidiaries are held by a financial holding company established within the Union, in accordance with the third subparagraph of Article 143 (3) of Directive 2006/48/EC,32 the college will be chaired by the resolution authority of the Member State where the consolidating supervisor is located.

30 In my opinion, the reason behind this condition is not entirely clear. 31 See Article 81 (2). 32 The specific recalled provision deals with the case of a credit institution, the parent undertaking of which is a credit institution or a financial holding company, the head office of which is located in a third country and which is not subject either to consolidated supervision under Articles 125 and 126 of Directive 2006/48/EC, either to an equivalent consolidated supervision by a third-country competent authority. In such a case, competent authorities may, inter alia, in particular require the establishment of a financial holding company that has its head office in the Community, and apply the provisions on consolidated supervision to the consolidated position of that financial holding company.

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2.5

Information exchange (Article 82)

Article 82 of the Proposal deals with the exchange of information among the resolution authorities of a group. As a general rule, it prescribes that the resolution authorities shall spontaneously provide one another with all the information relevant for the exercise of their respective tasks, as well as communicate the same information, in case they receive a specific request in that sense. In particular, the group level resolution authorities have a duty under this norm to provide the other resolution authorities with all the relevant information in a timely fashion, in order to facilitate the exercise of the tasks set forth in Article 80 (1), second subparagraph, letters (b) to (h). The Article here at stake finally prescribes that the information exchanged pursuant to it may be shared also with the competent ministries.

2.6

Group resolution (Article 83)

Article 83 can be divided into two parts that address the (likely) failure, respectively, of a subsidiary of a group and of a Union parent undertaking. With respect to a subsidiary, Article 83 (1) prescribes that when a resolution authority decides or is notified by a competent authority33 that such an institution is failing or likely to fail, it shall promptly notify its decision in this sense and the resolution actions or the other insolvency measures believed to be needed to the group level resolution authority and to the other resolution authorities that are members of the resolution college of the group at stake. The group level resolution authority shall assess, together with the other members of the resolution college, what kind of impact the failure, the resolution or the other measures notified could have on the entire group or on the affiliated institutions in other Member States. Two possibilities are envisaged at this stage. The first case is when the expected impact would not be a detrimental one. In such a circumstance, the resolution authority responsible for the ailing institution may take the actions or measures notified and should regularly and fully inform the resolution college about said actions or measures and their on-going process. The second case is when the expected impact would be a detrimental one. The envisaged way out consists in the proposal, by the group level resolution authority, within 24 hours after receiving the notification mentioned above, of a group resolution scheme that should be submitted to the resolution college. If any member of the latter disagrees with the scheme, preferring, for reasons of financial stability, to take independent actions or measures in relation to an institution or group entity, it may refer the matter to EBA within 24 hours, in accordance with Article 19 of Regulation (EU) No. 33 Notification requirements are set forth in Article 74 (3) of the Proposal.

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1093/2010.34 EBA shall take a decision within the next 24 hours, and such a decision will be binding for the resolution authority. With respect to a Union parent undertaking in crisis, Article 83 (8) states that when a group level resolution authority decides or is notified that the Union parent undertaking for which it is responsible is failing or likely to fail, it shall notify to the resolution authorities that are members of the resolution college of the group at stake its decision in that sense and the resolution actions or other insolvency measures believed to be needed. In the present case, and not in the case in which a mere subsidiary is ailing, group resolution schemes can be comprised among the resolution actions pointed to by the group level resolution authority. Article 83 (9) underlines the importance of performing all the activities described above in a timely fashion, taking into account the ‘urgency of the situation’. The content of group resolution schemes is set forth in Article 83 (5): (i) they outline the resolution actions that should be taken by the relevant resolution authorities in relation to the Union parent undertaking or particular group entities, aiming at preserving the value of the group as a whole, minimizing the impact on financial stability in Member States where the group operates as well as the use of extraordinary public funding; (ii) they specify how resolution actions should be coordinated; (iii) they establish a financing plan that shall take into account the principles for sharing responsibility set forth in Article 11 (3) (e) of the Proposal.35 In any case in which a resolution scheme is not implemented, and therefore actions are taken just with respect to each affected institution, considered in its own individuality, the competent authorities are anyway required to cooperate closely with one another within the resolution college in order to reach a common solution for all the entities involved.

2.7

Financing of group resolution (Article 98)

Member States shall ensure that each national financing arrangement36 of each of the institutions part of a group contributes to the financing of a group resolution undertaken in accordance with Article 83. For this purpose, the group level resolution authority, in 34 Article 19 regulates the ‘Settlement of disagreements between competent authorities in cross-border situations’. 35 For which see above. 36 Even if Article 98 (1) uses the term ‘financial’, it is submitted that, in the present case, the meaning is the same as that of the term ‘financing’. Financing arrangements are established in accordance with Article 91 of the Proposal.

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consultation with the other pertinent resolution authorities, shall establish, if necessary before taking any resolution action, a financing plan, which is going to be part of group resolution schemes referred to in Article 83. Such a plan should determine the total financial need for the resolution and the modalities for the financing. The latter might come from the national financing arrangements or from borrowings or other forms of support from financial institutions or the Central Bank.37 Member States shall ensure that each respective national financing arrangement contributes to the plan immediately after resolution authorities receive a request from the group level resolution authority in this sense. Moreover, Member States shall ensure that the group financing arrangements38 are allowed to contract borrowings or other forms of financial support for the total amount needed to finance the resolution of the group. Each national financing arrangement shall guarantee any such borrowing, in a measure not exceeding the part of its participation in the financing plan. Each national financing arrangement shall benefit in the same measure from any proceeds or benefits that arise from the use of the financing arrangements. The Proposal enables the Commission to determine further details regarding the financing plan.39

2.8

Groups established in both EU and non-EU countries: cooperation in resolution among authorities (Articles 84, 88 and 89)

Title VI of the Proposal encompasses a number of provisions that regard relations with non-EU countries. Their relevance is evident since ‘many Union institutions and banking groups are active in third countries’.40 As far as groups are concerned, Articles 84, 88 and 89 are relevant.41 Starting from Article 84, it envisages the possibility for the European Union to enter into agreements with one or more third countries regarding means for cooperation between resolution authorities in the planning and process of resolution of groups having entities both inside and outside the Union.42 Proposals for the negotiation are to be submitted by

37 Supposedly national central banks, even if the text of the norm is not entirely clear. 38 Namely ‘the financing arrangement or arrangements of the Member State of the group level resolution authority’. 39 See Article 98 (8) of the Proposal. 40 Explanatory memorandum to the Proposal, para. 4.4.14. 41 On the contrary, it seems that Articles 85, 86 and 87 apply only to cases of institutions having their seat in third States and only branches in the Union. This is necessarily true as far as Article 87 is concerned, given its title. As to the other two Articles, they are not entirely clear on this point; however, this is what is presumably to be inferred from Article 85 (2) (b). 42 See, in particular, letter (a) and (c) of Article 84 (1).

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the Commission to the Council, either at the request of a Member State or on the Commission’s own initiative. To the extent that no such agreement is concluded, Article 88 states that EBA shall conclude non-binding framework cooperation arrangements with relevant authorities of the third countries where part of the entities of the group are located. The said arrangements can also be entered into in case agreements of the kind referred to in Article 84 already exist but cover different subject matters. Agreements referred to in Articles 84 and 88, according to Article 88 (3),43 should establish processes and arrangements for cooperation between the participating authorities, taking into account relevant provisions both of the Directive and of the law of the third countries involved. In particular, the following issues must be considered: (i) the development of resolution plans; (ii) the assessment of the resolvability of the institutions involved; (iii) the application of powers to address or remove impediments; (iv) the application of early intervention measures; (v) the application of resolution tools and exercise of resolution or similar powers. The framework arrangements entered into by EBA will serve as a model for non-binding cooperation arrangements concluded between competent authorities or resolution authorities of Member States and third countries. These arrangements shall contain provisions related to (i) the exchange of information necessary for the preparation and maintenance of resolution plans and for the application of resolution tools and exercise of resolution or similar powers provided for in the law of the third countries; (ii) consultation and cooperation in the development of resolution plans; (iii) early warning to or consultation of the other parties to the arrangement before taking any significant action affecting a particular institution or the group to which the arrangement relates; (iv) the coordination of public communication in case of joint resolution actions; (v) procedures and arrangements for the enactment of all the activities just mentioned, including, where necessary, the establishment and operation of crisis management groups. Member States shall notify to EBA the conclusion of said agreements. Lastly, Article 89 sets forth tight conditions necessary to protect the confidentiality of information exchanged between authorities of EU and non-EU countries.

43 Reference to Article 89 contained in Article 84 (2) looks like a typo: it should probably be interpreted as a reference to Article 88 (3).

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3

3.1

Comments and observations

A three-step itinerary to resolution

The Proposal sets out a highly sophisticated resolution system, made up of three different actions to be undertaken in at least two44 different stages of a group’s life. Before the outbreak of a crisis and before proper resolution measures could be adopted, the proposed directive engages resolution authorities and other competent authorities in what could be called preparatory duties, namely the drawing up of resolution plans and the assessment and removal of impediments to resolvability. The extreme importance of these provisions can be well perceived if one makes a comparison with the ratio underlining the frequent use of compromissory clauses in business contracts. Non-experts could be surprised by the fact that, after all the efforts made to conclude a certain agreement, the parties to it, since the closing, foresee the possibility that one of them could eventually breach that same contract just entered into, and therefore introduce in it provisions accordingly. In other words, a compromissory clause can appear to nonprofessionals as a negative element that weakens the contract. On the contrary, it is known that such a solution is indeed the best one, especially if compared with its opposite one, consisting in entering into a compromise once the dispute has arisen: prevention always works better than treatment. In the same way, addressing all the issues that can arise in case of resolution before resolution actions have even become necessary, that is in times of normal business activity, is the best way to make the most out of resolution itself. In this sense, it can be said that the three-stage itinerary represents a guarantee of a rational resolution procedure, which can benefit from having been designed ex ante, far from hitches and time constraints. It is submitted, however, that the Proposal could have made it clear whether there needs to be a relation between resolution plans and resolution schemes and, if so, of what kind. Their content, as set forth respectively in Article 11 (3) and in Article 83 (5), somehow partially overlaps. Nevertheless, it seems reasonable that schemes would be more concrete than plans, being drawn up in relation to a specific crisis and not before its onset. Yet, schemes should extensively abide by what plans establish, in order not to frustrate their usefulness underlined in the preceding paragraph.

44 It is not clear in which moment the assessment and removal of the impediments to resolvability shall be carried out.

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What impact do structure and nature of the exercised activity have on the content of provisions governing resolution?

The resolution system set forth in Articles 80-83 analysed above can be called a system of coordinated territoriality. In effect, on one side, it maintains the identity of each supervisory authority, with its own tasks, creating, at the same time, through the resolution colleges, a framework where cooperation among all the supervisory authorities can prosper. On the other side, besides the possibility of adopting measures or actions in relation to a single entity of a group, the option is also envisaged of drafting a group resolution scheme. In order to better understand the above described norms and the reasons behind them, it is believed that it would be useful recalling, extremely shortly, the solutions endorsed, for the subject matters falling under their respective scope of application, by Directive 2001/24/EC and by the Proposal for the amendment of the EIR. The first element of comparison has been chosen because, even if leaving groups outside of its scope of application, it deals with the insolvency of credit institutions. The second because, even if it does not apply to credit institutions and investment firms, it proposes a new set of norms on the insolvency of members of a group of (commercial) companies. Therefore, attention is paid, on one side, to the nature of the exercised activity and, on the other side, to the type of structure adopted for it. Under Article 9 of Directive 2001/24/EC, the home Member State’s authorities can open winding-up proceedings in respect of a credit institution having its registered office in that Member State and of its branches located in other Member States. The Proposal amending the EIR addresses the issue of the insolvency of the groups by recommending three forms of cooperation and communication: between courts, between liquidators and between courts and liquidators (Articles 42a-42c). Cooperation should take place only if it is appropriate to facilitate the effective administration or coordination of the proceedings, if it is not incompatible with the rules applicable to the said proceedings and, only as far as cooperation between liquidators is concerned, if it does not entail any conflict of interests. In line with Part three of the UNCITRAL Legislative Guide on Insolvency Law,45 the increasingly practical relevance of protocols as possible instruments of cooperation is recognized. If one has to determine which instrument, among the above two, creates a system more similar to that contained in the Proposal, he or she would certainly choose the second, even if, with respect to the Proposal, it is indeed less detailed and structured. It is submitted that such a remark makes clear that a discipline on the insolvency of any kind of group of companies needs to have its own specificities, which therefore have to be considered before any other issue. The nature of

45 UNCITRAL, Legislative Guide on Insolvency Law, Part Three: Treatment of Enterprise Groups in Insolvency, 21 July 2010, p. 108 ff.

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the exercised activity (commercial or financial) will certainly play a role in shaping the desired rules, but it will be a later in time concern. Problems posed by the group structure are hard to solve, and indeed it is no coincidence that, irrespective of the nature of the activity of the group, a discipline of insolvency of this kind of entities, as already pointed out in the foreword, has been lacking until now.

3.3

Other recent international initiatives dealing with insolvency of cross-border financial groups

Beyond the EU, a number of international bodies have recently endorsed some proposals specifically dealing with the insolvency of cross-border banking groups. Reference is made, in particular, to the Report and Recommendations of the Cross-border Bank Resolution Group of the Basel Committee on Banking Supervision,46 to the document of the International Monetary Fund (hereinafter ‘the IMF’) proposing a framework for enhanced coordination in the resolution of cross-border banks47 and to the Key Attributes of Effective Resolution Regimes for Financial Institutions drafted by the Financial Stability Board (hereinafter ‘the FSB’).48 Among the Recommendations of the Basel Committee, Nos. 3, 4 and 7 are of particular interest for the purposes of the present paper. First, harmonization of national resolution tools and measures is recommended, in order to facilitate a coordinated resolution of cross-border financial institutions. Second, the development of procedures that facilitate the mutual recognition of resolution proceedings and/or measures is encouraged. Third, competent authorities in different States are expected to find a way to exchange all relevant information regarding their respective responsibilities. The main features proposed in the framework envisaged by the IMF are (i) the modification of domestic laws in order to make the authorities of the several jurisdictions involved coordinate among each other, provided that such a coordination would be consistent with the creditors’ interests and with the domestic financial stability; (ii) a deeper level of coordination, in case of resolution, among certain countries that meet the so-called core coordination standards that represent a sort of guarantee that a particular State is trustworthy. This qualified cooperation, according to the IMF, would have to be conducted by lead authorities that will have to be designated by each country. Specific arrangements for communication and exchange of information at an early stage should be made, in particular to guarantee to the parties involved the statutory authority necessary to share confidential information. 46 Of March 2010, available at: (last visited 20 April 2013). 47 The exact title is ‘Resolution of Cross-Border Banks – A Proposed Framework for Enhanced Coordination’, 11 June 2010, available at: (last visited 20 April 2013). 48 Of October 2011, available at: (last visited 20 April 2013).

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Moreover, specific protocols could be prepared before a crisis, as a part of the recovery and resolution plans that large financial groups will be required to establish. Finally, turning to the FSB Key Attributes, which set forth tools and powers for incorporation into national legislations, as if they were a sort of model law, besides the usual provisions regarding the need for cooperation between authorities and for the exchange of information, they contain remarkable rules dealing with the so-called Crisis Management Groups, whose aim and composition clearly resemble those of the Proposal’s resolution colleges. Except for what has just been said with regard to the key attributes, none of the other initiatives goes further than the Proposal. Indeed, the opposite is true, both from the point of view of the nature of the instrument endorsing the EU rules, which is going to be a Directive and not mere soft law, and from the point of view of the content, since the Proposal, through the resolution colleges, puts forward a particularly enhanced coordination framework.

4

Concluding remarks

Coming to some closing remarks, it must be recalled that three main models have traditionally been envisaged as possible means to address the insolvency of cross-border groups. We can evoke, going from the least to the most advanced, a cooperation between insolvency officials and courts across the several legal orders involved in a specific case; a cooperation of the kind just described, with the addition of a lead administrator having all the needed powers; the opening of just one proceeding with respect to all the entities of the group, as if the latter were a single entity.49 The Proposal of the Commission outlined above adopts the second model, conferring on the group level resolution authority a leading role. At first sight, the newly proposed solution is certainly to be welcomed, at least because, differently from the EU legislation in force up to now, it has identified the existence of a problem related to the insolvency of cross-border groups and has tried to find a way to solve it. Moreover, the framework set up seems to be a well-designed environment where difficulties related to cooperation50 may be overcome: it is prescriptive and flexible at the same time, mingling the benefits of a well-defined set of rules with those of the adaptability of the said rules on a case-by-case basis.51 According to the Commission, it also assures that authorities could ‘act quickly and decisively where the situation requires it’.52 However, 49 See B. Wessels, ‘The Future European Union Legislative Framework on Cross-Border Crisis Management in the Banking Sector: A Legal Stress Test’, in B. Wessels & P.J. Omar (eds.), Cross-Border Management in the Banking Sector, INSOL Europe, Nottingham, Paris (2011), p. 57. 50 See e.g. the exemplification of Prof. B. Wessels in Wessels (2011) p. 161 f). 51 The flexibility here referred to may be seen, in particular, in the provisions of Article 83 (1), (3), (4), (6) and (8). 52 European Commission, Communication, COM(2010) 579 final, cit., p. 13, available at: (last visited 21 April 2013). Through the so-called cross-border insolvency protocols, for a list of which see (last visited 19 April 2013). Available at: (last visited 22 April 2013). Available at: (last visited 22 April 2013). Juris Publishing, 2003. Available at: (last visited 22 April 2013). Adopted on 2 April 2009, available at: (last visited 22 April 2013). Communication COM(2009) 561, final, cit., 13, available at: (last visited 21 April 2013).

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an obligation on Member States to render cooperation binding through appropriate normative instruments. It follows that two situations can be imagined: on the one side, in case a Member State does not transpose the Directive, infringement proceedings can be opened against it; on the other side, if the State is compliant but still relevant authorities do not abide by pertinent domestic provisions, internal remedies could probably be undertaken, with the possibility of filing a preliminary ruling before the EUCJ. Nevertheless, a real step forward would have been the endorsement of a global solution, whose adoption had been hoped for – either at a European level or at an international one – by several distinguished scholars.60 Two reasons have been put forward for such a default. The official one, adduced by the Commission, resides in the fact that ‘it would be difficult to establish a EU integrated resolution model […] in the absence of a harmonised insolvency regime and of a Single European Supervisory authority’.61 Similarly, the nonuniformity of solutions adopted in the Member States in some areas of law that directly affect insolvency proceedings has been recalled.62 The second reason is a political one: it is believed that Member States are not yet ready to give up that part of their sovereignty that, under the current regime, they still enjoy in this particular field of law.63

60 M. Čihák & E. Nier, The Need for Special Resolution Regimes for Financial Institutions – The Case of the European Union, IMF Working Paper (September 2009), p. 26, available at: (last visited 21 April 2013); Hüpkes, (2010), p. 239; C. Cumming & R.A. Eisenbeis, Resolving Troubled Systemically Important Cross-Border Financial Institutions: Is a New Corporate Organizational Form Required?, Federal Reserve Bank of New York Staff Reports, July 2010, p. 39, available at: (last visited 19 April 2013); Wessels (2011), cit., (164). See also IMF, Resolution of Cross-Border Banks, cit., 3, 5. For a solution more similar to that envisaged by the Proposal, see W. Fonteyne, W. Bossu, L. Cortavarria-Checkley, A. Giustiniani, A. Gullo, D. Hardy & S. Kerr, ‘Crisis Management and Resolution for a European Banking System’, IMF Working Paper, March 2010, p. 57 ss., available at: (last visited 19 April 2013) and G.G.H. Garcia, R.M. Lastra & M.J. Nieto, Bankruptcy and Reorganization Procedures for Cross-Border Banks in the EU: Towards an Integrated Approach to the Reform of the EU Safety Net, LSE Financial Markets Group Paper Series, May 2009, p. 25, available at: (last visited 19 April 2013). 61 European Commission, Communication, COM(2010) 579 final, cit., 12, available at: (last visited 21 April 2013). 62 H. Wegman, ‘Improving the Monitoring of Cross-Border Banks in the EU: Towards a Common Framework in Crisis Management’, European Company Law (2010), p. 67. 63 Hüpkes (2010), p. 226.

