Stay recognition requirements for third country law financial arrangements

From June 1, 2016, certain UK financial institutions (defined below) and members of their global group will be restricted from entering into, or materially amending, ‘financial arrangements’ governed by the laws of a ‘third country’ (being a country that is not an EU Member State) unless their counterparties enable them to meet a new, UK-specific, “stay recognition requirement”. The finalised stay recognition requirement will be contained in a new ‘Stay in Resolution’ Part of the PRA Rulebook.

The UK’s stay recognition requirement obliges certain statutory EU resolution measures to be given effect in an ‘enforceable manner’. This requirement seeks to address the problem that, because resolution measures arise under statutory powers, they are not legally effective in contracts governed by third country law. Accordingly, the stay recognition requirement aims to ensure that financial arrangements governed by third country law are able to be subjected to resolution measures in the same way as contracts governed by the laws of an EU Member State.

The particular resolution measures to which the UK’s stay recognition requirement seeks to give effect are statutory ‘stays’ on contractual rights related to resolution (the contractual stays). In resolution, contractual stays override certain contractual terms in order to prevent a resolution action from triggering terms that could further destabilise the UK financial institution and thus undermine the effectiveness of the resolution action itself. Although the contractual stays were introduced into UK law as part of a wider EU package of reforms (the BRRD¹), the stay recognition requirement is not a BRRD requirement.

This updater considers the commercial and legal implications of the stay recognition requirement for UK financial institutions, their subsidiaries and counterparties of these entities, addressing the following matters.

There are four types of contractual stay: a permanent stay of rights relating to default (the general stay); and three temporary stays on each of termination rights (the temporary stay), payment, delivery and collateral provision obligations (the payment & delivery stay), and security rights (the security stay). These stays can be used together and are intended to support the powers granted to the Bank of England (the Bank), as the UK’s resolution authority, to facilitate the orderly resolution of UK financial institutions.

Contractual stays apply when the Bank has taken resolution action against a UK financial institution or a member of its group. Resolution actions include transferring shares or assets to a private purchaser, a bridge bank (owned by the Bank) or into temporary public ownership and effecting a bail-in of shareholders and certain creditors. The contractual stays can also be triggered where the Bank has elected to recognise (and therefore to assist) a third country resolution action.  Whilst the general stay has permanent effect, the temporary, payment & delivery and security stays each only take effect if and when they are exercised by the Bank and last for a maximum of two business days.²

The scope of rights set out in statute which can be suspended by the general stay is very broad but, generally speaking, comprises those that would normally be considered as rights exercisable on entry into resolution by the UK financial institution (the scope of “resolution” includes certain pre-resolution actions in the case of the general stay). These include (among many others) the ability of the counterparty to terminate or modify the contract or rights and duties under the contract, terms which make a sum payable or cease to be payable, and provisions such that an interest is created, changes or lapses.

By contrast, the temporary stay affects a slightly narrower set of rights, being those to terminate a contract; to accelerate, close out, set-off or net obligations, or any similar provision that suspends, modifies or extinguishes an obligation of a party; or a provision that prevents an obligation from arising under the contract. The payment & delivery stay suspends obligations relating to payment and delivery and the security stay prevents a secured creditor from enforcing security interests.

The stay recognition requirement applies only to third country law financial arrangements that contain rights that could be subject to one of the contractual stays if the contract were instead governed by the laws of an EU Member State. It does not apply to contracts which do not contain rights against which one of the contractual stays can be exercised.

The PRA has expressly noted that it is for UK financial institutions and their subsidiaries to identify which contracts are ‘financial arrangements’. In-scope financial arrangements are:³

1. contracts relating to transferable securities, or a group or index of transferable securities (including for their purchase, sale or loan and options, repurchase or reverse repurchase transactions on such contracts);
2. contracts relating to commodities for future delivery or a group or index of commodities for future delivery (including for their purchase, sale or loan and options, repurchase or reverse repurchase transactions on such contracts);
3. futures and forwards contracts, including contracts (other than a commodities contract) for the purchase, sale or transfer of a commodity or property of any other description, service, right or interest for a specified price at a future date;
4. swaps and options relating to interest rates; spot or other foreign exchange agreements; currency; an equity index or equity; a debt index or debt; commodity indexes or commodities; weather; emissions or inflation; total return, credit spread or credit swaps; and any agreements or transactions that are similar to such an agreement which is the subject of recurrent dealing in the swaps or derivatives markets; and
5. any other derivatives⁴ and master agreements for such derivatives, any of the arrangements referred to above, and for contracts for the sale, purchase or delivery of any currency.

The stay recognition requirement applies to ‘financial arrangements’ entered into or materially amended from the relevant effective date (see below). A ‘material amendment’ is not defined but it does not include automatic changes to contractual terms (e.g. roll over or renewal) or administrative changes (e.g. to notification or payment details). However, the PRA has the power to oblige a UK financial institution to take further action to give effect to the stay recognition requirement if it deems that this is required in order to remove impediments to resolution.

