The Banking Act
2009 and its
impact on UK
banks and their
stakeholders and
counterparties.
Contents
Introduction
1
Part I – Key Aspects of
3
the SRR
Part II – Potential Impact
13
of the Act
Introduction
On 21 February 2009, Parts 1-4 (and parts of Part 7) of the Banking Act
2009 (the “Act”), which sets out the most substantial change to banking law
in the United Kingdom for decades, came into force. The core provisions in
Parts 1-3 of the Act relate to the special resolution regime (“SRR”) and the
substantial powers given to the Treasury, the Bank of England (the “BoE”)
and the Financial Services Authority (the “FSA”) (together the “Authorities”)
to deal with and stabilise banks that are in financial difficulties.
The SRR applies to “banks”, which are defined as UK incorporated entities
that have permission to accept deposits (so would not include UK branches
of foreign banks), and in a modified form to “building societies”. The
definition of a bank could catch insurance companies which have permission
to carry on the regulated activity of accepting deposits. In addition, the
Authorities can in certain circumstances extend the public ownership power
under the SRR to the UK holding company of a UK bank.
The Act contains various provisions relating to the role of the Bank of
England and the Financial Stability Committee, payouts and financing of the
Financial Services Compensation Scheme and regulation and enforcement
of rules for intra-bank payments. However, the most controversial aspect of
the Act is the SRR regime. The SRR consists of three stabilisation options: a
private sector transfer, a bridge bank transfer and temporary public
ownership. The Act also provides for two new bank insolvency procedures.
The powers given to the Authorities in connection with the SRR are wideranging and allow the Authorities to override, in certain circumstances,
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contractual law, property rights and other key English legal principles. This
note focuses on the SRR.
While the Act does, to some extent, erode the rights of stakeholders and
creditors of a UK bank, it sets out a clear legal framework within which the
Authorities may exercise intervention powers when a bank is in difficulty.
Although the government did not explicitly have such powers before the
Banking (Special Provisions) Act 2008 (temporary legislation to enable the
nationalisation of Northern Rock) came into force in February 2008, most
commercial parties accept that banks are different to other corporate entities;
an inherent risk of dealing with banks is that the government may take
emergency action which impacts on the rights of counterparties, if the
financial system is at risk. The Act provides a permanent statutory regime,
on which an extensive consultation exercise was performed. This should, in
fact, limit the likelihood of government intervention in an emergency having
unintended consequences and may therefore be viewed as largely a positive
development. However, the act does create certain areas of concern from
both a legal and commercial perspective for UK banks and their
counterparties. This note analyses those issues in Part II, while Part I
summarises the key aspects of the SRR.
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Part I – Key Aspects of the SRR
Statutory objectives
The Banking Act has replaced the Banking (Special Provisions) Act 2008
(the “BSPA”), which lapsed on 21 February 2009. The BSPA was an
emergency piece of legislation to deal with the Northern Rock situation and,
as such, was not subject to consultation. In contrast, as part of the extensive
consultation process regarding the Act, the Authorities have taken on
suggestions from both an expert liaison group and financial market
participants. This process has led to a number of beneficial amendments
from early drafts of both the Act and the secondary legislation under the Act.
Two statutory instruments came into force at the same time as the Act.
These are:
– the Banking Act 2009 (Restriction of Partial Transfers) Order (the
“Safeguards Order”), which gives specified arrangements with a UK
bank protection from interference if the UK bank is placed in the SRR,
and
– the Banking Act 2009 (Third Parties Compensation) Regulations (The
“Third Party Compensation Regulations”), which deal with
compensation payable to third parties left behind in the failing bank.
In deciding whether to use the SRR powers, the relevant Authorities should
have regard to the five SRR objectives, none of which have any more priority
than the other. These are: to protect and enhance the stability of the UK’s
financial systems, to protect depositors, to protect and enhance confidence
in the UK banking system, to protect public funds and to avoid interfering
with property rights. These objectives are wide-ranging and may be to some
extent contradictory. In practice, it is likely that in the case of a failing bank
one or more of the objectives would be met.