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Part 5 Bail-in and Counterparties

8

Bail-in: Some Fundamental Questions

Victor de Serière* There is a pecking order: ideally, uninsured depositors should be the very last category to be touched. The European Commission draft directive foresees exactly this. There is not, at present, a specific distinction between categories of bond holders and uninsured deposits in the draft directive but the point is that, if it can be avoided, uninsured depositors should not be touched. (Draghi at a press conference of 4 April 2013)

1

Introduction

The general concept of ‘bail-in’ is now firmly and generally accepted, economically and politically, as a prime ‘tool’ to be used for resolving a failing bank. This paper queries the underlying considerations as to why a bail-in should be deemed a better mechanism for resolving a failing bank rather than using other possibly available options. This paper will subsequently look at the principles to be applied if the bail-in tool is to be used. Should the normal insolvency ladder be applied as the basis for determining which classes of creditors should be made to participate in a bail-in? Or should some other principle be applied? Should there be equality of treatment for all creditors standing on the same step of the insolvency ladder? Should the ‘no creditor worse off’ principle be applied? Can that principle, practically speaking, actually effectively be applied? Should banks be forced to issue and have outstanding certain levels of separate ‘bail-in-able’ debt instruments, and if so is it right that those levels should be determined by the relevant resolution authority? Should banks be permitted (or encouraged) to create their own ‘bail-in-able’ bonds using their own triggers for write-off or conversion? These are some of the intriguing questions that this paper will endeavour to examine. To the extent that bail-in issues have been discussed in the press, in policy statements and in legal analyses, these questions have not always been addressed with the necessary level of clarity, granularity and consistency. The above quote of the President of the ECB demonstrates this and suggests that the rather complex issues around bail-in deserve more thinking and analysis. The paper of Prof. Garcimartín in this book describes what is meant by the term ‘bail-in’; reference is gratefully made to his paper for that purpose. Basically, to state it summarily, it concerns a situation where the mounting losses of a failing bank are no longer sustainable *

Solicitor Allen and Overy and Professor of Securities Law, Radboud University Nijmegen.

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and will drag the bank down into the deep waters of insolvency unless these losses are absorbed and the bank is restructured. The term ‘bail-in’, as opposed to the term ‘bail-out’, signifies that the absorption of losses will preferably not be externally sourced by ‘outsiders’ (i.e., by Governments), but will rather be for the account of ‘insiders’, being shareholders and (certain categories) of creditors. This premise is perceived by European politicians and the media as being a workable, better alternative to applying taxpayer money, but not, however, as an ‘exclusive’ alternative. The EU Commission describes it as an effort ‘to limit the recourse to taxpayers’ money’. See the EU Commission’s (DG Internal Market’s) Discussion Paper on the Debt Write Down Tool – Bail in, page 2, to be found on the ec.europa.eu/internalmarket/consultations website. See also consideration (35) of the RRD:1 Save as expressly specified in this Directive, the resolution tools should be applied before any public sector injection of capital or equivalent extraordinary public financial support to an institution. This, however, should not impede the use of funds from the deposit guarantee schemes or resolution funds in order to absorb losses that would have otherwise been suffered by covered depositors or discretionarily excluded creditors. In this respect, the use of extraordinary public financial support or resolution funds, including deposit guarantee funds, to assist in the resolution of failing institutions should respect the relevant State aid provisions.

2

Relationship between bail-in and other resolution tools

It is important to understand that the adoption of the bail-in tool will not do away with the necessity of other tools, including Government support. There are at least two scenarios where Government support will in any event be unavoidable. First, if losses to be absorbed are too large to be absorbed by creditors writing off their claims. This is, of course, not theoretical. If one looks at the capitalization of G-SIFIs as they will be further capitalized under CRD4, the absorption capacity of major banks is or will be vast, but so are the theoretical losses they may suffer. The arguments of major banks against this finding are generally based on the notion that such levels of theoretical losses are wholly unrealistic. That may be true (who knows?), and the arguments that the major banks put forward certainly have persuasive power. It should be noted that this finding becomes less theoretical if one

1

This paper refers to the draft of the RRD dated 18 December 2013 (final compromise text) as published by the Council of the European Union File 2012/0150 (COD). I note that Prof. Garcimartín in his paper refers to an earlier draft of the RRD, and, accordingly, there may possibly be some discrepancies in the references, which, hopefully, will not cause confusion.

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limits the classes of creditors who are to suffer if ‘their’ bank fails. Draghi’s above quoted comments hint at such limitation … But his quoted comments run contrary to the basic premise of the RRD: However, in order to ensure that the bail-in tool is effective and achieves its objectives, it is desirable that it can be applied to as wide a range of the unsecured liabilities of a failing institution as possible.2 A contradiction? Indeed, and exemplary for the sometimes somewhat muddled approach that regulators and politicians take in respect of these fundamental issues. If there is a shortfall, the ‘financial sector’ should cover that shortfall, according to current thinking, using a resolution fund to be financed by financial sector contributions. The Single Resolution Mechanism now contemplates a single resolution fund, eventually to be funded by the financial sector itself, to be used to enable the resolution tools to be effectively applied. It is, accordingly, not to be used as a ‘backstop’ facility (other than to provide temporary liquidity support or guarantee support), but the current draft of the SRM Regulation3 does contemplate that: There might be exceptional circumstances where, after sufficiently having exhausted the internal resources (at least 8% of liabilities and own funds) the primary objective could not be achieved without allowing the Fund to absorb losses or provide capital. If the single resolution fund does not have sufficient funds available, the fund could attract loans from Governments, under an ultimate funding commitment of the financial sector. The creation of a resolution fund capable of absorbing potential G-SIFI losses should be a huge fund, particularly if one considers a scenario where a systemic default affects more than just one isolated bank. This, of course, is not within the realm of possibilities, and hence an ‘intermediate’ solution of a euro 55 billion fund is now being considered; a probably rather inadequate sum of money for any systemic default situation.

3

Collective responsibility of the banking sector?

A fundamental question is, why should ‘good banks’ suffer to bail out ‘bad banks’? The arguments in favour of (or against) a collective responsibility of the banking sector have 2 3

Consideration (47) RRD. See the Presidency of the EU Council’s Proposal dated 6 December 2013 for the SRM Regulation.

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never been convincingly spelled out – neither in relation to the Deposit Guarantee Schemes, where of course the same question arises, nor in relation to the RRD resolution scheme. Obviously, the amounts to be covered in a RRD scheme can be huge. But even in the DGS, the amounts can be relatively sizable. In the case of SNS Bank, a smallish Dutch bank, the total amount of covered deposits was estimated to be some euro 35 billion. It makes a sizeable difference if such an amount is to be divided between banks in an oligopoly position in a small country like the Netherlands as compared with a division in a large country with a much more diversified banking sector. One of many reasons for the Government intervention in SNS Reaal in February 2013 was the fear that application of the Deposit Guarantee Scheme in an insolvency scenario would weaken the contributing banks’ health to a perhaps unacceptable level. Apart from the unattractive prospect that the DGS would have to be wholly prefinanced by the Government, the financing of the DGS by the large Dutch banks in the case of SNS Bank would mean they would each have had to contribute about euro 5.8 billion per annum for a number of years.4 (That amount is not equal to the amount of the ultimate loss, which will depend on the proceeds of the recourse claim that the contributing banks have on the insolvent estate of the failing bank.) No wonder, of course, that in the Netherlands banks such as Rabobank ‘fume’ about their required contributions to the scheme, in their perception caused by dubious strategies and decisions of other banks …

4

Liquidity versus solvency

The second scenario where Government support will unavoidably need to be given is that in which a bank suffers a liquidity crisis causing a bank run. In that scenario, even where the solvency position of the bank in question might possibly still be at acceptable ‘safe’ levels, a bank can quickly run out of steam and come to a grinding halt. Bail-in then does not help, as the theory goes, since bail-in is a tool for loss absorption and a liquidity crisis is not resolved by capital measures but must rather be saved by a restoration of public confidence. There are basically two ways to restore public confidence in a bank. The first is to have a healthy bank take over the failing bank. In a systemic default situation, that remedy is, however, rather unlikely to be available.5 The second is to obtain Government support, which, ironically, is exactly the remedy that the RRD tries to avoid.

4 5

See paras. 33 and 34 of the Expropriation Decree of the Minister of Finance dated 1 February 2013, to be found on the website of the Ministry. The Dutch experience with smaller banks like DSB Bank and SNS Bank shows that even in isolated nonsystemic instances a takeover by third parties is difficult to achieve. Timing constraints are a big factor, since due diligence will need to be carried out and solutions found for contingencies.

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But liquidity problems on the one hand and solvency shortfalls on the other hand are not isolated phenomena. The one may lead to the other, and vice versa, and they can go hand in hand as well, of course. There may be other external factors that will generally exacerbate the troubles that a failing bank finds itself in. Such exacerbating factors may include a dramatic fall in the quoted stock price of a bank, media hypes, unpredictable behaviour of a bank’s clients, etc. In the Netherlands, the rapidly falling stock prices of certain Dutch financial institutions (Fortis, etc.) in the latter half of 2008 led to a hastened Government intervention. Stock prices in themselves of course do not affect the liquidity or the solvency position of a bank. Stock prices are a measure of investor confidence. However, lack of investor confidence can be dangerously contagious, and may, accordingly, easily spill over to client confidence. On the other hand, as the Dutch financial institution SNS Bank was getting more and more deeply ensnared in its real estate portfolio losses in 2012, the stock price did not really respond correspondingly, and there certainly was no bank-run at any time prior to the Government intervention that followed. This may to a large extent be attributable to the public’s belief at the time that Government support would in any event be forthcoming, but it does illustrate that there is quite some uncertainty as to why the public and markets behave the way they do. These instances, accordingly, serve to show that each situation in respect of a failing bank or a bank that is at the edge of the precipice, will have its own idiosyncratic features that the regulators will have to contend with.

5

Collective responsibility for shareholders and creditors

If a bail-in tool is used, this is for the account of shareholders and creditors. Is it justified that shareholders and creditors will be made to suffer, in lieu of the tax paying public? That shareholders will be made to suffer seems a foregone conclusion. They are at the end of the queue, at the bottom rung of the insolvency ladder. That their claims be written off would seem logical. But is it under all circumstances justified that they should not participate in the recovery of a failing bank after restructuring? The argument here is that recovery would normally be due to factors other than their capital contributions of way back when, and that they should not benefit from a recovery that they have not funded. The strength of this line of reasoning is obvious. But of course they actually did participate in the recovery by writing off their claims, which, however subordinated they may be, were still claims until written off. But the value of these claims is very uncertain, if there is any value at all. There is no way that a ‘Phoenix’ restructuring operation is realistically possible where the participants in that exercise would allow shareholders to share in the upside. With respect to creditors, subordinated creditors and senior bondholders, the analysis may be somewhat different. Here the premise of their sacrifice should be compared with

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the premise of such sacrifice being made by taxpayers if a bail out would be effected. This is a complex comparison. Assume that the debt instruments of a failing bank are held by hedge funds and distressed debt traders who might have paid 20 cents in the Euro for their claims, wagering on the possibility of Government support or some other form of recovery being realized in the end. In that scenario, it would seem politically easy to justify that these creditors take the burden of the loss absorption rather than taxpayers. Of course, the real world is never quite as simple as the assumption underlying this scenario. And it is relatively easy to point the finger at hedge funds and distressed debt traders, but one must always bear in mind that these institutions also are being funded by other institutional investors and ultimately always by retail investors, savers and pensioners. At the other end of the spectrum, take the assumption that the debt instruments issued by the failing bank are held by pension funds, insurance companies and therefore much more visibly by ultimately ‘innocent’ (i.e., non-speculating) retail investors, savers and pensioners. Is it logical that these parties pay the bill rather than the taxpayers, who, in any event, have perhaps had the benefit of the infrastructural functions of the bank in question before it failed? In other words, is there perhaps a more direct economic ‘link’ between the taxpayer and the failed bank than there is between retail investors and the failed bank? There are, of course, several flaws in this kind of reasoning. One important flaw relates to the allocation of investment risk. Another relates to the complications of burden sharing. Burden sharing is an issue that has never been resolved, largely due to politics and the complexities surrounding the issue.6 For so long as the burden sharing issue remains unresolved (and this writer fears that it will remain indefinitely unresolved), a tax payer bailout is by definition contained in one jurisdiction,7 while the activities of the failing bank may span across various countries and continents. These two arguments weigh heavily in favour of bail-in. Another complicating issue is that of costs. The cost of funding of banks will be negatively affected by bail-in. No one really knows how many basis points will be added to the cost of funds. But if we assume that the additional cost will be Eurocent for Eurocent passed on to the customers of the banks concerned, then the amount of that cost borne by customers ought to be compared with the cost of bailouts borne by taxpayers. The cost of bailouts is, however, extremely difficult to calculate. It is said that since Lehman already 5 years ago the ‘gross costs’ of bailout borne by European tax payers amount to some euro 4,500,000,000,000. But nobody knows how much of that amount was actually disbursed 6 7

See i.a. D. Schoenmaker, Governance of International Banking, the Financial Trilemma, Oxford University Press, Oxford (2013), p. 98 ff. Unless of course a European wide tax payer-funded resolution fund would be used, but given the difficult debate on the Single Resolution Fund, such a structure would appear to be a bridge too far.

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and how much of the disbursed portion has already been recovered, or how much of that amount, if not recovered, may still be recovered. In the Netherlands, for instance, Government interventions in Aegon and ING have been rather profitable. If the IPO of ABN AMRO Bank NV will ultimately be successful and the restructuring of SNS Bank not too burdensome, then the cost to the Dutch taxpayer might well prove to be a substantial gain rather than a cost … These calculations and comparisons have never been definitively made, and perhaps they cannot actually be made with any acceptable level of accuracy. But that, of course, does not determine the outcome of the discussion one way or the other …

6

Why loss absorption?

For saving troubled banks we have traditionally had Government bailout scenarios in mind. Debt instruments issued by banks were said to carry lower coupons because of implied Government guarantees.8 This premise endured until Treasuries’ coffers had to be substantially delved into to keep banks afloat – in times where European nations were simultaneously facing or about to face a severe economic depression. Only since the larger European bailouts, particularly in the United Kingdom and the Netherlands in 2008 and 2009 occurred, did the notion that not just the equity (through severe dilution) but also the debt should be made to share the resolution pain attain more prominence, even to the point of monopolizing the debate on how to tackle systemic risk in Europe. Prior to the banking crisis there was really no good reason to thoroughly analyse that proposition. Several factors were at play here. Generally, the perception that the financial crisis was largely caused by the irresponsible action of the financial sector very strongly influenced political thinking (and continues to do so). One factor of substantial impact was the existence, in the traditional approach, of the ‘implied government guarantee’ of banks’ indebtedness. The capital markets priced the implied guarantee into debt instruments issued by banks, which, practically speaking, meant substantial funding cost benefits for banks. The political perception was, simply stated, that this implicit government guarantee exacerbated the moral hazard issue: it was thought that banks could engage in risky proprietary banking activities since if this would go wrong, Government would always be there to help out.9

8 9

See, for instance, The Great Bank Downgrade, What Bail-in Regimes Mean for Senior Ratings, a J.P. Morgan Credit Research Paper dated 7 January 2011. For more elaborate analysis, see a.o. K. Rogoff, ‘International Institutions for Reducing Global Financial Instability’, 13 Journal of Economic Perspectives (1999), p. 21 ff; Schoenmaker (2013), pp. 22 ff and 108 ff (and the literature referred to by Schoenmaker).

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In this context, the fundamental question arose as to why a bank should actually be rescued – why is it not possible to let nature run its course and treat banks in the same way as commercial enterprises: if there is no voluntary way out by way of a compromise between the enterprise and its creditors and other stakeholders, formal insolvency proceedings take over.10 This question is not so easy to answer as it might seem at first glance. The answers usually given refer to the special infrastructural function that banks fulfil in the everyday lives of people. People are fully dependent on banks. They need banks for their money transfers and debt payments, for their savings deposits, and for a host of other services that a bank supplies. A bank is a necessary intermediary in many crucial aspects of everyday life. How can you receive your salary, pay for your household costs and fund your pension savings or draw your pensioner’s entitlement without the intermediary of a bank? But this special infrastructural functionality does not really provide a credible context for the answer to the question at hand. This is because the dependency of society on banking functions is solvable in other ways: it is solvable through the avoidance of banking oligopolies that exist in a number of European jurisdictions (such as the Netherlands), in combination with a flexible system of transferability of banking relations on the one hand and a deposit guarantee scheme on the other. (The emergence of the non-banking sector as a sizeable force in local economies, by the way, might very well help in this regard.) In a relatively small economy where there is a banking oligopoly and where a bank insolvency could, for the lack of flexibility, lead to prolonged falling away of banking functions for clients, a bank failure will readily be seen to be systemic. The failure of a small regional financial institution in a northern province of The Netherlands (DSB Bank) was for that reason perceived to be of systemic proportions. The possible failure in 2012 of a relatively small Dutch financial institution, SNS Bank, was for that same reason deemed to constitute a systemic risk justifying Government intervention. But in a multi-bank environment like the United States with easy bank services switching facilities (which of course would, ideally, need to be statutorily underpinned), there should be no systemic risk: the failing bank goes belly up, the clients suffer just a small temporary grinding to a halt of services, which is vexing but not structurally relevant and would last only until the accounts and services are transferred to another financial institution. Undoubtedly, losses would be suffered – one could argue that is the penalty for choosing to do business with a weak institution. This is a normal risk of doing business in the everyday world outside of the banking sector – why should it be different for the banking sector? There are several reasons why the above analysis is flawed, or, rather, unrealistic and unworkable. One is that where this multi-bank environment does not exist, it cannot be created. And banking services transferability is not easily achieved: there are numerous 10 T. Judt, Ill Fares the Land, Penguin Books, New York (2010), p. 152.

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technical hitches that would need to be statutorily resolved. Easy switching from bank to bank by customers will create significant interbank receivables. There would probably need to be an in-depth analysis as to what this means in terms of inter-bank competition and the banking environment more generally. And, of course, many banks operate cross border. So national statutory solutions would not work: one would need a European legal framework. And a European framework, probably anyway impossible to achieve, would beg the question how this system could be made to work also outside of the borders of the European Union. In this day and age of internet banking and of global, cross border cash pooling, an ‘insular’ European approach is, by definition, imperfect.

7

Volcker Rule impact

If indeed the special infrastructural function of banks is an important justification for a special EU or Government-established resolution framework for failing banks, then a logical inference would be that such a resolution should only be used to save those business activities of banks that actually harbour these infrastructural functions. This notion, if carried through, would require a strong set of distinctive definitions as to what such activities comprise and what are to be regarded as being non-infrastructural activities. The division (roughly to be equated with the Volcker Rule) is extremely difficult to draw, and that is exactly the reason why the Dodd-Frank Act regulations that try to separate proprietary trading activities from regular banking activities take so long in getting promulgated and why, when they do get promulgated, they are criticized for not being exact enough, leading to legal uncertainty allegedly to be used (or exploited) by inventive bankers and their advisers. In this paper I will not deal with the problems that an effort to make that separation would entail. The 2011 Vickers Report in the United Kingdom provides an excellent overview of the demarcation dilemmas involved. Is this debate about separating proprietary activities from regular banking activities relevant to the bail-in discussion? The answer is that it perhaps should be, but probably isn’t. It may well be possible to develop a convincing argument that if that separation were effectively realized, the bail-in of the proprietary trading activities of a bank would have different parameters than that of the regular banking activities. The argument would then run along the lines that regular banking activities fulfil a public utility-like function (such as electricity distribution and public transport) and that therefore if these banking activities would go belly up, it would be in the public interest, and therefore justified, to bail them out, if only to preserve these infrastructural functions. On the other hand, there being no public utilitylike function attributable to proprietary activities of banks, there would be no justification in using public funds to bail them out. It would then for those activities have to be ‘bail in

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or bust’. However, this line of reasoning was never embraced by politicians or regulators or by the industry, and the bail-in discussion largely continues to focus on universal banks, including their proprietary trading and investment banking businesses, albeit that the bailin tool does specifically focus on continuity of public utility-like functions. This may be attributable to the implementation of the Volcker Rule in the United States and of the Vickers Report recommendations in the United Kingdom, but there are quite a number of large jurisdictions where the notion of separation is regarded with some apprehension and a notable lack of enthusiasm, particularly in responses to the Liikanen Report of 2 October 2012.11

8

The positioning of the bail-in tool in terms of timing

When is the bail-in tool to be applied? As to resolution tools generally, consideration (24) of the RRD provides: The resolution framework should provide for timely entry into resolution before a financial institution is balance sheet insolvent and before all equity has been fully wiped out. Resolution should be initiated when a competent authority, after consulting a resolution authority, determines that an institution is failing or likely to fail and alternative measures as specified in this Directive would prevent such failure within a reasonable timeframe. This indicates that the resolution tools are to be regarded as the ultimum remedium to prevent insolvency of the failing bank concerned. The resolution tools are to be used when preventive measures or early intervention measures (see Article 23 RRD) have failed or are deemed an insufficient remedy. It is, however, not necessary that early intervention measures must have been tried before the resolution tools are applied (see Article 24 subsection 1c RRD). The conditions to be met before reaching for the resolution tools are laid out in further detail in Articles 27 and 28 RRD. Interestingly, the RRD also emphasizes the principle that the resolution tools should only be applied if it is determined that a ‘normal’ insolvency procedure would not be feasible because of the systemic consequences. Consideration (27) provides that:

11 See, for instance, the somewhat muted Dutch response in the form of the so-called Wijffels Report (the Wijffels Report is a Government-sponsored report of the Commission on the Structure of the Dutch Banking Industry).