The stay recognition requirement enables the contractual stays to take effect in respect of the financial arrangements noted above. Financial arrangements are a sub-set of all contracts. In the absence of the stay recognition requirement, the contractual stays only apply automatically to all contracts governed by the laws of an EU Member State. Therefore, the stay recognition requirement does not achieve complete equality of treatment with contracts governed by the laws of an EU Member State.

For these purposes, a ‘UK financial institution’ is a UK-incorporated bank, building society or investment firm authorised by the PRA and (if there is one) its UK-incorporated parent financial holding company or parent mixed financial holding company. A subsidiary of a UK financial institution must also comply with the stay recognition requirement if it is a bank, investment firm or other form of financial institution (e.g. an intermediate financial holding company, a money broker, payment service provider, or e-money issuer, among others) regardless of that subsidiary’s jurisdiction of incorporation. The PRA is of the view that this broad application is necessary to ensure that contractual stays are effective on a group-wide basis.

A UK financial institution’s subsidiaries could therefore be subject to multiple stay recognition obligations as similar requirements in various jurisdictions may overlap. However, whilst the requirements may not be identical in each jurisdiction, the PRA does not expect that compliance with its rules would prevent compliance with another jurisdiction’s requirements (or vice versa).

The stay recognition requirement does not apply to contracts entered into with only an ‘excluded person’, being all EU settlement finality systems,⁵ CCPs and third country financial market infrastructure, as well as central governments (including an agency or branch), and central banks.

Generally speaking, if the payment & delivery stay has not been exercised, the other contractual stays only take effect if the entity benefitting from the stay is continuing to perform its obligations in respect of payment, delivery and the provision of collateral. Before it exercises any of the temporary, payment & delivery or security stays, the Bank must consider the impact that the suspension would have on the orderly functioning of the financial markets. This consideration is expected to have particular weight where the Bank is considering exercising the payment & delivery stay, in light of the general position that payment and delivery obligations should continue to be performed.

The counterparty’s recognition of the contractual stays must give effect to the Bank’s exercise of the contractual stays against a UK financial institution or certain of its subsidiaries as if the financial arrangement were governed by the laws of an EU Member State. The stay recognition requirement only requires this to be achieved in an ‘enforceable manner’ – strictly speaking, it does not need to be a written contractual term. Equally, legal opinions confirming enforceability are not technically needed.

However, both written clauses and legal opinions would be useful for UK financial institutions. This is because they are responsible for ensuring, and being able to demonstrate, both their own and their subsidiaries’ compliance with the stay recognition requirement. The PRA’s general sanctioning and supervisory powers apply, which include the ability to issue public censures and impose financial penalties as well as to suspend or impose conditions on the UK financial institutions’ permission to carry on regulated activities.

The stay recognition requirement takes effect from 1 June 2016 for all in-scope entities whose direct or indirect counterparty is a credit institution or investment firm (regardless of where the counterparty is incorporated). For all other types of counterparties, the stay recognition requirement is effective for in-scope entities from January 1, 2017. This delay is intended to mitigate the impact on groups and particularly on their subsidiaries.

The International Swaps and Derivatives Association (ISDA) has replaced its 2014 Resolution Stay Protocol with the ISDA 2015 Universal Protocol for ISDA Master Agreements, which has been developed in consultation with the International Capital Market Association (ICMA), International Securities Lending Association (ISLA) and Securities Industry and Financial Markets Association (SIFMA) to also cover certain securities finance master agreements.

However, ISDA generally expects the buy-side to adhere to the ISDA Resolution Stay Jurisdictional Modular Protocol (released May 5, 2016), rather than the ISDA 2015 Universal Protocol which, though they serve essentially similar functions, the Modular Protocol will be tailored to different jurisdictions.

Like the stay recognition requirement, bail-in recognition clauses (BIRCs) under Article 55 BRRD seek to establish recognition of BRRD resolution measures in contracts that are governed by the laws of a third country. However, whilst the contractual stays may be used in conjunction with bail-in, they are distinct from the bail-in powers and their use is not necessarily linked with a bail-in.⁶

Determining the precise scope of the stay recognition requirement is already giving rise to similar issues as experienced in the market with BIRCs, even though a ‘financial arrangement’ to which the stay recognition requirement applies is more closely defined than a ‘liability’ to which the BIRC requirement applies.

Although the stay recognition requirement is not a requirement under the BRRD (and therefore is not being introduced by all EU Member States), it is part of a co-ordinated effort among the Bank and other regulatory and resolution authorities in France, Germany, Japan, Switzerland and the USA. This co-ordination derives from a Financial Stability Board mandate⁷ and therefore stay recognition requirements should be introduced throughout the G20 (although whether the scope and form of the requirement will be identical in each G20 nation remains to be seen).