Responsibility for running the SRR and conditions
The responsibilities for exercising the stabilisation powers are split between
the FSA, which decides whether the bank has met the “general conditions”
that bring the SRR into effect, and thereafter the BoE which actually
implements and runs the SRR, other than in the case of temporary public
ownership, in which case the Treasury takes over. There are requirements
for the Authorities to consult with each other, which are intended to foster
more cooperation and co-ordination.
As mentioned above, the FSA is responsible for deciding whether a bank
has satisfied the “general” conditions, which must be met before a bank is
placed in the SRR. These conditions are that the bank is failing or is likely to
fail to satisfy the threshold conditions set out in the FSA Handbook and that,
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having regard to timing and other relevant circumstances, it is not
reasonably likely that action will be taken that will enable the bank to satisfy
those threshold conditions. The FSA must consult with the BoE and the
Treasury before determining whether the latter condition is met. The
threshold conditions in the Handbook are relatively wide-ranging and deal
with most aspects of a bank’s business, not just minimum requirements for
the adequacy of a bank’s resources.
One concern that arose during the consultation process was that basing the
SRR trigger on the threshold conditions gave the FSA extensive discretion to
use the SRR process before a bank was really in trouble. The FSA has,
however, noted in its Consultation Paper, “Financial stability and depositor
protection: FSA responsibilities”, that it is likely that the adequacy of
resources condition will be the focus of a determination and has given
guidance as to the factors it will have regard to in assessing whether a
breach of the threshold conditions stemming from liquidity or capital
concerns is capable of remedy. While this guidance is useful, it is not binding
on the FSA and concerns remain as to the exact scope of the general
conditions.
The FSA has clarified in the same Consultation Paper that it rarely expects a
bank to go from normal supervision straight into the SRR. It is likely that the
FSA will subject a bank to “heightened “supervision” before it triggers the
SRR. This refers to the ability of the FSA to intensify supervision and
oversight when it identifies a firm is at risk, in particular of failing to meet the
threshold conditions.
Stabilisation options
Before any of the stabilisation options are used, the FSA must decide
whether the general conditions discussed in the paragraph entitled
“Responsibility for running the SRR and conditions” above have been met.
The Authorities may utilise three stabilisation options under the Act: full or
partial transfer to a private sector purchaser, full or partial transfer to a bridge
bank and transfer to temporary public sector ownership. Each of these is
summarised below.
Private Sector Transfer
The BoE may transfer all or part of the business of a bank by way of a
property and/or share transfer to a commercial purchaser. This would
provide continuity of banking services while achieving the best outcome for
creditors and counterparties without the use of public funds. The BoE may
affect a private sector transfer provided that it is necessary, having regard to
the stability of the financial system in the UK, confidence in the banking
system, or the protection of depositors. Alternatively, it may do so if the
Treasury has given financial assistance and recommends a transfer is in the
public interest. It is likely that one of these conditions would be met in the
case of a failing bank.
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Bridge Bank Transfer
The BoE may transfer all or part of a failing bank to a new bank established
by the BoE, after consultation with the FSA and the Treasury, by way of one
or more property transfer instruments. The deteriorating or poorly performing
assets would be retained by the failing or residual bank, which could go into
the bank administration process. The failing bank must support the bridge
bank to facilitate a sale of the bridge bank to a private sector purchaser. The
BoE can only effect a bridge bank transfer if certain conditions, which are the
same as those for a private sector transfer, are fulfilled.
Temporary Public Ownership
The third option is to take the bank into temporary public ownership, by
transferring the shares to a nominee of the Treasury or a company wholly
owned by the Treasury. This would involve the Treasury making share
transfer orders, with a view to returning the failing bank to the private sector
in due course. The conditions for the exercise of this power are that it is
necessary to resolve or reduce a serious threat to the stability of the UK
financial system, or that the Treasury has provided financial assistance in
respect of the bank for the purpose of resolving or reducing a serious threat
to the stability of the UK financial systems and that the exercise of the power
is necessary to protect the public interest.