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A failing institution should in principle be liquidated under normal insolvency proceedings. However, liquidation under normal insolvency proceedings might jeopardise financial stability, interrupt the provision of critical functions, and affect the protection of depositors. In such case there is a public interest in applying resolution tools. This principle is worked out in Article 27 subsection 1(c) RRD. It is accordingly necessary that before applying resolution tools the national resolution authority will have to determine that a failing bank cannot be left to die by itself: a determination, in other words, as to whether the failing bank concerned poses a systemic risk or not. This principle might create a somewhat distorted level playing field in Europe: it means that a small bank in the Netherlands, being more prone to systemic risks,12 might be saved with the help of RRD resolution tools while a bank of the same size in the United Kingdom, Germany or France would perhaps, by virtue of this principle, not be resolved. Thus, ironically, application of this principle might, in a sense, reinforce the lack of a level playing field as signalled in Consideration (5) of the RRD. It is of course up to the Government concerned to determine whether the public interest requirement under Article 27 subsection 1 sub (c) is fulfilled, and Governments’ perceptions may vary.

9

The ‘no creditor worse off’ (NCWO) principle

This principle is a basic premise underlying the application of any resolution tool under the RRD. See consideration (31) of the RRD, which states: Interference with property rights should not be disproportionate. Affected shareholders and creditors should not incur greater losses than those which they would have incurred if the institution had been wound up at the time that the resolution decision is taken. In the event of partial transfer of assets of an institution under resolution to a private purchaser or to a bridge bank, the residual part of the institution under resolution should be wound up under normal insolvency proceedings. In order to protect shareholders and creditors who are left in the winding up proceedings of the institution, they should be entitled to receive in payment of their claims in the winding up proceedings not less than what it is estimated they would have recovered if the whole institution had been wound up under normal insolvency proceedings.

12 See also section 6 above.

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It is interesting to note that the NCWO principle is so expressed as to apply not only to creditors generally, but also to shareholders. As a matter of principle, this is of course correct, but as a matter of practice, it seems, by definition, inconceivable that shareholders are not wholly written off before the question arises as to whether and the extent to which holders of debt instruments should be made to suffer. This, as already noted, is the corollary of shareholders standing at the bottom rung of the insolvency ladder. The question whether this waterfall is to be strictly adhered to in the bail-in process will be dealt with in paragraphs 20 et seq. below. Nevertheless, there is a possible argument for allowing shareholders to ‘survive’ resolution and permitting them to share in any future (post-insolvency) upside.13 If a restructured resolved bank is built partly on a foundation supplied by the original shareholders, it may provide a justification for having them share, in a modest (strongly diluted) way, in the upside. After all, shareholders will seldom be a contributory cause to the downfall of the failed institution. The failure of a bank is more likely than not a mixture of wrong decisions and inaction by both management of the bank and the regulators. This may perhaps be different in the case of banks owned by private equity or by a single majority shareholder, but very rarely is the cause to be found in external circumstances against which management and regulators are helpless, but if so shareholders will generally be all the more blameless. One particular scenario in which shareholders might ‘survive’ resolution and share in a post-insolvency upside could be when the losses that need to be absorbed are not so great that senior creditors need to share the pain. If shareholders and holders of subordinated hybrid instruments taken together can absorb the losses, not by a complete but by a partial write-off, then it seems arguable that shareholders and holders of such instruments should be treated on a pari passu basis. That argument would in the view of this writer only hold if the terms of such instruments make them economically and financially completely equivalent to shares, so that there is no reason for applying the waterfall principle. Such complete equivalence is not inconceivable. Many trust preferred securities or hybrid bonds issued by or for the account of banks work very much in the same way as shares in terms of distributions and entitlements. The argument is probably reinforced by the fact that these instruments all qualify as belonging to the same regulatory capital treatment (CET1). If the notion of ‘control’ does not distort the comparison (and it shouldn’t except possibly where shareholders hold large stakes conferring control), then pari passu treatment is arguably justifiable.

13 R.J. Rolef de Weijs, ‘Too Big to Fail as a Game of Chicken With the State: What Insolvency Law Theory Has to Say About TBTF and Vice Versa’, 14 European Business Organization Law Review (2013), pp. 201-224.

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Interestingly, the NCWO principle is not specifically imposed by the RRD in the context of making recovery and resolution plans. Does this mean that the principle can then be set aside? No. National supervisory authorities that require recovery and resolution plans to be prepared by banks tend to adhere to the NCWO principle. Of course, any recovery or resolution transaction will involve private legal acts of the institution concerned. In that case, even if the RRD or other EU legislation do not provide a basis for application of the NCWO principle, the civil and common law doctrines of fraudulent creditors preference and of tort will impose the principle. An interesting question arises here: if a recovery or resolution plan is endorsed by the supervisory authorities, would that circumstance be usable as an effective defence against a claim based on fraudulent creditors preference? This may ultimately be a question for the ECJ to determine, but this writer suspects that in at least civil law jurisdictions the doctrine will be deemed by the courts of law to apply regardless of endorsement by Government or supervisory authorities. There has, fortunately, never been occasion for this question to be answered by the courts … It will be clear from the foregoing that the NCWO principle is closely linked to the principle of application of the solvency waterfall and the principle of equality of treatment of creditors who are in the same position vis-à-vis the failing bank. But is the principle workable in practice? To apply the principle, it will be necessary to determine what creditors would have received ‘if the whole institution had been wound up under normal insolvency proceedings’. This must of necessity be an estimation, but even if an estimation suffices, the task is impossible. The RRD contemplates that this is done on the basis of a separate independent valuation; see section 18. In order to make this estimation, one would have to create a ‘virtual’ bankruptcy situation. For each creditor or group of creditors, one would have to determine the strength of their claim, and where they stand on the insolvency ladder. Imagine a valuation expert having to determine the chances of success of a collective action against the failing bank by disgruntled shareholders for misleading information … In case of secured creditors, one would have to determine what the value of collateral is and what the residual claims of secured creditors are once they have foreclosed on their collateral. One would have to determine the amount of the claims of counterparties under derivative contracts and under structured finance transactions. These claims are normally extremely sensitive to market prices of underlying assets or indices. In case of systemic default situations, such prices may be impossible to ascertain. One would have to determine whether or not set off rights and netting arrangements are legal, valid, binding and enforceable even in an insolvency situation. In all these instances the date as per which such calculations must be made is extremely important: a difference of days or weeks can make a very significant difference in the result of the calculations, especially in case of volatile markets. And what to do if there is no market for the assets concerned? If there is no possibility to ascertain a market price for assets, the trustees in a ‘normal’ insolvency

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scenario will have the ability to hang on to these assets until better times arrive. (The experience with the divestment of so-called Alt-A assets of ING in the United States, for instance, demonstrates that this can indeed be a realistic, attractive proposition.14) When resolving a failing bank under the RRD the strategy of waiting for better times to return is of course also possible, using the bridge institution tool or the asset separation tool. But how can assets in such cases be valued ex ante, that is when the NCWO analysis needs to be made? This writer fears that this is an impossible exercise.

10

Using the insolvency ladder principle

Philip Wood has described the insolvency ladder as follows: It is often said that on bankruptcy everybody is equal, pari passu, and lies in the dust together. In fact nowhere is the hierarchy, the ladder, more potent than on bankruptcy, as creditors struggle for the squeezed bubble of oxygen at the top as the swirling tides of debt rise up below them.15 The insolvency ladder principle entails that shareholders and creditors of the failing bank should basically be subject to bail-in in the same manner as they would be made to write off in a normal insolvency situation. Leaving aside preferential creditors, this would mean shareholders first, subordinated debt holders second, and senior debt holders and concurrent creditors on a pari passu basis third. There are, however, as the above-mentioned quote suggests, many complicating factors, which are exacerbated by the requirement that the failing institution, at least as far as its infrastructural functionalities are concerned, must continue its day-to-day operations (I will in this paper refer to this as the ‘continuity principle’). I will get to these complications later. First, the fundamental question must be addressed whether the insolvency ladder is the correct principle to be used in bail-in situations. The main argument pro is the fact that the insolvency ladder has been developed and (re)defined and evolved over centuries and may be regarded as the established perception as to what is fair if there are insufficient funds to satisfy all creditors. The main argument contra is to be found in the circumstance that a resolution of a bank must not only satisfy the principle of fairness as regards the position of creditors among themselves and vis-à-vis the failing bank, but must also serve other interests than those of creditors, mainly being the interests of society at large, that is, the need to realize the continuity principle. It must also satisfy the political goal that small deposit holders should not suffer. 14 Press release of the Minister of Finance on IABF dated 4 December 2013. 15 P. Wood, ‘State Insolvency – What Bondholders and Other Creditors Should Know’, to be found at .

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Given these interests other than those of creditors inter se, one could argue that the insolvency ladder is not the right starting point, but that the correct approach is to distinguish between those creditors that use the infrastructural functions of a bank and those that fund the use of such functions. The first category should in this approach be absolved from bailin, and the second category should suffer bail-in. Parties who fund the use of such functions are risk-taking investors. They include shareholders, holders of subordinated debt and bondholders. It could also be argued that deposit holders should be included in this category. The debate on how to treat the holders of deposits in the commercial banks of Cyprus in 2012 and 2013 has shown how controversial this notion is.16 But this problem is actually ‘merely’ a demarcation problem that is technically easy to resolve but, conversely, politically extremely sensitive. It would for instance be relatively easy to devise a rule that holders of deposits above euro 500,000 are deemed to be risk-taking investors with bail-in-able claims, and that holders of deposits up to that amount are deemed to be users of the infrastructural functionalities of a bank, with claims exempt from bail-in. Such an approach has several advantages. First, the threshold amount concerned (or any other amount that would be politically acceptable) would ensure that a large part of the SME sector is protected. Second, it would force major depositors to distribute their favours among more banks, thereby perhaps fostering more diversity and risk mitigation in the banking sector. We will in this paper revert to the approach described in the paragraph below as the ‘investor only bailin approach’. It is noted that a statutory basis for preferential treatment of different classes of senior creditors is an absolute must for bail-in to work. In the absence of a statutory preference, senior creditors that are bailed-in would possibly have a claim in tort on the basis that they are unfairly discriminated against. Until the RRD is implemented on a national law level, a bail-in on the senior creditor level will thus simply not work in jurisdictions where this statutory preference is not yet provided for. The RRD does not embrace the ‘investor only bail-in approach’, nor does it wholeheartedly adopt the insolvency ladder principle. Rather, it applies a functional approach, considering each controversial category of creditors and their contribution to the realization of the continuity principle. See Article 41 and following RRD. According to this writer, this must be the appropriate approach (although the ‘investor only bail-in approach’ has its obvious merits, and is probably much easier to give practical effect to). This paper will now look at the different categories of creditors and their position under the RRD. 16 Eventually, after much political and legal discussion in Cyprus and between Cyprus and the ‘Troika’, the so-called Resolution of Credit and Other Institutions Law 17(1) of 2013 was passed, whereby insured deposits below the ceiling of euro 100,000 were placed in the ‘good bank’, and uninsured deposits above that ceiling were placed in the ‘bad bank’.

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11

Insured deposit holders

There is no question that this category is to be held whole. There is, however, an issue as to the scope of the protection. There is a lot to be said for including SME deposit holders into this category, and although that triggers the complex question of demarcation, that in itself is not a reason to deny this sector of the economy the protection of coverage. Widening the insurance coverage is an economic benefit to a sector that suffers from the depression that Europe now slowly seems to be emerging from. It also means a further reduction of the risk of bank runs. Another issue that arises is that of statutory preference. Small deposit holders should be given a better spot, at or very near the highest rung of the insolvency ladder.17 There may be a certain advantage in that the cost of funding the deposit insurance liability will be reduced: the higher on the ladder these creditors stand, the higher the chances of a payout to the benefit of the institutions that provided the insurance. A statutory preference might, in addition, help reduce the risk of a bank run; but for this to work there must be a mechanism for immediate payout once the failing bank can no longer meet its payment obligations; most insolvency systems do not provide for such a mechanism. It should be noted that granting statutory preference status to small deposit holders may also help reduce the threat of fraudulent creditors preference if such deposits would be subject to a forced migration pursuant to the RRD out of the failing bank to a bridge institution or an asset management institution. A problem in relation to statutory preference is that banks often operate their activities on a cross-border basis, and this means on the one hand that insolvency laws must be harmonized across the European Union, and on the other hand the question must be resolved whether statutory preference should also be given to depositors outside of the European Union. Should deposit holders at the Singapore branch of a large French bank have the same entitlement as deposit holders in Paris? It is easy to answer this question on the basis of the equality principle, and since we are discussing the distribution of assets of the insolvent estate, issues of inter State burden sharing would not arise. That question does of course arise at the level of the application of the Deposit Guarantee Scheme. That Scheme, as ordained by the European DGS Directive,18 is in the Member States largely based on territorial scoping of the deposit insurance coverage. However, the extremely complex issue of burden sharing will arise where a resolution entails both ‘bail-in’ and State support. On the issue of statutory preference and the DGS, it is noted that a combination is perhaps worth considering. It could be stated that while deposits up to euro 100,000 are protected, the claims in relation to both these claims (including the recourse claims of contributing

17 See the Vickers Report, p. 13. 18 Directive 94/19/EC of 30 May 1994, amended by Directive 2009/14/EC of 11 March 2009.

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banks) and claims of larger deposit holders (up to e.g. the euro 500,000 level) will have preferential status in the insolvency of the failing bank. Finally, one general comment with respect to the protection of the position of retail and corporate depositors: the extent to which the statutory bail-in provisions deny such protection might well have a direct adverse effect on the size of the so-called ‘funding gap’ of banks. That could at least be the case if depositors would be enticed to find alternative uses for the funds they would otherwise place on deposit with banks. The funding gap refers to the difference between the amount of the lending receivables of a bank in relation to the amounts of deposits that they have at their disposal. In the Netherlands, for instance, the ‘funding gap’ of the larger high street banks appears to be relatively large.19

12

Suppliers

Suppliers are normally unsecured, concurrent creditors. It may be that they have security, which would usually take the form of title retention arrangements, but generally they are unsecured. As a class of creditors in the ‘traditional’ insolvency waterfall, they would rank pari passu with other unsecured concurrent creditors. On the basis of the principle of equal treatment of creditors that belong to the same class in the waterfall, suppliers should accordingly be part of a bail-in exercise on the same footing with senior bondholders and other creditors. But here two problems need to be dealt with. The first one relates to the question, is it fair that suppliers are made to suffer for problems with which, by definition, they are not involved or concerned? The answer to this question appears simple: there is no reason why suppliers should be protected when supplying banks with their goods and services while they are not so protected if they supply their goods and services to other customers than banks. Nevertheless, a certain nagging feeling remains on the question of fairness. The second problem that needs to be dealt with relates to the continuity principle. Bailing in suppliers means they will discontinue their services; they will not wish to stay on board the sinking ship. The continuity principle, accordingly, dictates that they should not be bailed in. But does that apply to the entire class of suppliers, or just to suppliers that provide services that are indispensable to the continuation of the infrastructural functions of a bank? Logic says the latter, but the equality principle says the former. The RRD takes a functional approach, abandoning the equality principle to a certain extent. In Article 38 subsection 2 sub (f) the following exclusion from bail-in is provided for: 19 See, for instance, the Deloitte report on the Dutch funding gap dated September 2012, Close the funding gap, How to make Dutch residential mortgages attractive for investors again, to be found in the Deloitte website, citing a 52% funding gap of euro 334 billion in 2011.

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a commercial or trade creditor arising from the provision to the institution or entity referred to in points (b), (c) or (d) of Article 1 of goods or services that are critical to the daily functioning of its operations, including IT services, utilities and the rental, servicing and upkeep of premises. Suppliers that do not fall within that category could still be absolved from bail-in on the basis of Article 38 subsection 3c RRD, which provides that an exclusion from bail-in is inter alia possible in exceptional circumstances if: the exclusion is strictly necessary and is proportionate to achieve the continuity of critical functions and core business lines in a manner that maintains the ability of the institution under resolution to continue key operations, services and transactions. In these provisions, the RRD embraces the continuity principle on a rather narrow basis: one wonders whether the RRD is not too strict in its approach. The remaining ‘good bank’ that gets the benefit of these exclusions is supposed to become a healthy surviving banking enterprise, probably in that context needing more products and services than those which are strictly necessary. It should be noted that if the ‘investor only bail-in approach’, as suggested on page 151, is adopted, these difficult issues caused by conflicting principles should not arise at all … Finally on this topic, it is to be hoped that the exclusion possibilities of Article 38 subsection 3c would allow certain groups of creditors that are not specifically dealt with in the functional approach of the RRD to be excluded from bail in. One could think here of money market funds providing liquidity to banks, creditors under FX transactions, creditors under outsourcing arrangements, etc. One could also think of creditors under escrow arrangements and under custody arrangements where the requirements of the exclusion under Article 38 subsection 2 sub ca RRD (‘provided that such beneficiary is protected under the applicable insolvency or civil law’) cannot be met. Non-availability of exclusions in these cases could severely dent confidence in these infrastructural functions that banks perform. This writer regrets that the RRD does not contemplate that the EBA develops Regulatory Technical Standards (RTS) to provide much needed clarity on the possible scope of the exclusions.

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Derivatives

How should derivatives be treated in the context of bail-in? A claim of a counterparty under a derivatives contract may well be secured (and security will mostly be provided on the basis of a financial collateral arrangement), but there will also be unsecured claims. If secured, the problem is reduced to the net claim that remains after the counterparty has realized the financial collateral arrangement by which he has been given the benefit of the security. Financial collateral arrangements have the advantage over ‘traditional’ forms of security (pledges) in that they can be foreclosed without delay. The problem with derivatives is that they basically defy categorization. There are derivatives that are entered into with clients to hedge exposures that such clients have on the bank or vice versa. Interest rate swaps are a typical example of derivatives entered into to cover interest rate exposures of a borrower towards its banks under bilateral and syndicated loans. There are derivatives that the bank enters into with third parties to hedge exposures that the bank has on clients. Such exposures may, for instance, be future delivery obligations of securities that are the subject of repo or securities lending transactions that the bank has entered into with clients. There are derivatives that a bank enters into to hedge its own exposures generally. A typical example would be currency and interest rate swaps designed to minimize a bank’s funding mismatch. Then derivatives are also entered into by banks for proprietary trading purposes. This broad-ranging functionality of derivatives makes it very difficult to fit these transactions into a logical bail-in framework. In this book, Prof. Garcimartín provides an excellent and comprehensive analysis of how derivatives may be dealt with in a bail-in context. This paper is confined to reiterating only the following three general critical points in relation to derivatives: 1. The RRD only gives rather generalized principles in relation to the bail-in of derivatives. This means that a substantial degree of discretion is accorded to the resolution authorities of the Member States to deal with derivatives. This is not conducive to a level playing field in so far as the application of resolution tools is concerned. It may well be (and it is hoped) that RTSs will be introduced that would enhance a certain level of harmonization, but we will have to wait and see. 2. The exclusion permitted by the provisions of Article 38 subsection 3c RRD can only be applied in very limited circumstances (i.e., it must be a case of ‘exceptional circumstances’, and then the exclusion may only be applied if it is ‘strictly necessary and proportionate’). These requirements are very strict indeed, and in a literal interpretation they would probably mean that a large portion of derivatives that support the realization of the continuity principle cannot be excluded on the basis of Article 38 subsection 3c RRD. It is suggested that this approach is not conducive to the realization of the conti-

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nuity principle and that the statutory rules relating to derivatives should be somewhat more relaxed. 3. Article 44 RRD suggests that resolution authorities will not only have the right to terminate and close out derivative contracts entered into by a failing bank, but will be obliged to do so unless an exclusion under Article 38 RRD would apply. There is, however, a contradiction here: in Article 44 subsection 3 sub (b) RRD it is stated that the resolution authority will determine the value of liabilities using: appropriate methodologies for comparing the destruction in value that would arise from the close out and bail-in of derivatives with the amount of losses that would be borne by derivatives in a bail-in. It might be inferred from this somewhat obscure language that if the value destruction is or could be unfavourable, termination and close out could be postponed or averted altogether. It is important that clarity is given by the legislators in Brussels as to the scope (and timing) of the obligation of resolution authorities to terminate and close out. The termination right that the RRD grants to the resolution authorities, it would appear, overrides the express contractual terms of the derivative contract concerned. In other words, the termination and close out netting can (at least in theory) be effected by the resolution authority without regard to the terms of the derivative contract concerned. This authority naturally needs to be given to the resolution authority, but the RRD provides no guidance as to how this authority is to be exercised. For instance, timing of termination and close out is of course a crucial issue, especially in circumstances where markets and asset prices are extremely volatile as one may well expect them to be in a situation of systemic turmoil. One can imagine that tension may arise in a situation where the loss absorption amount needs to be determined at a certain point in time at which it would be rather unfavourable to terminate a derivative contract. The RRD states only that the EBA is to develop technical standards to be followed when applying the: principles for establishing the relevant point in time at which the value of a derivative position should be established. In the view of this writer, more certainty will have to be provided, if only firstly to give resolution authorities more guidance as to what is expected of them, and secondly to enable parties to derivative contracts to determine more exactly what their risks are vis-à-vis a failing counterparty bank.

