Trade Finance: the Challenges of the Requirement for Contractual Recognition of Bail-In

The Banking and Recovery Resolution Directive (2014/59/EU) (‘BRRD’) was passed in an effort by the EU to provide ‘adequate tools at EU level to deal effectively with unsound or failing credit institutions and investment firms’. The key features of the BRRD are preparation procedures, early intervention powers and resolution tools (including 'resolution stays', which are a limit on the right of counterparties of distressed institutions to exercise early termination rights). 

Bail-in is the process whereby the relevant authorities are permitted to write-down and/or convert certain of the institution's liabilities into equity, with the aim of ensuring its ongoing viability (albeit perhaps fundamentally restructured). Broadly speaking, the BRRD applies to EU incorporated banks, their EU incorporated holding companies and any EU subsidiaries of such institutions. This is important for creditors. Debt owed by in-scope institutions can be converted, reduced or written off altogether, meaning creditors and shareholders may be required to prop up the failing entity. 

Article 55

Article 55 states that non-EU law governed contracts entered into by in-scope institutions must include a clause recognising the effectiveness of actions permitted under the BRRD. The rationale is that objections to such actions are less likely to be successful if the party has explicitly agreed to the possibility of them occurring in the underlying contract. (For EU law governed contracts, the BRRD will automatically apply and no explicit clause is required.) Whilst there is no specimen clause provided in the legislation, there is a list of elements which the clause must contain. ISDA (the International Swaps and Derivatives Association) and AFME (the Association for Financial Markets in Europe), amongst others, have produced specimen bail-in clauses.

Whilst there are some exceptions for the requirement under Article 55, these are, at present, not clear.

The impact on trade finance

Trade finance documentation presents some particularly complex issues for an Article 55 clause. For example, letters of credit are relevant liabilities under the legislation but commonly do not specify any governing law. How then should it be determined whether Article 55 is applicable?

The UK regulator has recognised some of the challenges which market participants may face and has allowed an exception for UK entities caught by the BRRD where compliance with the Article 55 requirement would be ‘impracticable’. One example given was the creation of liabilities governed by an international protocol which the UK financial institution has in practice no power to amend. An obvious example of this is the UCP (Uniform Customs and Practice for Documentary Credits) rules which are incorporated into almost all letters of credit but include no governing law provisions.

If the UK leaves the EU, it may (dependant on the exit model) be classed as a third country and therefore any UK in-scope institutions entering contracts creating relevant liabilities with EU counterparties (governed by English law) would be required to incorporate an Article 55 clause. Such wording is already required for relevant contracts governed by, for example, New York or Swiss law. However, with reports in the market of significant pushback from non-EU counterparties and concern that the requirement may skew competitiveness, it remains to be seen how the banks will negotiate the challenges that Article 55 presents for trade finance in particular.

This post come to us from Holman Fenwick Willan. It has been co-autored by Laura Hingley and Philip Prowse.