The Treasury may also take the holding company of a bank into temporary
public ownership if it is satisfied that (i) the general conditions are met in
respect of the bank (ii) the public ownership conditions detailed above are
met and (iii) the holding company is incorporated in the UK.
Share and Property transfer
In order to facilitate the transfer of shares or business of a failing bank, the
BoE or (in the case of temporary public ownership) the Treasury may make
share or property transfer instruments or orders. The powers under these
instruments are extensive and are detailed below.
Powers under share transfer instruments
A share transfer instrument or order can provide for securities to be
transferred and make other provisions for or in connection with, the transfer
of securities. Share transfer instruments are made by the BoE to effect the
transfer of a bank to a private sector purchaser while share transfer orders
are made by the Treasury to effect the transfer of a bank or its holding
company to temporary public ownership. Share transfers back to the original
transferor and onward from the transferee to another entity (known as
“reverse” and “onward” transfers) can also be made during the exercise of a
stabilisation power. For the purposes of a share transfer order, the definition
of “bank” includes a bank holding company.
Share transfers cover the transfer of “securities” which are widely defined to
include, among other things, shares, debentures, loan stock, bonds, and
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certificates of deposit issued by the bank. The definition includes physically
settled warrants and other instruments which entitle the holder to acquire
shares or debt instruments issued by the bank.
The share transfer powers are extensive and include an ability to override
any contractual or legislative restrictions on transfer, to extinguish rights to
acquire securities, and to provide for the conversion of one form or class of
securities into another form or class (for example, convert debt securities
into equity). This means that as a result of a share transfer, a debt securities
holder could become an ordinary shareholder, and thereby lose its
contractual payment rights. The Treasury have confirmed in the Explanatory
Notes to the Banking Act 2009 that the conversion and delisting power
applies to all of a specified bank’s securities, whether transferred or not.
In addition, a transfer takes effect free from any trust, liability or
encumbrance and may include provisions about their extinguishment.
The BoE (or the Treasury) can also effectively remove and appoint directors
to the board of the bank.
Powers under Property Transfer instruments
The BoE may transfer, by way of a property transfer instrument, all or part of
the property of a bank to a private sector purchaser or bridge bank. Where
the Treasury have made a share transfer order to bring a bank into
temporary public ownership, it may make a property transfer order.
Property includes the assets and liabilities of a bank. A property transfer
instrument may provide not just for the transfer of property, but also make
other provisions for the purposes of, or in connection with the transfer.
The property transfer powers are very wide-ranging. For example, the
property transfer instrument may be made without regard to contractual or
legislative restrictions on transfer. In addition, the BoE or if applicable, the
Treasury, has the power to apportion enforceable rights and liabilities
between the transferor and transferee to a specified extent and in specified
ways. The property transfer instrument can also enable the transferor and
transferee by agreement to modify a provision of the instrument, provided
that the model factor “achieves a result that could have been achieved by
the instrument”. It is unclear whether this provision would permit the BoE or
the Treasury to modify or alter contractual terms, pursuant to such
apportionment.
The property transfer instrument can provide for the terms on which property
is to be held on trust to be modified, and for the trust to be removed. It is
unclear on the face of the wording whether this is limited to trust property of
which the bank is a beneficiary or would also allow the BoE or the Treasury
to transfer assets (for example shares or accounts) held by the bank on trust
for a third party, enabling those assets to become both beneficially and
legally owned by the transferee. The latter interpretation would clearly be
detrimental to the property rights of third party beneficiaries of such
arrangements.
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Notwithstanding the scope of the SRR, it is clear that as regards property
transfer instruments, the SRR is intended to have extra-territorial effect, in
that property transfer instruments may be made with regard to contracts
governed by foreign law or foreign assets, both defined as foreign property.