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Senior bondholders

In the SNS Reaal expropriation in the Netherlands, senior bondholders were let off the hook. They were not expropriated, and therefore they were left, comfortably, with a claim on a Government-owned bank. The reasoning put forward by the Dutch Minister of Finance was as follows: We have thought about expropriation of also the non-subordinated debt. In an insolvency, these debts would admittedly not have lost all their value, but they would be worth less than their nominal value. We have abstained from expropriating the non-subordinated debt. According to DNB [the Dutch central bank] expropriation would have had a negative effect on the financing of other Dutch financial institutions and thereby also on the stability of the financial sector. Participating in the losses of SNS Reaal by holders of non-subordinated debt would come as a surprise. A sudden adjustment of market expectations may lead to a downgrading of these instruments and to higher funding costs for Dutch banks, who are strongly dependent on such funding. Market parties have argued that pre-empting on the outcome of the international discussion on the question to what extent non-subordinated debt of banks should suffer in resolution actions, could have as a consequence that the unsecured funding market for Dutch institutions would close down.20 The refusal to expropriate non-subordinated debt relieved the Dutch Government of an awkward dilemma: if senior bonds had been expropriated, then, following the equality principle, logically speaking also other pari passu senior debt ought to be expropriated. The question of where the line should be drawn and what could justifiably be left out of the expropriation was thus thankfully avoided. The international discussion referred to in the quote in the paragraphs above has meanwhile led to the firm and near universally accepted conclusion that senior bonds indeed will have to be bailed in, immediately following the bail-in of subordinated instruments. The abovementioned awkward dilemma thus resurfaces, and is addressed by the functional approach of the RRD. However, that international discussion triggered another debate, that is as to how much bail-in-able debt a bank should be forced to maintain outstanding. The outcome of that

20 Translation by this writer of para. 54 of the Expropriation Decision of the Minister of Finance dated 1 February 2013, to be found on the website of the Ministry.

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debate is crystallized in Article 39 RRD. This provision states that each bank is to maintain a certain level of own funds and eligible liabilities. Eligible liabilities are defined as all liabilities except for those which are specifically excluded pursuant to the provisions of Article 38 RRD. This means that inter alia secured liabilities are excluded, including liabilities arising from covered bonds. The approach of the RRD requiring a certain level of unsecured debt is designed not only to ensure that the loss absorption capacity at the bank funding level is sufficient, but also to prevent financial institutions from resorting to a much more voluminous level of secured funding (principally through the issue of covered bonds). But what is a ‘sufficient’ level of bail in-able debt? This is to be determined according to RTSs to be developed by the EBA and adopted by the European Commission. The ultimate responsibility for determining the level of bail-in-able debt rests with the national resolution authorities, who are evidently bound by the said standards but who may ‘provide for additional criteria on the basis of which the minimum requirement for own funds and eligible liabilities shall be determined’ (Article 39 subsection 1 RRD). This presumably means that Member States can impose higher levels of loss absorption capacity on banks than would be required under the RRD. This raises the level playing field issue. However, it seems logical that this discretion is given to Member States and their resolution authorities, in view of the diverse characteristics and risk profiles of banks generally and in view of the fact that if the European generally accepted ‘mean’ level as determined according to the RTS is deemed too low by a Member State, there is no good reason why a more prudent level should not be imposed locally. A further argument in favour of discretion is that there may in different Member States be different perceptions as to what constitutes a systemic risk that a failing bank might generate in the country concerned, based on the characteristics of the financial industry in that country in the context of that country’s economy. In conclusion, quite possibly very different levels of own funds and eligible liabilities will be imposed on banks. This may, however, because of the cost of funding consequences, affect the competitiveness of banks operating in the EEA. It is noted that the RRD also contemplates a level of bail-in-able debt at the level of a failing bank’s subsidiaries (including, apparently, non-regulated subsidiaries). This ‘solo’ approach recognizes the current tendency whereby regulators urge international bank groups to remove intra-group dependencies (guarantees, double leverage). It is also in recognition of a current trend of national regulators preferring bank subsidiaries to branch offices. The approach would possibly facilitate a resolution based on an ‘MPE resolution strategy’

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rather than an ‘SPE resolution strategy’;21 a flexibility that on the one hand is recommendable but on the other hand may lead to the imposition of requirements on subsidiaries of banks that perhaps unnecessarily tie up capital where the risk of systemic failure may be rather remote. The debate on the merits of the MPE approach versus the SPE approach has, at the time of writing this paper, not yet led to consensus. In the context of requiring banks to help regulators develop resolution plans, regulators are known to require both approaches to be examined and catered for by international banks.

15

Contractual bail-in versus statutory bail-in

The RRD leaves it to the institutions concerned to determine whether they would opt for contractual bail-in instruments to become part of their eligible liabilities or opt for statutory bail-in instruments. Contractual bail-in instruments are instruments of which the terms and conditions provide that they will be written off or converted into ordinary shares if and when the solvency of the issuer falls below a certain defined level.22 Given the requirements that are imposed on contractual bail-in instruments,23 it should not make a substantial difference to financial institutions which approach is taken. However, if a bank would issue contractual bail-in instruments that would convert at an earlier point in time than when the application of resolution tools would be permitted by Article 27 RRD, this might have certain advantages for the institution concerned. Earlier conversion may conceivably buy time, and may possibly even buy sustained client confidence when the going gets tough. But in reality these advantages are probably rather uncertain given the unpredictable nature of systemic risks and of public and regulatory response to systemic risks. It is finally noted that pre-existing contractual bail-in instruments may have to be adapted to the RRD requirements if and when the RRD is implemented.

16

Covered bonds and other secured liabilities

Secured liabilities, including those under covered bond transactions, are excluded from the bail-in. The logic for this approach is simply that these liabilities, to the extent secured, 21 The so-called Multiple Point of Entry resolution mechanics as opposed to the Single Point of Entry resolution mechanics. See Schoenmaker (2013), at pp. 109 and 110. 22 Enhanced Capital Notes issued by Lloyds Bank, for instance, provide for conversion into ordinary capital if and when CET1 falls below 5%. Rabobank has issued various series of Notes, including so-called Senior Contingent Notes and CRD2/CRD4 Compliant Capital Notes, with comparable features (referring, however, to a different solvency threshold, being, in its Notes issued in 2010, 8% of its Equity Capital Ratio). The terms and conditions of these various notes can be found on the websites of these institutions. Many other international banks have issued similar instruments. 23 Article 39 subsection 4f RRD.

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would not be affected by the insolvency of the institution concerned. Secured liabilities are a defined term under the RRD, comprising liabilities: where the right of the creditor to payment or other form of performance is secured by a charge, pledge or lien, or collateral arrangements including liabilities arising from repurchase transactions and other title transfer collateral arrangements.24 Personal security is excluded. This seems logical: a write-off should, depending of course on the text of the guarantee and the governing law, not frustrate the claim of the creditor on the guarantor. The guarantor’s recourse claim, being a senior claim, would then be subject to the bail-in. It is an interesting question how the claim of the creditor on the guarantor is affected if the bail-in takes the form of a conversion into ordinary shares. In that case, the value of the stock accorded to the creditor should be deducted from the claim on the guarantor. The residual recourse claim of the guarantor, if any, would then presumably also be converted into equity. Could these conceivably lead to ‘double counting’ of the bail-in-able claim if the value of the stock is severely discounted against the nominal amount of the creditor’s claim? Article 45 subsection 2 RRD, stating that the conversion rate shall represent ‘appropriate compensation to the affected creditor’, may perhaps be argued to prevent such double counting. A potential difficulty arises where the security proceeds are less than the amount of the secured liability. The shortfall should be a senior claim that itself should be subject to the bail-in. There may, however, be a significant time lag between the moment in time that the bail-in-able debt needs to be calculated and the time where it becomes clear what the shortfall really is. This should not occur in the case of financial collateral arrangements where the foreclosure should be straightforward and swift, but with security in the form of illiquid assets the timing constraints may be substantial. Perhaps then, the resolution authority concerned may invoke Article 38 subsection 3c sub (i) RRD, which provides that bail-in can be excluded when it is not possible ‘to bail-in a liability within a reasonable time notwithstanding the good faith efforts of the resolution authority’. But this could clearly be rather unfair towards other pari passu creditors who are made to suffer …

24 Article 2 sub (58) RRD.

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Set-off

How to deal generally with set-off rights that a senior creditor can invoke against a failing bank? It would be in the interest of the effectiveness of the bail-in instrument that set-off is not permitted. But to the senior creditor, who could presumably at least in ‘set-off friendly jurisdictions’ invoke his set-off rights in a ‘normal’ insolvency scenario, the denial of setoff rights would appear grossly unfair, particularly also considering that, in specific instances, such as in relation to derivative transactions, repo transactions, securities lending, financial collateral arrangements and netting arrangements, set-off would be specifically allowed under the RRD. A denial of set-off rights could also adversely affect the proper functioning of inter-bank transactions. Set-off rights, however, will have to be respected under the RRD. This, in any event, follows, in the opinion of this writer, from the NCWO principle as set out in Article 65 sub (b) RRD. But of course in ‘set-off unfriendly jurisdictions’, this principle would not work in favour of set-off arrangements; this could conceivably lead to a distortion in the effectiveness of bail-in in various Member States.

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Valuation

Article 30 RRD prescribes that before any resolution action is undertaken, the assets and liabilities of the failing bank are subjected to a valuation by an independent third party. If independent valuation is not possible, a provisional valuation may be made by the resolution authority concerned. The purpose of valuation is to provide a factual basis for various determinations to be made in respect of the resolution process: e.g., whether the conditions for resolution have been met, which resolution tools are to be applied, what in the case of bail-in the write-down or conversion rate should be, and how compensation to owners of shares or other instruments of ownership is to be calculated. An extremely important function of valuation is to ensure that ‘any losses on the assets of the institution […] are fully recognised at the moment the resolution tools are applied or the power to write down or convert capital instruments is exercised.’ This is stated in Article 30 subsection 2a sub (g) RRD. The RRD does not give guidance as to how to deal with losses that are contingent, for example, on the basis of guarantees issued or structured finance transactions that have yet to be unwound. A further important function of valuation is that it will help in establishing whether a resolution plan complies with the NCWO principle (see, however, under the paragraph below). The valuation, according to Article 30 subsection 4 RRD, will have to indicate the insolvency waterfall together with ‘an estimate of the treatment that each class of shareholders and creditors would have been expected to receive, if the institution […] were wound up under normal insolvency proceedings’. A rather tall order!Subsection 4 of Article 30 RRD concludes that the estimate shall not affect the application of the ‘no

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creditor worse off’ rule to be carried out under Article 66 RRD. The latter Article requires a separate, independent valuation for the purpose of determining compliance with the NCWO principle. This separate valuation is to be made ‘as soon as possible after the resolution action or actions have been effected’ – therefore ex post facto. In case of unjustified mistreatment of a shareholder or creditor, the application of the resolution tool will not need to be adjusted to remedy that mistreatment, but the shareholder or creditor concerned will have a claim to be satisfied from the relevant Member State’s ‘resolution financing arrangements’.25 This does not of course absolve resolution authorities from strict compliance with the NCWO principle: Article 65 subsection (b) squarely imposes compliance with this principle on the Member States. But the RRD correctly takes the approach that resolution tools, once applied, will not need to be subject to correction in case of noncompliance. The penalty for non-compliance is that the Member State’s resolution financing arrangements will suffer. This cost, however, is ultimately borne by the financial sector itself; one could query whether this is fair towards the contributing banks; they have no tasks or responsibilities in the resolution process. If the resolution financing arrangements are to be used, an interesting question is whether banks that have contributed to the resolution financing arrangements could claim against the Member State or the resolution authority of that Member State if the NCWO principle is negligently violated. In summary, valuation is crucial to the whole process of resolution. But the valuation task is a daunting one. It would normally take months to do a rough independent valuation on a financial institution, and the question arises as to how to deal with this requirement if that amount of time is simply not available because quick, decisive intervention is necessary to ensure effective resolution.

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Conclusion

The RRD in its current form raises many more questions than this paper is able to address. The RRD is a mer à boire for regulators and lawyers. The subject matter of bank resolution, and in particular bail-in, is extremely complex. The implementation of the RRD is a daunting task if the national regulators would wish in their national laws to resolve many of the open questions as to the meaning of the detailed provisions of the RRD. Hopefully, the RTS will provide some sensible guidance … If ever the RRD is going to have to be applied in relation to a European G-SIFI, this could well lead to a host of uncertainties that would, under the extreme pressure of a systemic situation, quickly need to be resolved. Some of these uncertainties might then well lead to lengthy lawsuits.

25 See Article 91 RRD.

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A few staccato conclusions are offered: – Generally, the RRD approach to bail-in looks right, if one accepts as unavoidable that funding costs for banks will increase in an economic environment where banks face a difficult struggle to fund their operational activities. But see the next bullet. – In the view of this writer, the ‘investor bail-in only approach’ is both simpler and perhaps more effective (but this appears, regrettably, to be a ‘water under the bridge’ conclusion). – The RRD exclusions to the bail-in requirement are too strict and should be made more liberal to ensure the correct realization of the continuity principle. – The RRD provisions on bail-in leave too much discretion to the home Member States, and would therefore allow a distortion of the level playing field across the European financial sector. – The RRD provisions (like the SRM provisions)26 raise serious issues as to whether resolution authorities can act quickly and decisively enough to address a more or less unexpected systemic failure.

26 See the Presidency of the EU Council’s Proposal dated 6 December for the SRM Regulation.

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Francisco Garcimartín* The legislation giving the resolution authority statutory bail-in powers should provide clarity and certainty as regards the authority triggering entry into resolution; the process and the threshold conditions under which bail-in, and other resolution tools, could be used; the relevant consequences for capital providers and creditors; and the scope of liabilities covered by the bail-in powers. It is desirable that divergence is limited across countries. (FSB, Consultative Document, Effective Resolution of Systemically Important Financial Institutions, July 2011, at 12).

1

Introduction

In response to the financial crisis, several jurisdictions have laid down special resolution frameworks giving national authorities extraordinary powers to deal with failing financial institutions. The resolution toolkit includes: (a) selling businesses to a third party, (b) transfer to a bridge institution (bridge institution tool), (c) transfer to an asset management vehicle (asset separation tool), and (d) the bail-in tool. In their practical application, these resolution tools are creating serious economic and legal problems. This paper focuses on one of them: the application of the resolution tools to derivatives transactions. The framework set out in the EU Proposal for the Recovery and Resolution Directive (RRD), draft of 28 June 2013, is taken as reference for the analysis.1 The paper is divided into three sections. The first two deal with one of those resolution tools: the bail-in. Section 2 describes the concept of ‘eligible liabilities’, that is, those liabilities that may be subject to bail-in, adopted by the RRD. Section 3 focuses on the particular problems raised by the application of the bail-in powers to derivative transactions. Finally, Section 4 examines certain problems that the application of other resolution tools may pose for those transactions.

* 1

Chair Professor of Private International Law, University Autónoma of Madrid. The references are made to the numbers of the Articles in this text. They will likely change in the final version.

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2

2.1

Bail-in: eligible liabilities

Introduction

In colloquial terms, the concept of ‘bail-in’, as opposed to ‘bail-out’, means that the losses suffered by a distressed financial institution are not paid for by taxpayers, but by its shareholders and stakeholders (creditors). Accordingly, creditors, and not taxpayers, contribute to shoring up the failing institution’s balance sheet by (i) taking haircuts on their claims and/or (ii) converting these debts into equity. Since in many cases formal insolvency proceedings are not an efficient alternative, the bail-in tool is supposed to both reduce moral hazard, that is, forcing creditors to be more careful with their investments, and at the same time prevent bail-outs, that is, turning private debt into public debt. The bail-in mechanism can form part of the terms and conditions of the contract entered into by the creditors and their debtor, for example of bonds (=contractual bail-in), or be imposed by the competent authorities in a resolution scenario (=statutory bail-in). In the former case, the debt instrument envisages its conversion into equity or the write-down of its nominal value when certain predetermined trigger events are met. This is the case, for instance, with contingent capital instruments that are convertible into equity in times of financial distress. In the case of statutory bail-in, the competent authority has the power to write down an entity’s liabilities and/or convert them into equity following its entry into resolution.2 Note that there are significant operational differences between these two mechanisms: contractual bail-in is usually triggered automatically and well in advance of an entity approaching insolvency. Statutory bail-in will be triggered by the competent authority exercising its powers of resolution when the institution is failing or likely to fail. This paper focuses on statutory bail-in. In more formal terms, the RRD defines bail-in as the exercise by a resolution authority of the write-down and conversion powers in relation to the liabilities of an institution under resolution (Article 2 (49) RRD). The key factor for using the bail-in powers is that there is an institution to be rescued, in whole or in part, which needs to continue servicing its customers. Bail-in powers can be activated alone or in combination with other resolution tools. Therefore, they can be used to restructure an entity as a going concern as a whole

2

Nonetheless, statutory bail-in can also be explained as an ‘implicit term’ of the contract. When creditors enter into a contract with a debtor, the former should assume the exercise of the bail-in powers under the law of the home Member State of their debtor as an ‘implicit term’ of their relationships. In general, restructuring measures and insolvency law can always be explained as a part of the ‘implicit terms’ of a contractual relationship between the creditors and their debtor.

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or to guarantee financing a bridge institution, a sale of business or an asset separation tool (Article 37.2 RRD).

2.2

Scope: eligible liabilities

The scope of application of the bail-in powers is a critical part of the directive. Delineation of eligible liabilities, that is, those that may be subject to write-down or conversion, must be clear and precise, so that investors can determine ex ante the risks associated with their claims and price them accordingly. And the same holds for the determination of the allocation of losses among eligible liabilities, that is, how much each stakeholder is going to lose. In so far as a bail-in entails a sort of ‘synthetic insolvency’, it is essential that the exercise of the bail-in powers satisfies a double test: (i) it must respect, as far as possible, the insolvency statutory order of priorities and the pari passu treatment of creditors (ii) and, in general terms, it must leave no creditor ‘worse off’ than if the failed entity had gone into formal insolvency proceedings. The liquidation value is therefore the threshold. The RRD reflects these two parameters in different provisions: for example Articles 29, 38 (3) (cb), 43 and 65. The RRD limits the scope of application of the bail-in powers in a negative way (Article 2 (62)). The starting point is that the bail-in powers may be applied to all liabilities of an institution, unless explicitly excluded (Article 38 (1) RRD). The RRD contains a list of these exclusions (Article 38 (2)) and a general clause that allows resolution authorities to extend that list, but under very strict conditions (Article 38 (3)). The liabilities explicitly excluded are: i. Covered deposits up to the amount guaranteed, that is, deposits that are guaranteed by deposit guarantee schemes up to the coverage level laid down by Article 7 of Directive 94/19/EC (see also Article 2 (83a)). ii. Liabilities, secured by a security interest or by title transfer collateral, including covered bonds, up to the amount guaranteed by the value of the collateral (see also Article 2 (58) (83b)). iii. Any liability arising from the holding of client assets or client money or a fiduciary relationship between the institution and another person (beneficiary), provided that such client or beneficiary is protected under the applicable insolvency or civil law. iv. liabilities to institutions, excluding those of the same group, with an original maturity of less than seven days. v. Liabilities arising from a participation in a system designated according to Directive 98/26/EU (Settlement Finality Directive).

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vi. liabilities to employees, commercial or trade creditors and tax and social security authorities, but only if the conditions specified in Article 38 (2) (f) are met. For example, tax liabilities are excluded only to the extent that they have preference under the applicable law; commercial or trade creditors are excluded only to the extent that they arise from the provision of goods or services that are critical to the daily functioning of the entity under resolution. Alongside this list of exclusions, Article 38 (3c) adds a general clause that allows resolution authorities, in exceptional circumstances and under certain conditions, to exclude certain liabilities from the scope of the bail-in powers. The main objective of this general clause is to give resolution authorities certain flexibility to extend the list of exclusions when necessary either to ensure the effectiveness of the rescue of the institutions or to protect the stability of financial markets. Within that scope of eligible liabilities, the sequence of write-down and conversion when applying bail-in tools is defined by Article 43 RRD (and corresponding provisions, e.g. Articles 29 or 52). As explained above, the main idea when applying the bail-in is to replicate the priority of claims under normal insolvency proceedings and to distribute the losses pro rata among creditors of the same rank.

2.3

Cross-border dimension

Bail-in powers apply to all eligible liabilities irrespective of the governing law, that is, whether they are governed by the law of the State of the resolution authority, the law of another Member State or the law of a third country, and on a non-discriminatory basis: local and foreign liabilities of the same nature should be treated alike. In application of the insolvency rank of priorities (where there is no difference between national and foreign claims), the bail-in should therefore be applied to foreign claims with the same extent as to equivalent national claims. Within the EU, mutual recognition of the exercise of the bail-in powers does not raise particular difficulties: all Member States must recognize the write-down or conversion powers exercised by the resolution authority of the Member State of origin (Article 59 (4)). Furthermore, the rights of creditors to challenge those measures are also subject to the law and the jurisdiction of the Member State of origin (Article 59 (6)). Example. Let us imagine that the home Member State of the failing institution is Spain. In accordance with the national law implementing the RRD, Spanish resolution authorities

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decide to impose a bail-in on senior creditors, such as unsecured bondholders. In principle, the bail-in should apply to all bonds of equivalent features irrespective of the applicable law; for example to bonds governed by Spanish law and to bonds governed by Dutch law. The outcome would therefore be the same as in formal insolvency proceedings. Furthermore, Dutch authorities must recognize the write-down and conversion imposed by the Spanish authorities. With regard to third countries, since mutual recognition is not guaranteed, the RRD lays down a special rule to enhance the effectiveness of the bail-in powers. When eligible liabilities are governed by the law of a third country (i.e. non-EU Member State), the RRD foresees a contractual incorporation of the bail-in powers, that is, ‘contractualizes’ the exercise of these powers. According to Article 50, institutions shall include in the contractual provisions governing any foreign law eligible liability that the creditors (i) recognize that the liability may be subject to the write-down and conversion powers of the issuer’s resolution authority, and (ii) agree to the consequences of the exercise of such powers. This contractual recognition of the bail-in powers includes both the substantive aspects of the write-down or conversion and the judicial remedies and safeguards. This mechanism may facilitate cross-border recognition of the bail-in measures in so far as the parties freely accept, as a matter of contract, the implementation of a statutory bailin and, therefore, should take this into account when entering into the corresponding contract. Additionally, resolution authorities may require a legal opinion relating to the legal enforceability and effectiveness of such terms (Article 50 (1) II, see also Article 39 (2a) excluding, when the resolution authority is not satisfied that the bail-in powers would be effective under the law of the third country, those liabilities from the minimum requirements for own funds and eligible obligations). However, the absence of such a clause does not prevent the resolution authority from exercising the bail-in powers. In this case, however, it is true that the bail-in measures might not be recognized by foreign countries, and this limits their effectiveness, in particular when creditors may enforce their claim in such foreign countries, for instance because the failing entity has assets there. To reduce the drawbacks from this fact, the EU may negotiate agreements with third countries to ensure mutual cooperation and recognition (Article 84 et seq.).

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3

Derivatives

In relation to derivatives, two issues have to be analysed: (i) whether they are subject to the bail-in powers; (ii) and if so, how the bail-in applies to those transactions.

3.1

Derivatives as eligible obligations

It is true that there may be certain grounds for excluding derivatives from the bail-in powers, since they are not usually designed as funding transactions. Furthermore, the valuation of derivatives to determine the amount of liability to be written down and/or converted entails serious practical difficulties. They are highly volatile instruments with markedly changing values over very short periods of time. The policy underpinning the RRD is, however, to reduce privileges to a minimum (note that any exclusion increases the losses that the rest of the eligible liabilities and/or taxpayers must support) and, therefore, derivatives are included within the scope of eligible obligations. To the extent that they are not mentioned in the list of exclusions, they may be subject to write-down and conversion, like any other non-excluded liability. The only loophole would be the general clause (supra). The RRD gives national authorities discretionary powers to extend the list of excluded liabilities on a case-by-case basis. The reasons that may justify extension are enumerated in Article 38 (3c), that is, when it is not possible to bail in that liability within a reasonable time, or when exclusion is strictly necessary to continue the core business of the institution or to prevent a severe disruption of financial markets. The original text of the RRD contained a specific provision on the conditions under which derivatives may be excluded from the scope of eligible liabilities. This provision was redrafted as a general clause. In principle, resolution authorities may exclude any liability in so far as the strict conditions set out by that provision (i.e. Article 38) are satisfied. However, derivatives, unlike other liabilities, are transactions that might typically satisfy those conditions (actually, Article 44 (1a) II mentions this possibility expressis verbis). On the one hand, since the application of the bail-in powers to derivatives may require the close-out of a large number of outstanding transactions (infra), this may be difficult to do in a reasonable time frame. And, on the other hand, the high degree of interconnectedness among institutions and the huge amounts of money at stake may significantly increase the contagion effect and, therefore, the systemic risk. Nevertheless, note that the ‘test of exclusion’ is very demanding: resolution authorities may only exclude derivatives ‘in

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exceptional circumstances’ and when such exclusion ‘is strictly necessary and proportionate’ to achieve those objectives (see also Article 38 (3cb) (d) and (5), foreseeing a certain intervention of the Commission). Secured liabilities are, in any case, exempted from the bail-in powers but, in principle, only up to the value of the collateral. As regards derivatives secured by a security interest, for example a pledge, these qualify as secured liabilities and are therefore excluded from the bail-in powers up to the value of the encumbered assets. If the collateral is provided on a title transfer basis, the bail-in only applies to the net close-out amount, that is, the difference between the value of the secured obligation and the assets transferred (infra). The issue of whether derivatives cleared through a central counterparty (CCP) should have priority over OTC derivatives, that is, whether non-cleared derivatives will have to be fully bailed-in before any cleared derivatives, has been raised within the Parliament, but remains open (November 2013).

3.2

How does the bail-in tool apply to derivatives?

Theoretically, the bail-in powers are relatively easy to apply to an obligation. Its nominal value is written down and/or converted to the corresponding amount following the hierarchy set out by Article 43 RRD. Conversely, derivatives are contingent while the transactions are outstanding. An outstanding swap, for example, usually implies an exchange of cash flows with reciprocal obligations to be performed when the failing institution enters into resolution. Application of the bail-in tool to such liabilities may give rise to severe valuation and operational difficulties. Actually, the application of the bail-in powers to derivatives may only be conceived when the failing institution is ‘out of the money’ and with regard (i) to the periodic payment amount – that is, the amount that has become due and payable on a payment date under the derivatives, when the bail-in power is exercised, or (ii) to the net close-out amount under a master agreement if the transactions are cancelled. Indeed, the application of the bail-in powers to the latter, that is, to the net closeout amount, is what is important in practice. Naturally, to determine whether a derivative contract gives rise to liability and to determine its exact amount requires a closing out of the transaction. That is why Article 44 RRD establishes that resolution authorities will only exercise the write-down and conversion powers upon or after closing out the derivatives. This, however, raises two additional problems: the exercise of the close-out rights and the calculation of the net close-out amount.

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First, the master agreement governing the derivatives may not envisage the exercise of resolution powers as a default or termination event. But even if it did, that is, assuming that the resolution qualifies as an event of default, the close-out rights and therefore calculation of the netted amount would normally correspond to the party in bonis, that is, the counterparty to the institution under resolution. However, since this counterparty would suffer the consequences of the bail-in, he or she may have no interest in closing out the agreement. In order to overcome these obstacles, the RRD gives the resolution authorities a specific power to trigger application of that clause. Article 44 (1a) expressly recognizes that such authorities ‘[…] shall be empowered to terminate and close out any derivative contract’ (see also Article 56 (1) (lbis)). Note that this power is nothing extraordinary from an insolvency law perspective: in many jurisdictions, the administrators have the right to reject executory contracts under certain conditions and to assess the value of the damages corresponding to the party in bonis.3 Naturally, when derivatives are excluded from the application of the bail-in tools in the terms described above, the resolution authorities shall not exercise that power. Second, valuation of the net close-out amount corresponds to the resolution authorities, but in accordance with the terms of the agreement. The reference to the terms of the agreement is mainly to the valuation methods of each transaction, the obligations to be included under the same close-out netting master agreement and determination of the net amount. The master netting agreement must be honoured. This is a corollary of the fact that a netting arrangement limits the reciprocal exposure of the parties to a net amount calculated in accordance with the contractual terms. It prevents the counterparty to the institution under resolution from being required to meet its payment obligations while at the same time seeing its claims written down. In this regard, the current text of Article 44 may be confusing, since alongside a reference to the contract for determining the method of calculation, EBA standards are mentioned. Finally, the RRD also adds that, for the purpose of determining the fair and realistic value of the assets and liabilities of an institution (Article 30), the value of all derivatives subject to the same netting agreement shall also be calculated on a net basis. These powers of the resolution authorities, that is, triggering the close-out of the transactions and applying the bail-in to the net amount, should apply to all derivatives irrespective of the law governing them. If, for example, the resolution authority of Member State A exercises the write-down and/or conversion power with regard to derivatives, it should in

3

See, e.g., with further references, F. Robert-Tissot, ‘The Effects of a Reorganization on Executory Contracts: A Comparative Law and Policy Study’, at .

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principle include all derivatives irrespective of whether they are governed by the law of Member State A, Member State B or a third country (this, however, may give rise to additional problems, see infra 3.2).4 The general framework on cross-border scope of application governs this aspect (supra). Therefore, in that example, Member State B must recognize the decisions made by the resolution authority of Member State A.

4

Other issues: suspension of termination rights and transfer to another entity

In this last Section, I examine certain problems that the application of other resolution tools, different from the bail-in powers, may pose for derivatives.

4.1

Suspension and termination rights

As explained, financial contracts, particularly derivatives, usually include mechanisms to reduce the parties’ reciprocal risk exposure. One of the most effective mechanisms is the so-called close-out netting agreement. Application of this agreement is triggered by certain events. In such a case, (i) all transactions covered by the agreement are terminated, and the value of each is determined under a pre-defined valuation mechanism, and (ii) the sum total value of all transactions is then aggregated, resulting in a single payment obligation or ‘net amount’. The net amount remains the only obligation to be settled and is generally due immediately after being determined. The RRD interferes with application of this clause in two ways. On the one hand, it gives resolution authorities the statutory powers to trigger application of the clause in order to apply the bail-in tool. We have already described this situation (supra 3.2). On the other hand, it excludes the rights of the counterparty to trigger application of that clause, in order to enhance the effectiveness of other resolution tools. We analyse this second aspect in the following paragraphs. Traditionally, close-out netting agreements have enjoyed special protection in insolvency. In many jurisdictions, general principles of insolvency law prevent executory contracts from being terminated by reason of the counterparty’s insolvency. That is, the debtor may assume an executory contract notwithstanding an ‘ipso facto clause’.5 The rationale behind 4

5

The words ‘in principle’ are used to qualify the sentence because, as has been explained, the resolution authorities may always resort to Article 38 (3c) to exclude certain categories of liabilities under the conditions set out in this provision. Robert-Tissot, endnote 4, pp. 6-24.

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this limitation is to enable the debtor in possession or the insolvency administrator to continue running the business as a going concern and therefore to reorganize the company, when this is a better alternative to its liquidation. Nevertheless, most jurisdictions have also recognized ‘safe harbours’ for derivatives and other financial transactions. Derivatives, mainly due to their volatility and to prevent systemic risk and promote liquidity in financial markets, are usually exempted from core insolvency provisions and, for example, a party may exercise its close-out or termination rights upon the mere declaration of its counterparty’s insolvency by a court. Supranational bodies, such as the Basel Cross-border Bank Resolution Group has recommended that jurisdictions promote techniques such as netting in order to reduce systemic risk.6 The financial crisis has led public authorities to partially reconsider their position and therefore to reduce the privileges of derivatives transactions.7 Derivatives are in part rerouted to the general rules.8 Since close-out netting provisions may entail the accelerated cancellation of a major portion of outstanding transactions, they may frustrate the implementation of the resolution measures aimed at achieving the continuity of the failing entity or the transfer to a bridge bank or to a third party. Legislators have therefore introduced rules limiting the effectiveness of such provisions on two fronts: (i) excluding the entry into resolution as an event that triggers the early termination clause: that is, a general disapplication of the termination rights linked to the mere entry into resolution; and (ii) allowing resolution authorities to suspend all other obligations and termination rights for a limited period of time: that is, a temporary disapplication of the termination rights linked to other circumstances. This purportedly enables the resolution authority to focus on maximizing the effectiveness of the resolution tools. Although the wording is not absolutely clear, the framework laid down by the RRD seems to follow that approach. First, outstanding contracts and encumbered assets are protected vis à vis cancellation rights and enforcement proceedings linked to the mere entry into resolution. According to Article 60a RRD, the mere opening of a resolution process or the adoption of resolution tools, including the occurrence of any event directly linked to the application of such measures, cannot of itself be characterized by the parties as a triggering event. Hence the 6

7 8

See, Basel Committee on Banking Supervision, Report and Recommendations of the Cross-Border Bank Resolution Group, March 2010, pp. 36-39; see also UNIDROIT, Principles on the Operation of Close-Out Netting Provisions. Explanation and Commentary (2013), pp. 3-4. Basel Committee Report, endnote 7, pp. 40-42; UNIDROIT Principles, endnote 7, pp. 65-67; also ‘EU Commission Bank Recovery and Resolution Working Document’, January 2001, at . See, for a further elaboration of the theoretical foundations, D.A. Skeel & T.H. Jackson, ‘Transaction Consistency and the New Finance in Bankruptcy’, Colum. L. Rev. (2012), pp. 152 et seq..

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counterparty may not exercise an early termination right and close out the derivative contracts solely upon the entry into resolution or the exercise of the resolution power, provided that the substantive obligations under the contract, including payment and delivery obligations, and provisions of collateral, continue to be performed. By the same token, counterparties are prevented from obtaining possession or enforcing any security right over assets of the failing institution by the mere entry into resolution of such institution or the exercise of resolution powers. This implies that derivatives, as other contracts, are also subject to the general framework on ‘ipso facto clauses’. Furthermore, these rules are qualified as overriding mandatory provisions within the meaning of the Rome I Regulation (Regulation 593/2008), that is, they will apply irrespective of the law governing the contract (Article 60a (2d)). Second, the resolution authorities may impose a temporary suspension of the payment or deliver obligations deriving from a contract until midnight the next business day, that is, a ‘temporary stay’ (Article 61). This may give resolution authorities some time to, for example, carry out a transfer of assets and liabilities of the failing institution, including derivatives, to a creditworthy new entity (a bridge bank) or to a private sector purchaser. Alongside the time limit, which cannot be extended, these powers of the resolution authorities are accompanied by certain safeguards. Two, in particular, are as follows: (i) during that period, the obligations of the counterparties are also suspended, and (ii) the RRD expressly states that the obligations of the failing institution will become due immediately upon expiry of the suspension period. In order to ensure the effectiveness of these measures, the RRD gives resolution authorities an equivalent power of suspension that may be invoked vis à vis the enforcement of security interests (Article 62) and the exercise of termination rights (Article 63). This latter provision envisages the exercise of suspension rights for events different from those established in Article 60a, that is, the exercise of resolution powers. In any event, the obligations to Central Banks, CCPs and EU SSSs are excluded from this temporary stay. Although the wording of this exclusion refers to EU systems (those recognized by Directive 98/26/EC), it should also be applied vis à vis equivalent systems of third countries. Third, once the suspension period has expired, and with regard to termination rights, if the contract has been transferred, the counterparty may only exercise his rights on the occurrence of a subsequent default by the recipient. These rules mainly complement two other resolution tools: the sale of business and the transfer to a bridge institution (Article 31 (2)). When the pool of transferred assets includes derivative contacts, it is essential to assure the new acquirer that those contracts will not be immediately terminated after the transfer. The RRD guarantees this objective. According to Article 63 (4), if the resolution authority has exercised its suspension rights, the counterparty can only trigger the close-

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out netting provision on occurrence of any continuing or subsequent enforcing event by the recipient. If neither a new termination event nor a new event of default occurs, the derivatives must remain outstanding. Conversely, if the contract has not been transferred, and the resolution authority has not applied the bail-in tool, which entails that the counterparty is left with an insolvency residual entity, it may exercise his termination rights (Article 63 (4) (b)).

4.2

Cross-border aspects

Both the general disapplication of entry into resolution as an event of default and the resolution authorities’ power to temporarily suspend close-out netting agreements and enforcement of collateral rights must apply irrespective of the law governing the agreement or the collateral. Otherwise, by choosing a foreign law, it would be relatively easy for the parties to avoid the application of these powers. The RRD prevents this outcome in two ways. We have already mentioned the first: by characterizing Article 60a, which excludes the mere exercise of the resolution powers as a termination event, as an overriding mandatory provision for the purpose of the Rome I Regulation (see Article 60a (2d)). That provision shall therefore apply even if the contract is governed by a foreign law, that is, the law of another Member State or the law of a third country. And it must be applied by the authorities of any Member State, that is, the resolution authorities or the authorities of another Member State, since it is an EU overriding mandatory provision. Alongside that characterization, the RRD modifies the conflict of law rules laid down by the Directive on restructuring and winding up of credit institutions (Directive 2001/24/EC). In the current version, Articles 25 and 26 of this instrument establish that the effect of any reorganization measures on netting or repurchase agreements shall be governed solely by the law governing such agreements. This may lead to the argument that the effects of any resolution measure are not subject to the law of the home Member State of the failing institution but to the law chosen by the parties in the agreement, and, therefore, to attempts to exclude the effects of those measures in so far as they have not been adopted under the law governing those agreements. To prevent this, the RRD amends Articles 25 and 26 Directive 2001/24/EC. According to the new wording of these provisions, the effects of entry into resolution, restructuring or winding-up proceedings on netting and repo agreements shall be governed by the law applicable to those agreements, but without prejudice to Articles 60a and 63 RRD, that is, without prejudice to (i) the general exclusion

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of the entry into resolution as a termination event and (ii) the power to temporarily suspend other termination rights exercised by the resolution authorities of the home Member State. Example. Let us imagine again that the home Member State of the failing institution is Spain. Derivatives are subject to an ISDA Master agreement under English law. In this case, Article 60a would apply, and therefore the resolution measures adopted by the Spanish authorities cannot be invoked to trigger the close-out netting, even though the contract is not governed by Spanish law but by English law. By the same token, if the Spanish authorities exercise the suspension right set out by Article 63 RRD, this cannot trigger the close-out netting either, even though the contract is subject to English law. The same holds if the contract were governed by, for example, New York law. But this is probably not sufficient. To avoid any ambiguity, the exceptions to the application of the law governing the agreement (i.e. English law in the example) should also extend to other resolution powers (Articles 61-62), and in particular to the exercise of the bail-in tool (Article 44). Furthermore, Articles 21 and 24 of Directive 2001/24/EC, which point to the lex rei sitae as regards rights in rem, should also be amended along the same lines to safeguard the application of Article 62 RRD (resolution authorities’ power to restrict the enforcement of security interests). At this stage, if the EU lawmaker followed this approach, it would be legitimate to question whether keeping those provisions really makes sense. Note that the application of the law of the Member State of origin (= lex fori concursus) to those aspects significantly reduces the nature of Articles 21, 24, 25 and 26 as exceptions to the general rule laid down by Article 10 of Directive 2001/24/EC.

4.3

Transfer to a bridge bank

Finally, the RRD ensures additional protection for the rights of counterparties in cases of transfers of assets and liabilities, either to a third party or to a bridge bank. This protection is consistent with the nature of derivatives transactions. Derivatives allow parties to assess their counterparties’ risk on a net basis. For this purpose, it is essential that when a resolution authority carries out a partial transfer of assets and liabilities, it does not separate transactions that are economically and functionally linked. All transactions subject to the same master agreement must remain together (the ‘no cherry-picking rule’), and the secured liabilities must remain linked to the correspond collateral. The RRD guarantees this double protection. On the one hand, in accordance with Article 69, the resolution authorities must prevent partial transfer of transactions subject to the same netting or set-off agreement, that is, all derivative transactions under the same netting

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master agreement shall be transferred together. And, on the other hand, the transfer of secured obligations is legally ineffective unless the related security arrangements, together with the security assets, are also transferred to the new counterparty (Article 70).