The Act obliges the transferee and transferor of foreign property to take any
steps necessary to ensure that the transfer is effective as a matter of foreign
law. Importantly, the Act provides that until the transfer is effective, the
transferor holds the foreign property on trust for the transferee and must
discharge any liability on behalf of the transferee, and that such an obligation
is enforceable as if made by contract. The judicial enforceability of such
provisions outside the UK is questionable.
Powers common to property and share transfers
Contractual default event provisions
The Act provides that a share transfer or property transfer instrument can
(but does not necessarily have to) disapply any contractual default event
provision which applies as a result of the making of the transfer instrument,
anything done by virtue of the instrument or any action or decisions taken
under the Act. The commercial reason for this is to prevent, as far as
possible, counterparties from terminating contracts which are part of a
transfer to a new bank.
Contractual default provisions are split into two types which overlap to some
extent, but which broadly aim to cover any contractual right that a party may
have to take or not take some form of action if a particular event occurs or
does not occur. Type 1 default event provisions include those which trigger
rights to terminate a contract, claim a payment right or not perform or deliver,
or replace or modify rights and duties upon the happening of a specified
event or situation. Type 2 default event provisions include those which
provide that a contract takes effect, or does not take effect, or only has
effect, or applies differently, if a specified situation occurs.
The Act allows the Authorities to disapply contractual default provisions
which are triggered by the transfer or action taken under it (for example a
change of control event of default) but not contractual default provisions
unrelated to the transfer, such as termination rights relating to credit or
performance. So an event of default that arose prior to the transfer or during
the SRR but unrelated to the transfer (for example non-payment), should be
enforceable as a termination right against the transferee. If an event of
default occurred as a consequence of the transfer (for example the
transferee’s credit rating meant the credit rating event of default was
triggered), then it would appear that the counterparty should be able to
trigger the termination right against the transferee. However, counterparties
whose contracts are not transferred (and thereby remain in the residual
bank), may not be able to terminate by virtue of the moratorium on
enforcement of contractual rights in the administration of the residual bank.
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Continuity provisions and impact on group companies
The SRR provides that when a share or property transfer instrument/order is
made, provision can be made to ensure the continuity of arrangements
operating in respect of a failing bank. This will directly affect the failing
bank’s corporate group (or former group) companies, requiring them to
support the failing bank and cooperate with the bridge bank or transferee, by
providing services and facilities (for example premises and computer
systems).
The BoE may also cancel or modify contracts or arrangements between the
residual or transferred bank and a group company and also impose
obligations on the residual bank. The exercise of the continuity power is
subject to the condition that the BoE aims to provide payment on commercial
terms for the services and to use the continuity power only as far as it is
necessary to enable the effective continued operation of the transferred
business.
Partial property transfers and Safeguards Order
Impact of partial property transfers
The partial property transfer powers provide the Authorities with flexibility to
split a bank by transferring the “good” part of a failing bank’s business to a
bridge bank or private sector purchaser, leaving a residual “bad bank”
behind, containing any un-transferred assets and liabilities. Such
rearrangement of assets and liabilities could be detrimental to those parties
whose arrangements are left behind in the “bad bank” in terms of, in effect,
concentration of their exposure.
If partial transfers could have the further effect of eroding the efficacy of
security and netting set-off arrangements, thereby actually increasing the
exposure of counterparties, this could have serious regulatory capital and
commercial consequences for banks relying on such arrangements to
quantify and limit risk.
Safeguards Order – General
With a view to avoiding this result, the Government has implemented
secondary legislation pursuant to its powers under Section 48 of the Act to
safeguard against unfettered use of partial property transfers. The
Safeguards Order protects, in a partial transfer, amongst other things,
security interests, set-off and netting arrangements and structured finance
arrangements.
EU Law
The overriding position under the Safeguards Order is that no action taken
by the Authorities under the Act is permitted to breach EU law, such as the
Financial Collateral Directive. This may overlap to provide protection where
the safeguards for Security Interests and Netting and Set-off described
below do not apply.
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Security Interests
The Safeguards Order gives wide-ranging protection to security holders to
ensure that partial transfers do not interfere with security interests.