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Part 6 Reports on Workshops

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Report on Workshop 1: Recovery Plans

Anthon Verweij* Moderator: Fernando de la Mata Speakers: Jan Adriaanse and Stephan Madaus

1

Recovery planning

While discussing and writing the paper on recovery planning, Professor Adriaanse, together with his colleagues at Leiden Law School, often thought about the boiling frog metaphor. This metaphor holds the premise that a frog will jump out when it is placed in boiling water, but it will not perceive the danger and be cooked to death if it is placed in cold water that is slowly heated. Adriaanse refers to this metaphor in light of the functions recovery plans may have, and the conclusion of the paper is that recovery planning should serve as some kind of preventive mechanism. Financial institutions should start restructuring as soon as the water starts heating up instead of waiting until the water has been boiled so that perilous situations of financial distress can be avoided. In evaluating the draft directive1 concerning recovery plans, Adriaanse and his colleagues focused on the economic function as well as the economic conditions and implications of recovery plans. When starting to review the proposal a business turnaround perspective was used in relation to recovery planning. The starting point of their evaluation was, what kind of lessons can be learned from other industries or ‘normal’ companies that run into financial difficulties? The first question Adriaanse wanted to answer was whether or not there is some ex-ante potential for recovery planning for institutions in financial difficulties. The draft directive leaves the impression that after financial distress arises, a recovery plan must be taken off the shelf somewhere and put to the test by implementing such a plan. However, Adriaanse wonders whether events by then have already evolved in such a way that an institution is already too late. According to Adriaanse, recovery plans or recovery planning should

* 1

Anthon Verweij is PhD-candidate at the Department of Business Studies of Leiden Law School. European Commission (EC), ‘Proposal for a Directive of the European Parliament and of the Council Establishing a Framework for the Recovery and Resolution of Credit Institutions and Investment Firms’, COM(2012) 280 final, June 2012.

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therefore be seen as a form of risk management or must be used as some kind of preventive risk management tool. In relation to this observation, Adriaanse refers to a framework concerning the downward spiral of companies in distress based upon a Roland Berger study2 from 2005. The main research questions of this study were: when was restructuring started, what were the triggers for restructuring, and lastly, when would restructuring have been preferred with the benefit of hindsight? The study concluded that on average, companies start restructuring 16 months too late. There is in some kind of form or shape a time-lapse or an incubation period in relation to financial distress. In relation to financial institutions the questions that arise according to Adriaanse are those of the possibility to make these institutions and their management start intervening or restructuring at an earlier stage and if there could be a role for recovery plans to facilitate such an early intervention. Adriaanse points out that, in fact, 71% of the businesses started to restructure too late as the best moment for intervention is within the strategic crisis or assumption crisis of the downward spiral of companies in financial distress. Although a financial institution at this stage is still making profits, it should be questioned whether an institution is still making the right assumptions about the market, the role of the institution within that market and with regard to customer preferences. Adriaanse states that this is perhaps the Holy Grail for institutions, in the sense that while an institution is still healthy and performing reasonably well, it must still be able to not only write such recovery plans but also use them to prevent drifting towards financial distress and possible failure. Additional findings from the previously mentioned research study were that tools for early detection of financial distress are considered crucial. However, only 38% of the business had fully implemented management information systems. Even though financial institutions will undoubtedly have sufficient management information systems already in place, Adriaanse does wonder if they are used for the right purposes. In addition, Adriaanse wonders if these systems warn the management sufficiently and at the right time. This is the big question that needs to be addressed according to Adriaanse in light of recovery plans.

2

M. Blatz, K.J. Kraus & S. Haghani, Corporate Restructuring. Finance in times of Crisis, Springer, Berlin (2006), pp. 77-87.

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With regard to recovery plans, Adriaanse wonders whether such plans can assist financial institutions to start restructuring from a more ex-ante point of view. Adriaanse and his colleagues at Leiden Law School did this by reviewing the strengths and weaknesses of recovery plans in light of the draft directive. Possible strengths of recovery planning are the ability to enhance risk management capabilities, mitigation of possible risks, analysis and improvement of legal and operational structures, enhancement of data and information systems and, lastly, increasing market confidence. However the downside of recovery planning is that recovery plans in themselves do not have any influence or power. Adriaanse wonders whether recovery plans will trigger the management of institutions to intervene and start restructuring before it is too late. In addition, there is the risk of too much focus on financial restructuring instead of the much needed business restructuring. Will recovery plans only provide for ‘rearranging the deck of the Titanic’ or address the actual underlying problems and issues within the business? Furthermore, recovery planning will perhaps internalize the costs of supervision and regulation. Adriaanse stresses his doubts about the added value of recovery plans. Moreover, Adriaanse points out that from a business perspective, recovery plans might interfere with innovation as entrepreneurial risk-taking might be downplayed in order to prevent perceived risks. Will it paralyse financial institutions in competing with other competitors? The biggest disadvantage of ex-ante recovery planning is that it will turn into a bureaucratic exercise and that might trigger a false sense of security. There are six guiding principles3 concerning recovery planning in order for recovery plans to be successful. First of all, recovery plans should be harmonized and coordinated across supervisors and all jurisdictions. Secondly, these plans should be risk-based and should carefully consider the firm’s business model. Thirdly, recovery plans should be closely integrated with both regulatory as well as risk management process. Fourthly, it needs to be considered on a continuum, and all stages of the downward spiral need to be taken into account. Fifthly, recovery planning requires an iterative basis in order to have recovery plans fully up-to-date and, above all, useful. Lastly, bank recovery plans must not be seen as the ultimate panacea. Adriaanse concludes that recovery planning can have an added value. From a regulatory perspective, it should be considered as a more ex-ante approach in addressing possible financial distress instead of an ex-post approach. In theory, Adriaanse and his colleagues at Leiden Law School believe that recovery plans enable restructuring at the earliest possible moment. However, recovery planning is not the ultimate remedy. 3

J.L. Douglas et al., Credible Living Wills: the First Generation, Davis Polk/McKinsey & Company (2011).

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2

Resolution planning

Professor Madaus starts by giving an overview of the draft directive in relation to resolution planning. Based upon the directive, a timeline with three consecutive phases can be distinguished. These phases are: recovery planning by the institutions, early intervention by the supervising authorities and resolution by the resolution authorities. During the first phase the institution is still healthy and performing reasonably well, although there might be a strategic crisis. In the second phase certain weaknesses are appearing, as for example a deterioration of the balance sheet of an institution. This is comparable with the earning crisis of the Roland Berger model. When the supervising authorities should apply intervention is open to debate, according to Madaus, as is the question of when intervention can be considered too early or too late. Madaus states that the first two phases can be considered risk management issues. These can be seen as more of a business perspective towards the institution in the sense of how to organize the business and the risk management in preventing crisis and failure. Everything concerning recovery planning and the results of early intervention by supervisors is considered by Madaus as simply fulfilling the duties of directors as laid down in the company law of a member state. Directors of a company are already obligated to make the right decisions for the company and to keep the company in proper shape. This is applicable to risk management as well as asset management. The new element is that supervisors may now intervene at a certain stage. Madaus wonders whether supervisory authorities can intervene within a living company that is not insolvent given fundamental and/or constitutional rights. Madaus, however, has focused on resolution planning in his paper because in the end not only are policymakers interested in improvement of risk management but they want a solution at hand if a financial institution fails and enters into insolvency. It has been designed as a shock absorber as it should prevent the shock and possible collateral damage for the financial industry and markets as a whole when such a financial institution fails. The draft directive envisages a resolution regime that is triggered by failure, which is defined as insolvency and not only balance sheet insolvency. Resolution will therefore become applicable in a very late stage, later than most jurisdictions currently allow a company to enter into insolvency proceedings. Insolvency must therefore be seen as illiquidity or imminent illiquidity in order for an institution to enter into the resolution stage.

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The next question that comes up is why it has been chosen not to deal with such an institution by means of the already available insolvency proceedings. Madaus points out that a totally new resolution regime has been created with this directive and wonders whether this is truly necessary, given that Lehman Brothers was also dealt with by means of the already existing Chapter 11 procedure. The resolution regime is motivated, according to Madaus, to prevent government bailouts. In the current situation, governments are asked to help out when a financial institution fails. However, as learned by trial and error, financial institutions have become so immense that government bail-out is not always possible. Nonetheless, the government or perhaps the International Monetary Fund (IMF) is in the end the lender of last resort. The resolution regime is needed in order to provide options to decide upon when faced with the failure of a financial institution. For financial institutions a different regime is needed as time is of the essence and an immediate option is therefore needed, which leads to some kind of pre-packaged resolution planning. Madaus believes that this line of thought is conclusive. But then, who is responsible for the resolution planning? In the United States the Federal Deposit Insurance Corporation (FDIC) is responsible. In the draft directive the same is proposed, as current authorities, instead of the management of a financial institution, would create new resolution authorities that are responsible for setting up the resolution plan. The reason for this is that an outside view is deemed appropriate in light of possible forms of denial or creative accounting. The management of a financial institution are not considered to be the right people for resolution planning given the previous experience in the Lehman Brothers case. The pre-condition for resolution planning is resolvability. Nonetheless, there are huge impediments surrounding resolvability. From the US experience can be learned that there is a vicious circle of ongoing discussions between the institutions and the authorities surrounding resolution plans. This process is also needed in Europe according to Madaus and the draft directive provides for this by giving the authorities the power to intervene concerning living and even well performing financial institutions. Institutions can be forced to change or restructure dramatically in order to be resolvable. Authorities will be inclined to demand banks to split up or to give up risky businesses. This is a huge task for national authorities to downsize national banks or international banking groups located within their jurisdiction. Madaus points out that this is a demanding task and it must be kept in mind that if there are no resolvable financial institutions resolution planning simply will not work.

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Concerning the implementation of resolution, Madaus prefers the US approach above the approach the United Kingdom (UK) or Europe have taken. This is a sale approach where assets are transferred to a new entity which acts as a safe haven. Stakeholders are allowed to have equity in the new entity or there could be a bridge-facility. Asset separation, where only the well performing assets are taken over and bad assets are left behind, is also possible. Madaus raises the question whether reorganization or restructuring of the failing entity must be allowed in the resolution stage or whether these entities should always fail, as is the common practice in the United States. Madaus also stresses the difficulties and complications regarding resolution planning with regard to banking groups, which requires multi-level planning. Even if the principle of single point of entry is embraced, resolution planning for these kinds of institutions requires resolution plans to be developed for every possible entry into the financial markets. This creates multi-level planning, which will be a huge task to complete. The procedure in the draft directive requires establishment of group level resolution authorities, which can be considered as a procedural group level consolidation of the whole process. Madaus believes that this consolidation at group level will be beneficial and will conveniently work alongside the principle of single point of entry at the group level. Madaus warns, however, that in order to allow banking groups to be resolvable they must be organized similar to their US counterparts by having a holding company at the group level. This allows for simpler handling of banking groups on the principle of single point of entry concept. In essence there will be a group resolution scheme implemented based upon the resolution plan after a bank fails. The real problem is that a huge number of people are involved in discussing the resolution scheme and what kind of measures must be taken despite time constraints. Madaus therefore considers conflict management essential in dealing with a transnational banking group as national authorities are involved, which might be in disagreement on steps that need to be taken. If no majority can be found to implement a resolution scheme, then the European Banking Authority (EBA) is mandated to mediate and, if necessary, allowed to make a decision. The EBA counsel is, however, composed of the board of supervisors, which consists of national representatives. This might frustrate decision-making by the EBA, and no other mediation or arbitration possibilities are available in such a situation.

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Discussion

De la Mata opens the discussion by pointing out that the draft directive allows only the resolution plan being drafted by the resolution authority and not by the financial institution itself. According to De la Mata, the rationale for this is financial stability in the broadest sense of the word. However, Madaus referred to the possibility of creative accounting, which leads to the premise that directors of banks are not diligent and will not take into account the interests of customers, creditors and employees. But De la Mata wonders why bankers would not be the most interested party to assess whether a resolution plan can be implemented. De la Mata raises the question of whether a financial institution should be allowed to present a pre-packaged resolution plan that can be authorized by the resolution authorities. According to Madaus, at the stage of resolution planning the situation at a financial institution is still good. There are no signs of creative accounting at this point. The problem is that the management of an institution for both recovery and resolution plans would aim to keep the entity alive, which is not one of the main goals of resolution plans. The main goal of resolution planning is maintaining the financial stability and functioning as a shock absorber in case of failure. The main interest is not keeping the institution alive but functioning as a cushion if an institution fails and containing the collateral damage. Resolution planning is therefore a different approach, which is not aligned with the interests of the management. If the management is allowed to draw up the resolution plan, this will most likely lead to a bail-in, keeping the entity together as best as possible and keeping the business as big as possible. Outsiders with no interests in the financial institution are therefore best to consider the possible options. De la Mata explains, however, that in Spain three types of banks can be identified. Apart from the good banks and bad banks, there are banks that can be considered in between. These banks may or may not go into restructuring in the near future, which makes them applicable for execution of the resolution plan. De la Mata points out that for these banks it is perhaps better to intervene in an earlier stage when the management of the banks are still involved. According to Madaus, all other options than resolution need to be explored. Even if a bank is in a deep liquidity crisis but is still able to make payments, resolution must not be applicable. However, at some point resolution must be enforced, but as late as possible. Madaus sees resolution as the very last resort. Verhoeven points out that information is always key in this process. This applies to both recovery and resolution planning. So from this point of view, the management of banks are always needed to make these plans. According to Verhoeven, authorities must of course

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assess and challenge these plans. Nonetheless, the whole process must start based on the plans from the management, and they must be involved in the process, unless they are unwilling to do so. Van Riel adds that in his opinion every manager has a duty to think about certain scenarios, and the regulator will continuously challenge those scenarios. These include scenarios on liquidity crises or big losses. Banks must continuously prepare for scenarios including: what if the whole thing fails? This is confirmed in the Vickers report4 from the United Kingdom and by the European Central Bank (ECB) as well as the European Monetary Union (EMU). Van Riel, however, points out that De la Mata is talking about something else. Resolutions plans might be stalled for all kinds of reasons when a resolution plan is presented, which is not favoured by certain stakeholders. He is of the opinion that an authority is needed and agrees with Madaus. In addition, Van Riel states that he also prefers the US approach, where the toolkit always allows for everything, but the tool should always be comparable to normal corporate insolvency proceedings. Concerning the three types of Spanish banks mentioned by De la Mata, Van Riel wonders if there are too many banks in Europe and, if so, the question then becomes: should you save them all? Secondly, Van Riel mentions the relative size of these banks for those countries. According to Van Riel, there are two possibilities: either countries must become bigger or banks have to become smaller through downsizing. Concerning recovery planning, Adriaanse wonders whether this will be a static process whereby recovery plans will be lying on the shelf until disaster strikes. Adriaanse prefers that recovery planning will be incorporated in normal business planning processes. Van Riel agrees, but points out that many regulators or committees are involved and their toolkit normally consists of regulation. This tends to lead to words, paper and processes. According to Van Riel, this will lead to a lot of shelving. Madaus asks Van Riel if an outsider is needed. Van Riel agrees but adds that a continuous good understanding of how a bank actually works is needed and that banks need to be challenged on a daily basis. Madaus then wonders if a special proceeding instead of a judicial process like a Chapter 11 process is needed for financial institutions as judges are not really experts on the banking industry. A resolution authority in which experts can be placed could then be beneficial. Van Riel states that both options could be implemented

4

The Independent Commission on Banking: The Vickers Report & the Parliamentary Commission on banking standards of 3 January 2013.

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as long as the entity is wound down accordingly. Van Riel prefers the US system of a judge being appointed instead of an agency, as a good judge will typically ask the right questions. De la Mata raises the point that it is up to the authority to prepare, present and implement plans and not the directors of a bank in distress. This is different compared with the traditional insolvency regime where directors of a company present a plan, file this plan with the courts and the creditors take it to a vote. De la Mata assumes that the rationale for this is market stability given the difference between banks and normal businesses. De la Mata sees this as an approach where directors are deemed unable to take into consideration the superior and common interests of community. In his view, directors of banks are thus considered to be negligent. De la Mata emphasizes, however, that the directors of a bank in distress possess insight information regarding the bank and its employees. In his view, directors should be able to draw up the required plans that make sense and can be implemented. Authorities can, in this approach, also review as well as reject the drawn up plans and act accordingly if no agreement can be reached. In other words, must authorities be in charge regarding the preparation and implementation of plans? Madaus reacts by saying that at first glance recovery and resolution planning are both based on the same facts and most likely on the same scenarios. The only difference is that resolution plans are based on the scenario where everything goes wrong. Perhaps it is more efficient if the same institution makes both plans. The problem, from an incentive perspective, is that if the management of a financial institution does the resolution planning, the possibility for bail-in as a reorganization tool is left open. Management will always plan resolution by reorganization, as this will allow the entity or the bank to survive even in a worst-case scenario. Secondly, if resolution planning is left to the management of the institution, there is no guarantee that the interest of financial stability is taken into account. Perhaps the only reason to have a resolution regime in place is to have a shock absorber present in case of failure. There is a different purpose in resolution planning compared with recovery planning, according to Madaus. Recovery planning is focused on the company, whereas resolution planning is focused on the system. Therefore, resolution planning must be carried out by the authorities. Madaus agrees that all the facts, information and scenarios are needed in order to be able to carry out resolution planning, yet it is up to the management to provide the authorities with this information.

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Prior Rank points out that this is more or less a grey area, given that although authorities are responsible for resolution planning, they are dependent on full cooperation by the management and the information provided by the management. Authorities and the management should therefore work closely together, according to Rank. Madaus agrees with this. Webb indicates, however, that during an earlier conference a representative of the Bank of England admitted that the challenge was that they did not know what to ask, although they felt that the resolution planning discussions were going well. According to Madaus, there is still a lack of experience as to know which questions need to be asked. Resolution planning is highly theoretical, as is the scenario testing process. Not only are highly skilled experts needed but the institutions also must be asked the right questions. Staal states that every situation must be regarded on its own, and the various stages of such a situation need to be regarded on their own as well. In his view, the supervisory board together with the authorities must address a situation and act accordingly when an institution is faced with financial difficulties due to denial by or inability of the managing board to address these problems. However, it must be prevented that authorities can act as a near Godlike entity by not only supervising but also managing an institution. Madaus states that if authorities are not able to ask the right questions or it is too confusing how a bank is organized, then perhaps the first question authorities must ask or the first thing they must demand is to restructure in order for the institution to become less complex. This is the problem of creating resolvability. Staal, however, points out that this is something that cannot be achieved overnight. Madaus agrees that time is needed, but stresses that resolution plans are meant for properly functioning banks and not already failing banks. If banks are unable to remove any ambiguities, then authorities are able to demand changes that will allow the business to be organized in such a way as to enable supervisors and authorities to understand it. With the directive, huge tools have become available to intervene in the day-to-day operations of a bank. It creates not only supervising, reporting and planning duties but also the ability to order institutions to restructure or stop hazardous business in order to improve resolvability. Rank points out that this could disturb the level playing field for banks, if a certain bank is prohibited from offering certain products while another bank may carry on to do so. Madaus agrees that it depends on the authorities if they deem it necessary to intervene and this may have a profound impact on the banking sector.

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De la Mata however, points out that authorities, in light of resolvability, compare the business activities of banks against the local gross national product of the country when in fact world-wide operating banks, like Santander perhaps, must be compared on a bigger European scale. According to De la Mata, this example highlights the need for Europe to progress on the banking union. Madaus points out that in this case maybe even a world banking union is needed. However, the directive would demand that national legislators create these resolution tools, according to Madaus. This would allow local authorities to demand a bank like Santander to restructure in such a way that the worldwide risks outside Spain or even Europe are mitigated should something go wrong. De la Mata stresses that the authorities in this case might be tempted to neglect business risks outside of their scope. Madaus states that the authorities need to be aware of the worldwide risks, but more importantly, they need to be aware of how these risks are mitigated for the local entity and what kind of plans are in place in the event of failure. Staal points out the importance of management explaining what direction they want to take the institution in and, more importantly, why they want to, in order for the management to justify their choices and make sense of their business activities. This is preferable to the restriction of the management in their decision-making process, which might create barriers that could affect the welfare we all benefit from. Madaus states that nowadays there is a lot of effort put into planning. According to Madaus, recovery planning might be a good thing as risk management is needed in every stage of conducting business. In addition, resolution plans need to be drawn up, which are costly as well. Madaus wonders, however, if the drawn up plans survive and remain standing in the remote event of failure. Madaus refers to a quote of Gen. Dwight D. Eisenhower, who said that in preparing for battle he always found that plans were useless, but planning itself is indispensable. Staal responds by saying that a living will must be seen more or less as a business plan and provides a perspective for the future. Janssen adds that recovery plans are mostly based on what a financial institution has experienced in the past, which most likely will not be applicable to the future. Janssen believes that recovery plans need to be updated continuously, but will not be insolvency proof. Adriaanse points out that recovery plans might instill some general confidence, but in his experience, turnaround plans are generally outdated within three months’ time. Nonetheless, such plans might give a proper sense of direction and issues to discuss with the regulators.

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Report on Workshop 2: Rule of Law v. Authorities Discretion

Xinyi Gong NACIIL-HCFL Conference, 23 May 2013 Moderator: Marjon Lok Speakers: Alexander Bornemann and Alexander Schild

1

Resolution regimes for financial institutions and the rule of law

Alexander Bornemann

1.1

The relevance of the rule of law

The rule of law is a very broad concept, which has different shapes in every jurisdiction and different labels in each state. In Germany, for example, it is known as Rechtsstaatprinzip, in France as État de Droit, and in the United Kingdom and the United States as Rule of Law. Nevertheless, these shapes have common fundaments where they belong to common constitutional traditions. As a legal foundation of the EU Treaties, the rule of law has long been acknowledged by the European Court of Justice. There are three dimensions of the rule of law. The first one could be labelled as its substantive nature, which imposes limitations on the authority of the legislator or on the content of its legislation. Legislators are directed to respect the fundamental rights and to intrude on such a right only when there is justification in terms of public policy or public interest. The second one is the procedural aspect, which is designed to ensure the proper operation of the substantive dimension. For instance, an authority is required to give notice to a party concerned before actions are taken against such a party. Between the substantive and procedural dimensions there is a structural dimension, which serves as a safeguard to protect the substantive dimension by limiting the powers of the authority and subjecting it to judicial review.

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Xinyi Gong How does that relate to the resolution regimes? If we look at the Key Attributes1 as well as the proposal of the Commission,2 some curtailment of pre-intervention rights can be observed. Extended notice periods are not provided. Instead, the authorities can intervene whenever they think it necessary with very short notice or even without any notice at all. Therefore, problems are incurred in regard to whether the powers conferred on the authorities meet the requirements of the rule of law.

1.2

Problems incurred by resolution regimes

1.2.1 Margins of assessment in the context of systemic risk tests The triggers in most resolution regimes, including the one proposed by the Commission, draw on a systemic risk test: intervention measures are triggered because insolvency proceedings against a financial institution would have consequences such as endangering financial stability. That is a quite complex and difficult test to be made in practice for many reasons, as it happens in a complicated and dynamic setting within a time constraint. To give a vivid example, there is even now some academic controversy as to whether the insolvency of Lehman Brothers has been the major cause for the realization of systemic risk. It is also claimed that the market reaction to the bailout of the AIG, which was three days after the Lehman Brothers bankruptcy filing, has had the same significant effect of destruction on the market as the Lehman Brothers insolvency. 1.2.2 Use of specific resolution tools and powers Most of the resolution regimes do not provide extensive periods of notice, especially notice of pre-intervention hearing. A substantial restriction of the rule of law concerns judicial review. This can be seen in the Dodd-Frank Act,3 which limits judicial review to a period of 24 hours, within which the court has to decide upon only two elements of the trigger for resolution measures: whether there is a danger of default and whether it is a covered financial institution. The standard review is limited, which means almost everything will pass because there is no substantive guideline for the court to actually review all factual and legal issues. Even if the court would be willing to do so, within only 24 hours almost nothing can be done. This has been criticized very much. The Dodd-Frank Act has been

1

2

3

FSB, ‘Key Attributes of Effective Resolution Regimes’, November 2011, retrievable under . The Key Attributes were endorsed at the G20-level at the Cannes Summit on 4 November 2011. For the European level see the European Commission’s ‘Proposal for a Directive Establishing a Framework for the Recovery and Resolution of Credit Institutions and Investment Firms’, COM(2012) 280, hereinafter referred to as the ‘RRD‐Proposal’. Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, Publ. L. 111‐203 signed into Federal law on 21 July 2010. The provisions of the Orderly Liquidation Authority are codified at 12.

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called into question also in a lawsuit against the liquidation authority in America. Plaintiffs allege that the FDIC has been conferred too much discretionary powers without meaningful restrictions, which would be incompatible with the Due Process Clause4 and violates the principle of the Separation of Powers.5 1.2.2.1 Solutions As one of the highest and most valuable fundamental principles in every constitution, it is obvious that the rule of law is not dispensable as such. Yet Judge Peck said during this conference, for a limited period of time, swift and effective action is demanded. There seems to be not a lot of room for formal hearings that would just exacerbate the danger and ward off the effect of resolution. In order to make the rule of law more workable in this context, some standards of the principle need to be modified, if we do not want to preclude a legislator from making meaningful legislation. Judge Frankfurter in the U.S.A. once said something about due process: it is not a mechanical instrument, not a yardstick.6 You cannot just apply it on a standard basis, and you must always take into account the specificities of the case. This is not new for the context of resolution regimes, but well established in other fields as well where swift reaction is demanded, such as terrorist combatting without giving terrorists prior notice. Authorities should have the right to intervene in order to have the possibility to serve public interest. On the other hand, this must be compensated for by extended and duly controlled power. Resolution regimes are particularly designed to safeguard financial stability. We have to defer to a later stage to see whether or not the authority has made decisions against the rule of law. Last but not least, we are dealing with situations in a complex and dynamic setting. It basically concerns business decisions. With respect to the curtailment of pre-intervention procedural rights, these must be compensated for by postjudicial review. The margins of assessment and of discretion do not necessarily violate the principle of legality if backed by procedural safeguards.

4 5 6

Second Amended Complaint dated 13 February 2013, Case No. 1:12‐cv‐01032, pp. 226-243. Id., pp. 244-250. Joint Anti-Fascist Refugee Committee v. McGrath, 341 U.S. 123 (1951).

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2

Does the directive on the recovery and resolution of credit institutions provide sufficient fundamental rights protection?

Alexander Schild

2.1

Introduction

The EU Charter of Fundamental Rights came into force in 2009. The Charter contains quite a broad range of rights. For instance, the right of peaceful enjoyment of property is guaranteed by the Charter in its Article 17. Furthermore, concerned parties have a right to due process and to having an effective remedy against the measures affecting them in accordance with Article 47 of the Charter. The question is, what kind of protection can be derived from these rights, which is not so easy to answer because there is not so much case law from Luxembourg regarding these fundamental rights. Fortunately, the Charter itself has established some basic principles applying to the protection of property. In addition, due to the lack of case law on the Charter, it will be assumed that the Convention for the Protection of Human Rights and Fundamental Freedoms (the Convention) shall be taken into account to fill in the gap when we refer to the scope and meaning of the relevant articles in the Charter.

2.2

The three requirements

As mentioned above, the Charter has established three requirements concerning the protection of property, namely (2.2.1) the principle of lawfulness; (2.2.2) the principle of a legitimate aim; and (2.2.3) the principle of fair balance. 2.2.1 Principle of lawfulness The principle of lawfulness means any infringement by the government upon the right to property should be lawful.7 In order to prevent the arbitrary use of power, legal provisions should be drafted with sufficient clarity and precision.8 2.2.2 Principle of a legitimate aim The principle of a legitimate aim requires that any interference with a property right should have to serve a legitimate aim.

7 8

ECtHR 20 May 2010 (Lelas v. Croatia), No. 55555/08, § 71. ECtHR 24 May 2005 (Sildedzis v. Poland), No. 45214/99.

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2.2.3 Principle of fair balance The principle of fair balance is the most important requirement. One of the key factors that determine the question whether the fair balance principle has been met is the amount of compensation that has been provided for the deprivation of property. The problem arises in the context of the various instruments that resolution authorities can utilize to infringe on property. In the RRD9 there are some provisions to guarantee sufficient compensation. The first relevant principle in the RRD is that creditors and shareholders will receive no less than they would have received under normal insolvency proceedings.10 However, it is a fact that in most cases, liquidation procedures would give them no compensation. Therefore, the second principle might be more useful, which principle means that a preliminary valuation must be made by a (legal) person who is independent of any public authority, before the resolution action may be taken.11 The RRD assumes that this will generate a fair market price. The primary interest of the resolution authority is to keep the financial system going, which may provide for an incentive to sell parts of the business or certain assets of a bank in financial distress quickly at a low price.

2.3

The Northern Rock case

In the Northern Rock case, the British government nationalized a solvent bank, namely Northern Rock. Former shareholders of the bank complained in Strasbourg that due to the lack of compensation, the British government had failed to strike a fair balance between the public interest and the interest of the shareholders. They also complained that they had a legitimate expectation that the Bank of England would step in to solve the temporary liquidity problem since the bank was still solvent. The court in Strasbourg (ECtHR) held that there should not have been such legitimate expectation. The fact that the shareholders failed to get any compensation could be considered justifiable. In that case, the court in Strasbourg was not that willing to protect the shareholders, and the review by the ECtHR was limited to ‘ascertaining whether the choice of compensation terms falls outside the State’s wide margin of appreciation in this domain’.12

9 10 11 12

Proposal of the Commission, COM(2012) 280/3. Article 65, RRD. Article 30 (1), RRD. ECtHR 10 July 2012 (Grainger v. The United Kingdom), No. 34940/10, § 37.

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3

Conclusion

As long as the member states will dutifully implement the safeguards as set forth in the relevant provisions of the RRD, it is difficult to envisage a situation in which the Convention (either Article 1 Protocol No. 1 or Article 13) will be violated.

4

Discussion

Prof. Bob Wessels raised a question about the three requirements: whether being lawful means the infringement must be based on domestic legislation or on secondary European legislation. The answer is the latter. EU law shall be applied directly in that regard. The European Court of Human Rights even accepts case law as a basis. In addition, Prof. Wessels used an example for a question concerning the issues of applicable law. When a Dutch Bank goes bankrupt and it has a branch in Belgium, all the Dutch branches fall within the ambit of Dutch law. If there is a lawful act from an agency of the state, which met the first requirement, what law applies when a Belgium creditor makes a complaint against the intervention action taken by the Dutch authority? Shall it be Dutch law or conflicts of law, or is there a direct possibility of going to Strasbourg? From the judicial perspective, the member state that takes the action is responsible for ensuring that all the requirements are met. The creditor must complain to the Dutch court first, in order to establish his rights, and then the creditor is entitled to go to Strasbourg. Several participants showed an interest in the precise requirements regarding the triggers of systemic risk. It would be reasonable to use a rebuttable presumption for any financial institution of a certain size that its bankruptcy would have systemic consequences, which can be reviewed later in court. Decisions can only be made based on the information available at that moment. It will not be possible to establish an absolute yes or no in advance, since no authority is able to predict the future. In that sense it might be inevitable to work on the basis of the presumption just discussed.

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Report on Workshop 3: Treatment of Cross-Border Groups

Valentina Caria Moderator: Jasper Berkenbosch Speakers: Paul Davies and Giulia Vallar

1

Introduction

In this workshop on treatment of cross-border groups two different resolution strategies have been discussed. The paper written by Giulia Vallar focused on the multiple point of entry strategy, which has been chosen in the Proposal for the Recovery and Resolution Directive (the Proposal).1 In his paper Paul Davies discussed the single point of entry system, which has been preferred by the bank resolution authorities of the United States (Federal Deposit Insurance Corporation (FDIC) and the United Kingdom (Bank of England).2 During the workshops the advantages and disadvantages of both systems have been considered.

2

The multiple point of entry strategy

In short, the multiple point of entry strategy aims at splitting the cross-border group into its parts, whereby the distressed parts would have to be resolved. Giulia Vallar presented the proposed European system as stated in the Proposal. She discussed Articles 80 to 83 of Title V of the Proposal, which focuses entirely on ‘Group Resolution’.

1

2

Proposal for a Directive of the European Parliament and of the Council Establishing a Framework for the Recovery and Resolution of Credit Institutions and Investment Firms and Amending Council Directive 77/91/EEC and 82/891/EC, Directives 2001/24/EC, 2002/47/EC, 2004/25/EC, 2005/56/EC, 2007/36/EC and 2011/35/EC and Regulation (EU) No. 1093/2010. ‘Resolving Globally Active, Systemically Important, Financial Institutions. A Joint Paper by the Federal Deposit Insurance Corporation and the Bank of England’, 10 December 2012, .

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First of all the members, the functioning and the nature and purposes of the resolution colleges were explained during her presentation. The members of the resolution colleges are the group level authority, the resolution authorities of all the Member States in which a subsidiary covered by consolidated supervision is located, the European Banking Authority (EBA) and eventually resolution authorities of third countries. These last authorities could also be members of the resolution colleges when one or more subsidiaries of the group are established in non-EU countries.3 The main tasks of the group level resolution authority that have been stressed during the presentation are the creation of the resolution colleges, the coordination of a college’s activities and chairing the meetings of a resolution college.4 The functioning of the resolution colleges is managed by two different norms: first of all, the ‘operational functioning’, which concerns draft regulatory standards developed by the EBA for the general functioning of any resolution college,5 and secondly, the norm consisting of ‘arrangements and procedures’ established by the group level resolution authority, after having consulted the other resolution authorities.6 Resolution colleges have different kinds of purposes. Ensuring cooperation and coordination, exchanging of information and the resolution of a group are three tasks of the colleges that were emphasized during the presentation. Following from Article 81 of the Proposal, European resolution colleges should be created when (i) a third country institution or a third country parent undertaking has two or more subsidiary institutions established in the Union and (ii) no arrangements related to the exchange of confidential information with third country authorities have been made. These European resolution colleges operate in the same way and have similar tasks as the colleges regulated by Article 80. According to Article 82, resolution authorities of a group shall spontaneously provide and/or communicate upon request one another all the information that is relevant for the exercise of their respective tasks. Finally, Article 83 of the Proposal focuses on the procedure in case of a likely failure. There are different norms involving two different situations: the first concerns the expected failure of a subsidiary, and the second regards the expected failure of a Union parent 3 4 5 6

See Article 80 (2). See Article 80 (1). See Article 80 (9). See Article 80 (5).

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undertaking. When the expected impact of the failing of a subsidiary would be a detrimental one, a group resolution scheme should be submitted to the resolution college.7 In the case of an expected failure of a Union parent undertaking, the group level resolution authority notifies to the resolution authorities members of the resolution college of the group at stake the resolution actions believed to be needed, which can include a group resolution scheme. Different advantages of this multiple point of entry strategy, chosen in the Proposal could be named. First of all, the system identifies the problem of group resolutions and proposes a solution. Furthermore, the strategy is prescriptive and flexible at the same time. Giulia Vallar stressed during the presentation that the Proposal also assures a quick and decisive action. Cooperation is also more likely to take place considering the fact that the Proposal aims at making this practice binding. On the other hand, a disadvantage could be that this system could be not enough. In the light of the proposed Recovery and Resolution Directive, one could ask whether the binding cooperation is sufficient. From this question follows the doubt whether it is possible to come to a solution in a short period of time, considering all the different authorities involved in the process. The question arises whether we should and can go to a more global solution.

3

The single point of entry strategy

In short, the single point of entry strategy consists of resolving the group as a whole, working downwards from the top company (topco), whereby a single resolution authority applies its powers to the top of a financial group. Paul Davies presented this single point of entry strategy, based on an agreement between the FDIC and the Bank of England.8 This could be a desirable system because it is in line with the Key Attributes of the Financial Stability Board (FSB), of which the purpose is harmonization.9 It also contributes to international cooperation. The proposed systems of the United Kingdom and the United States apply to globally systemic financial institutions (G-SIFIs). The UK and the US approaches differ in some 7 8

9

See Article 83 (1). ‘Resolving Globally Active, Systemically Important, Financial Institutions. A Joint Paper by the Federal Deposit Insurance Corporation and the Bank of England’, 10 December 2012, available at: . FSB, ‘Key Attributes of Effective Resolution Regimes for Financial Institutions’, October 2011, available at: .

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points, but aim at producing a recapitalization. In both systems the losses in the group will be allocated to the shareholders and to unsecured creditors. In this way a bail-out funded by the taxpayer, in which the creditors remain unaffected, should be avoided. As stated in the agreement between the FDIC and the Bank of England, the management will also be held responsible for the failure of the institution and will be removed.10 The aim of the UK procedure is to restore the failing topco to a going concern by writingdown the debt of unsecured creditors, but without liquidating the topco. The existence of a bail-in power is thus central to the UK approach. The US procedure, on the other hand, is, because of Dodd-Frank’s anti-bailout stance, a liquidation procedure. The failing topco will thus be liquidated. After the write-down of the unsecured debt, this will be exchanged for equity in a new institution. The topco’s assets and viable businesses will be transferred to this new private sector entity. During the discussion several advantages of the single point of entry system have been named. Paul Davies emphasized the fact that this single point of entry approach is in line with the Key Attributes of the FSB. Also, international cooperation and harmonization are stimulated. Moreover, compared with the multiple point of entry strategy, the single point of entry strategy seems much less demanding: the home country regulator does all the work. Another important advantage of the strategy is that only the topco is resolved, so that the operating companies can continue to run their businesses. Nevertheless, several issues of both the UK and US systems have been mentioned during the discussion. The first point that was raised was the amount of debt issuance in the topco. There must be a substantial unsecured debt to make the writing-off and the conversion into equity possible so that the regulatory capital requirements are met. Secondly, it could be possible that if the group has operating subsidiaries in other jurisdictions, the decisions are not only in the hand of the administrator. National authorities could act thinking of their own national interests. A solution to this could be to generate an ex ante commitment on the part of the resolution authority of the topco to also act in the interest of the host authorities. Finally, the question was raised whether the subsidiaries will have enough access to funding.

10 ‘Resolving Globally Active, Systemically Important, Financial Institutions. A Joint Paper by the Federal Deposit Insurance Corporation and the Bank of England’, 10 December 2012, p. 2, available at: .

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Conclusion

Both the multiple point of entry strategy and the single point of entry strategy are interesting systems dealing with the insolvency of cross-border banking groups. Although both strategies promote international cooperation, the single point of entry system makes a further step in this direction. During the lively discussion many interesting aspects were mentioned, of which several have been named in this report. Besides the described advantages and disadvantages of both strategies, the question of which strategy is most suitable to resolve a group will also depend on the specific situation the group finds itself in. Nevertheless, overall in the discussions, there seemed a consensus that a development to more cooperation or even giving more power to a single authority could be the only solution to the treatment of cross-border groups.

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Report on Workshop 4: Bail-in and Counterparties

Olga Falgueras del Álamo* Moderator: Rolef de Weijs Speakers: Victor de Serière and Francisco Garcimartín

1

Bail-in: some fundamental questions

Victor de Serière1 The bail-in tool works in the twilight zone before actual insolvency starts, once recovery plans have failed. It is designed to absorb losses through a total or partial equity write-off or conversion of the subordinated or even the senior creditors of the failing bank. On a European level, bail-ins are organized through resolution plans controlled by the resolution authorities, which have to work in close connection with the banks and their subsidiaries to understand and form the plans. Despite the bail-in instrument is based on the idea that the taxpayer would have to be let off the hook as much as possible, both the Dutch and English practice show that a large part of the plan is preserved for liquidity support, which could result in taxpayer’s funding if there is no other source available. In all, the development of the bail-in mechanism has stayed under a very theoretical point of view; real cases reveal some failed attempts of having tried to implement it over a weekend.2 One of the most important problems that the bail-in tool entails is the need for a clear trigger to determine when the institution is failing or likely to fail. Article 27 of the draft

* 1 2

Ph.D. candidate, University of Amsterdam. Allen and Overy Professor of Securities Law, Radboud University Nijmegen. Actually it was set as an example that one of the most simple Dutch bank expropriations took place over four months, after close collaboration between the Dutch Ministry of Finance and the Dutch central bank. It was argued that because under the RRD, implementation of the bail-in tool is not foreseen before 2018, some European countries have already made use of expropriation tools to front run a European bail-in instrument. Expropriation can result in compensation claims to be pursued at court (as opposed to the damages claim following a write-down). It is problematic when the object of expropriation is a bond issued under foreign law or they are tradable economic rights.

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Olga Falgueras del Álamo resolution directive3 gives an ample margin of discretion to the resolution authorities to make this decision, which allows both discretionary and mathematical triggers, such as the coco triggers. Wheighting them both is not always straightforward: despite the coco triggers are more predictable, a trigger event released much in advance will also impair bank managers. A balance between the two should argueably be struck; which can be also translated to the discretion required by resolution authorities and the bank’s reluctance to that discretion. The triggers of the resolution were a highlighted point of discussion. In the debate Mr. de Weijs asked one of the participants, Mr. Don Bernstein, about the suitability of implementing mathematical triggers. Mr. Bernstein disagreed with the proposal of the directive to believe that any numerical calculation has the possibility of being wrong; he proposed a two-stages approach where valuation would only take place once the bank is stabilized.4 Another highlight of the intervention referred to the hierarchy of claims in insolvency, as it was argued that, should be respected as much as possible. This was exemplified by the role of senior debt bondholders and their position towards the bail-in mechanism, since this question was raised in the Netherlands. The banks advised the Dutch Ministry of Finance not to include them due to the increase in funding costs and the unlevel playing field that this would provoke among the rest of the Member States that do not include them at present.5 It was pointed out that the application of the principle of equality also raises concerns with a bail-in; since the ultimate goal of a bail-in is to make critical functions continue, the suppliers of those functions have to be preserved. Notwithstanding, any deviation from this principle has to be properly justified. The problems of implementation described above also manifest in the area of classification of claims. Despite this Mr. de Serière agrees with the functional approach of the draft directive as the most workable criterion of classification, where a distinction is drawn between capital providers (investors) and service providers, he claims that the directive 3

4

5

Proposal for a Directive of the European Parliament and of the Council Establishing a Framework for the Recovery and Resolution of Credit Institutions and Investment Firms and Amending Council Directives 77/91/EEC and 82/891/EC, Directives 2001/24/EC, 2002/47/EC, 2004/25/EC, 2005/56/EC, 2007/36/EC and 2011/35/EC and Regulation (EU) No. 1093/2010, COM(2012) 280/3. Henceforth referred as to the ‘draft directive’. Mr. de Serière argued that giving resolution authorities too much discretionary powers to determine how much bail-in-able debt an institution (other than the tier 1 and 2 capital) would keep in its book could impair the multi-level European playing field and create uneven outcomes. The directive actually imposes a valuation requirement. On the basis of the equality principle, the Ministry of Finance decided to leave ordinary creditors of the bank untouched, stopping at a senior debt level.

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lacks granularity. Article 43 evaluates each type of liability and determines whether it provides a critical function for the bank, leaving aside how to deal with the non-guaranteed depositors. It does not address the question of how to deal with either other classes of creditors such as holders of securities or cash accounts with custodians, fiduciary relationships, or contingent liabilities (bank guarantees issued, etc.). It is also difficult to deal with holders of claims in tort or breach of contract. Nevertheless, other clarification criteria are even less workable (professionals versus non-professional counterparties, long-term versus short-term creditors or proprietary trading assets versus non-proprietary liabilities). Mr. de Serière concluded his presentation introducing some general remarks. He agrees with the draft directive in regard to the combination of contractual and statutory bail-ins: the contractual bail-ins or coco triggers could absorb losses and write off capital before the statutory intervention has to take place.6 He pointed out too that Article 29.1 of the draft directive underlines the ‘no creditor worse off’ requirement: a principle that is required to underpin any resolution plan but that due to the uncertainty as to the position of the creditor in insolvency is very difficult to avail in practice. In the round of questions, Mr. Georgios Zavvos from the European Commission questioned the preferential role of deposit holders. Mr. de Serière claimed that legally they are no different from other senior creditors, so any extra protection they could receive would be based on political or financial rationales. It was pointed out that the protection of the deposit guarantee scheme does not have distributional consequences, because of that Mr. Garcimartín defended the idea of sticking to the ranking of creditors under ordinary insolvency law.

2

Bail-in powers and derivatives

Francisco Garcimartín7 Mr. Garcimartín considers that the idea of applying insolvency standards to distribute losses in a bail-in as a general framework to provide objectivity to judges. A bail-in tool can be seen, therefore, as a synthetic insolvency proceeding that reduces the moral hazard of a bail-out. As losses will be absorbed by stakeholders and shareholders, there will be an incentive to monitor the behaviour of the bank.

6

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It was questioned during the discussions how to combine the write-down capital instruments with the bailin instruments, due to their similarities. It was argued that applying first the contractual bail-in and secondly the statutory one could be the best solution. Chair Professor of Private International Law, University Autónoma of Madrid.

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Article 2 of the draft directive defines the bail-in as the exercise by a resolution authority of the write-down and conversion powers in relation to the liabilities of an institution that meets the conditions for resolution. The directive allows combination with other resolution tools, such as the transfer to a bridge bank or the sale of the business to a third party or even the asset separation scheme. The focus of Mr. Garcimartín’s presentation is twofold: the scope of the bail-in and the amount to be bailed-in, as keys to investors in terms of risk assessment and valuation of claims. Unfortunately, the current text of the draft directive is not clear enough on these matters. Article 38 of the draft directive sets out the list of eligible obligations that can be bailed-in: in principle all liabilities could be subjected unless stated otherwise. And the list of excluded liabilities is limited: – Covered deposits but only to the extent they are guaranteed by the deposit insurance scheme, which under the current version of the Directive 94/19 amounts to EUR 100.000. It is uncertain whether the outstanding amount not covered by the deposit should have some sort of priority.8 – Secured liability but only up to the value of the collateral, so the excess can be subjected to the bail-in (this is made clear in the text of the directive). – Clients’ assets and money, as proprietary rights, cannot be written off or converted. – Liabilities to employees. – Liabilities to trade or commercial creditors are excluded up to the extent they provide goods and services that are critical to the daily functioning of the institution, a term that is ambiguous. – Public creditors are also excluded but only if they enjoy a privilege under normal insolvency law; that means that tax claims and social security claims are excluded from bail-in only if according to their national insolvency law this public claim enjoys a privilege (as in Spanish law that avails a privilege of 50% of the value of the claim, which can be discriminatory). – Derivative instruments, which will be analysed below, can be an object of bail-in but can also be excluded on a case-by-case basis. Some associated problems with the bail-in instrument concern its application over subordinated debt issued under foreign law. This is something the Spanish authorities have encountered, and in principle is contemplated in Article 15 of the draft directive. The

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He adds that the political position of Spain is against this idea. It is pointed out in the discussions that there is no clear solution under the draft directive when these deposits are partially secured. Mr. Garcimartín believes that in this case the application of insolvency laws can be of use. A set-off could be applied under Spanish insolvency law in this case, for example.

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formula applied involves including the possibility of a bail-in in the terms and conditions of the contractual agreement, and even if that was not the case, recognize it.9 The second aspect to be considered in the analysis is how much to bail-in. The ‘no worse off’ principle can be very useful to answer this question. Treating creditors as they would have been in a normal insolvency procedure has two consequences: to respect as much as possible the hierarchy of claims and the pari passu principle. Pursuant to the Article 29 directive, creditors of the same rank should be treated alike, so the losses should be distributed pro rata. It should be the national insolvency law to determine the ranking of creditors, as the order of priority is not indicated in the draft directive. This is exemplified in the difficulty to discriminate between short-term and long-term finance; despite their different treatment under European insolvency regimes, under the current text of the directive all ordinary creditors should be treated alike. So the idea is first to write off equity, after which subordinated debt will follow, and if that is not enough the bail-in institution should be applied to the rest of the creditors, excepting the privileged ones excluded from the bail-in tools. A point of discussion would be making a difference between shareholders and subordinated debt; the question whether we should write off shareholders completely before touching subordinated debt is not clear in the directive. Article 24 has created a lot of problems in Spain. The intervention concluded with an analysis of the problems raised in the application of the bail-in instrument to derivatives. It is uncertain whether they are bail-in-able instruments, and if so, how the mechanics of the bail-in would work in practice. A derivative is an outstanding contract that implies an exchange of cash flows between two parties, not involving a fixed amount. Their implementation as a bail-in-able instrument has given rise to a big discussion at the European level; the test for exclusion is based on resolution objectives (Article 26.2) and effects on counterparties (systemic impact, CCPs and risk management). In order to exercise the bail-in on derivatives we can understand two possible solutions: first, applying the bail-in tool to the periodical payment netting and then applying the bail-in tool at a periodical amount, or what makes more sense for Mr. Garcimartín, close out the derivative transaction and apply the bail-in to that resulting close out netting amount.10

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Victor de Serière remarked here that the approach of J.P. Morgan analysts to this problem was utterly different. Under US law the level playing field is achieved by subjecting all subordinated bonds to US law. 10 It was commented that the first option allows to cherry pick as long as the contract is still in place, but Mr. Garcimartín argued that in principle the draft directive does not allow to cherry pick within different transactions covered by the same master agreement, so the payment net amount should have been applied to the master agreement as a safeguard.

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Part 7 Report on Forum

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Conference Discussion Report: Valuation and Depositor Preference

Tom Dijkhuizen* and Mark van der Veer** After Bob Wessels introduced the various panel members and the Chair Matthias Haentjens, the Chair asked the panel members to give a first reaction on the reporting back from the workshops. Frederic Verhoeven took, after some remarks on the reports, this opportunity to start a discussion on valuation, in particular on the valuation of assets and derivative positions and on the valuation of what is left in the ‘bad bank’ and what goes in the new institution. Verhoeven stated that as the draft directive has several provisions on valuation, it takes a preliminary valuation before a resolution process is started as an important element. However, the intermediate conclusion, in his opinion, is that it is perhaps not worthwhile to go through the effort. It will lead to a lot of debate, and such debate might cloud the actual need at that time to put everything in a stable environment. Valuation is an important subject matter, and the timing of valuation should be shifted from the moment before you enter such a resolution process to the moment after you transferred and restructured the institution. Reinout Vriesendorp added to this that you should not expect too much of valuations. There are more urgent things to be dealt with, and you should focus on the rescue of the institution. Verhoeven elaborated further on the topic by stating that valuation can also spark litigation, as for instance on the different valuations of the real estate portfolio of the Dutch SNS Bank by two professional firms. Pim Rank agreed on this, but nevertheless took the role of devil’s advocate on this topic. He stated that when a regulator is on the verge of deciding whether or not it will intervene, the criteria for such an intervention allow the regulator some discretion. But at the same time, the regulator must at a certain moment in time be able to state that signals are received that the liquidity, solvency or own funds of a particular institution are such that we may fear for the stability of the financial situation. Verhoeven concluded that you should have a mechanism whereby the valuations that are done are either considered binding or are done by a court or independent valuators that *

T.C.A. Dijkhuizen, LL.M., M.Phil., is a Ph.D. Fellow in Corporate and Financial Law at the Department of Company Law of Leiden University. Mark van der Veer recently finished his Master’s in Corporate Law at Leiden University and works as a legal counsel. ** M. van der Veer, LL.M., recently finished his Master’s in Corporate Law at Leiden University.

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are appointed by a court. In such a way the valuation cannot be subject to debate. Vriesendorp responded that such an idea is an illusion and that the timing is of utmost importance. You should start the discussion on the valuation only after you have sold the assets. Paul Davies added to this that there is a second situation in which early valuation is important, namely the situation of bail-in and bonds. Here it is crucial that you work out the amount of loss that bondholders are going to bear at the beginning of the process rather than at the end of the process. The first thing the administrator in a resolution procedure has to do is to work out the extent to which the bonds are written down to bear these losses. Therefore, in his opinion, it seems that an early evaluation is unavoidable. Ian Jack agreed that the key thing the regulator wants to achieve here is to restore the regulatory capital of a financial institution by writing down bonds and other liabilities and converting them into equity capital. It then becomes a mathematical process whereby you look at the assets in order to calculate what the extent of the write-off has to be. In his view, the question of valuation does not have to be answered upfront in the situation of an expropriation of a financial institution, but this is different when you impose losses on creditors. If such is the case, you will have to know the losses in order to give the market certainty and to put the bank back on its feet. If you have a bail-in, but you decide on the valuation at a later moment, it will lead to market uncertainty, and this will have consequences for the rescue of the financial institution. Jack reiterates that the valuation exercise is a long one and different valuators can come up with different valuations, as this is dependent on, inter alia, which write-off policy and risk factors one applies. Rolef de Weijs then wanted to follow up on the valuation issue. The idea of this Directive is to prevent public funds from being sucked into a bank, and the government will have to step in to prevent a meltdown. The resolution authorities are then forced to step in against their will and reluctantly risk a wrong valuation. But Article 67 of the draft Directive says that the resolution authorities will have to pay damages in case of a wrong valuation. De Weijs is convinced that we should get rid of Article 67. It is more sensible to change what the shareholders got, if they received too little, afterwards. Alexander Bornemann clarified that creditors who are, contrary to the no creditor worse off-principle, exposed to larger losses than they would have had to bear within insolvency will be entitled to compensation. De Weijs intervened by stating that those creditors are entitled to a payment of the difference by the resolution authority and that it would therefore be a dream to have a resolution fund where these damages are funded out of. As this fund is not in place, we should have a critical look at Article 67 as the resolution authority will have immunity under Dutch law, but then will not have this under the Directive. Bornemann then added that it would be contrary to the idea of the Directive, if the taxpayers were liable for the

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amounts payable to creditors entitled to compensation. While admitting that the current draft might not be satisfactorily clear in that regard, he added that nothing should prevent Member States from allowing the resolution funds to recoup the compensation amounts from other creditors liable under the bail-in regime. Bornemann also pointed to the fact that bail-in can be synthetically replicated through the transfer tool, by just transferring parts of the liabilities to the good bank, while leaving the remainder behind in the insolvent institution. Paul Davies responded by reiterating what the idea of a bail-in is. He said that if we assume a situation where bail-in creditors have had too much taken away and also assume that the residual value of the bail-in debt was converted into equity of the recapitalized company, then the logical implication is that the creditors should be given more equity in the recapitalized bank. If the bail in-creditors are the only shareholders in the recapitalized bank, this makes little difference to their economic entitlements. On the other hand, it would improve the banks’ regulatory capital, and this result is not a bad result after all. The Chair then introduced another topic, namely the ranking of creditors, which is an interesting topic since the Cyprus case, in which there was a ranking between the (un)insured depositors and bondholders. Pim Rank started the discussion with an explanation of the Dutch legal position concerning ranking. In the Netherlands, both deposit holders and bondholders have a claim on the bank. Both parties entrust cash to the bank, and there is no reason to treat them differently. The question then remains, what about secured parties who, for example, have a right of pledge or security interest or parties who can set off a claim versus debt. These parties are de facto also secured creditors. It is therefore his view that if you decide that secured lenders should be protected in some way, then parties with a right of set-off should be protected as well, because from a material point of view their position is the same. Victor de Serière fully agreed, but he also mentioned a few other points that were made in his discussion group. For instance, nobody knows what is going to happen to financial institutions if large depositors are also going to be either expropriated or bailed in, because, basically, if that happens the whole funding structure of a bank will have to change. Banks will then make use of secured debt and avoid the problem of bail-in. We must ask ourselves whether that is desirable and what the consequences of it are. In his view, you should be careful with applying the bail-in further down the insolvency ladder until you know what the consequences are for the funding structure of the bank. De Serière concluded that the equality principle should dictate that bondholders and large depositors should be treated equally, but whether it is, from a financial point of view, a wise thing to do remains an open question. Chris van den Berge added that if new creditors actually move to a secured position, the percentage of incumbent assets would go down. If the bank then runs into trouble, there is hardly anything left for

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the depositors. The consequence, then, is that implementing the bail-in might lead to a much worse result to pay out the depositors as the secured creditors will get their money first and then there is little left for the depositors. The result, then, is that in the end the taxpayer will be picking up that bill. Ian Jack elaborated on this topic by stating that in different places you could have different types of institutions and different ways in which these institutions fund themselves. The draft Directive is targeted at systemic risks, and in fact systemic risk can happen when you have something that might be rather generic in the market and is happening to a lot of smaller banks at the same time. These smaller financial institutions will have a larger proportional depository-funding base. If you then focus on protecting the deposits, you will use a certain methodology that might preclude certain tools that are more suited to protect the (continuity of the) bank. Another consideration is the relative arbitrage between bonds for US banks issued by US banks and bonds issued by European banks. The latter are subject to this directive, and this leads to inherent risks to the bonds, while the economics otherwise appear to be the same. Pim Rank then added that measures that are meant to do good might turn out to do the opposite. He referred to the earmarking of financial institutions as SIFIs (Systemically Important Financial Institutions) by the authorities. These institutions might get more funding because they are under greater scrutiny by the authorities than an institution that is not earmarked. The earmarking leads to moral hazard on the part of the depositors. Alexander Bornemann commented that the ranking order should be the same in the Directive as in insolvency proceedings in order to calculate the credit risks and the risk premium. This should be desirable as a matter of principle. Depositors should be seen as creditors, and specific protection is given by the deposit guarantee scheme that can also exert market discipline. At the moment there are different ranking regimes in Europe, and that does not facilitate the coordination of several proceedings. Bornemann can therefore understand that the Commission is urged to take steps towards a harmonized approach. The Honorable James Peck then shared a couple of observations. The problem with valuation in a time when financial institutions are generally under stress is that the underlying asset base of all financial institutions in question is stressed too. This poses the fundamental question of how to valuate such assets, as was the case with RMBS securities that were wildly held by banks. At that time the securities were difficult to value, but they have mostly recovered since then. So, in his opinion, one of the questions is: valued by whom as of when using what assumptions, and what do you do when there is no market, and if there is no market, does that mean there is no value? That is a highly theoretical proposition, but in a bail-out situation the underlying asset base becomes difficult to value, and you

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should think about further actions, especially in cases where the affected parties challenge the valuation. Concerning the ranking order, Peck introduces the US Federal Deposit Insurance Scheme approach to this issue. Consumers and small corporate depositors are guaranteed up to $250,000. This does not apply to large corporations. His last remark was about Bear Stearns that was, in his view, an example of a near failure in which there was something of a bail-out. Here, the Federal Reserve provided assurances to JP Morgan Chase that it was safe for them to acquire the bank. This transaction led to a very low valuation of the securities and the stock, and everybody screamed that the price was wrong. However, within a matter of weeks it was re-priced. This was another example of the virtual impossibility of dealing with a crisis in a way that you will be judged right retrospectively. You will inevitably be judged wrong. Rolef De Weijs did take issue with the general thought that depositors are the same as bondholders. This might be the case from a legal viewpoint, but in society this is considered different. De Weijs argued that we should bring our laws in conformity with the latter view. There is a distinction between deposit holders and bondholders as we protect the former with the deposit guarantee scheme. If we also give them a preference, this would be beneficial in other respects. As we cannot expect them to take an interest in the solvency ratios of the bank, we will let the professional bondholders freeride with the ignorant deposit holders when we put them in the same class and protect that same class. Therefore, if we want to introduce healthy market mechanisms, we should also have the creditors involved when we consider who should pay. These creditors should assess the risk and health of the bank. If we give preference to the deposit holders, we shift the risk to bondholders, with the result that these bondholders determine the cost of funding and accordingly make a sensible assessment of the bank. This is, in turn, beneficial for the health and stability of the financial market. Pim Rank could endorse De Weijs’ viewpoints, but made a distinction between (retail) depositors, bondholders and professional bondholders. We cannot expect of the first two parties that they make a right risk assessment, while you can even wonder if you can expect that of the latter party. Ian Jack added that even in this case it remains a matter of education of the parties concerned. Marek Svoboda also commented on the topic of depositor preference and gave some insights into the view of the ECB. The ECB has openly supported the positive preference, at least for covered depositors as it promotes financial stability and reduces the risk of contagion. It will also give more scope to the resolution authority without incurring extra losses from a resolution decision. However, depositor preference is a hotly debated issue at the moment in Brussels. The debate is now whether you should have depositor preference for all so-called eligible depositors. The Commission has come up with some simulation exercises in order to assess the effect on bank funding in Europe. In these exercises they

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gave a preference for either eligible or covered depositors, and in both cases the results showed that the effect on funding and expected losses for banks would not be as high as originally thought. Svoboda stressed that although it is an important point to reduce the effect on funding, even more important is the amount of loss that is adsorbed by a writedown or bail-in. Alexander Bornemann then concluded the discussion by stating that if the deposit guarantee scheme works as it is supposed to work, the systemic risk concern with protecting depositors in the resolution context should not really be a concern as it is the deposit guarantee scheme that steps in or it is the bank that continues serving the depositors. It is the deposit guarantee scheme that can actually do what the dispersed depositors cannot because of the collective action problem in supervising and monitoring a bank. The deposit guarantee scheme can adjust its insurance risk premium to the risk profile of the bank and can therefore exert market discipline on the institution.

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Verschenen publicaties in deze reeks 1. Matthias Haentjens – De autonomie van de alchemist; Een beginsel van burgerlijk recht in het bankwezen – 2014, Boom Juridische uitgevers 2. Mattias Haentjens & Bob Wessels (eds.) – Bank Recovery and Resolution; A Conference Book – 2014, Eleven International Publishing

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