Effectively, liabilities and their related financial collateral have to be
transferred together in a partial transfer or not at all. Both fixed and floating
charges are covered by this protection.
Netting and set-off protection
The Safeguards Order prevents rights and liabilities covered by netting, setoff or title transfer arrangements (subject to the exclusions discussed below)
from being disrupted by a partial transfer. The rights and liabilities subject to
such arrangements must either all be transferred together, or not transferred
at all – effectively, cherry-picking is prohibited. Netting arrangements are
defined as arrangements under which a number of claims or obligations can
be converted into a net claim or obligation and include close-out netting and
multilateral arrangements. Set-off arrangements are defined as an
arrangement under which one debt can be set off against another to reduce
the amount of the debt. The impact of this protection is that, subject to
exclusions all transactions or positions with a bank which may be set off or
netted must be transferred together or not at all.
The Order also provides that the Authorities cannot disapply default event
provisions under any contracts which contain set-off or netting arrangements
provided that the contracts are not excluded rights or liabilities. This means
that a counterparty to a netting or set-off arrangement can exercise its right
to terminate against either the transferee entity (bridge bank or private sector
purchaser), if the rights have been transferred, or against the residual bank.
Exclusion from netting and set-off protection
Unlike the security interest protection, there are specific exclusions from the
protection for netting and set-off.
The protection will not apply where the relevant netting or set-off
arrangement relates to:
– a retail deposit or liability,
– subordinated debt,
– a contract entered into outside the course of carrying on a business
which solely relates to relevant financial instruments, and
– a claim for damages, an award for damages or a claim under an
indemnity which arose in connection with the carrying on by a bank of an
activity which relates solely to relevant financial instruments.
A relevant financial instrument is defined as (a) a financial instrument (by
reference to the definition in the Markets in Financial Instruments Directive,
which includes options, futures, swaps, other derivative contracts that can be
settled physically or in cash and transferable securities), (b) a deposit or a
loan and (c) an instrument creating or acknowledging indebtedness (by
reference to the Financial Services and Markets Act 2000 (Regulated
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Activities) Order 2001 and which includes bonds, letters of credit, and
debentures.
Clearing and settlement houses default rules
There was concern with earlier drafts of the transaction that a partial transfer
could interfere with and invalidate the arrangements that clearing and
settlement houses make to deal with counterparty and other risks which are
currently protected in the insolvency of a bank by Part VII of the Companies
Act 1989. Such interference would have a detrimental impact on the
operation of these financial markets. To address this, the Order provides that
a partial transfer may not interfere with the default rules or market contracts
of clearing and settlement houses.
Structured Finance Arrangements
Rights and liabilities which form part of a capital market arrangement are
protected rights. This provision is included to cover structured finance
arrangements, including securitisations and covered bonds.
Remedy for breach of Safeguards Order
If a partial transfer is made in breach of the relevant restrictions, the right to
exercise set-off or netting continues, despite the transfer. However, in the
case of a security interest or structured arrangement, the party must give
notice to the relevant authority of the breach, and the authority must remedy
the breach by transferring the property rights or liabilities that were not
transferred in the initial partial transfer.
Compensation mechanisms and other protections
The Act sets out a number of compensation mechanisms for creditors who
are adversely affected by the partial transfer of property. The main
compensation mechanism for the creditors left behind in the residual bank is
set out in the Third Party Compensation Regulations, otherwise known as
the “no creditor worse off Regulations”. The basic premise of these
Regulations is that a creditor of the residual bank should receive the same
payout as it would have done if the transfer had not taken place and the
whole bank had instead been subject to an insolvency. The Regulations
envisage the calculation by an independent valuer of the dividend, if any,
that creditors of the residual bank would have received from a winding up or
administration of the whole bank. This is then compared to the actual
amount paid out to creditors of the residual bank on its insolvency and any
shortfall paid out. The provisions give the independent valuer the discretion
of deciding whether to make the calculation on the basis of a liquidation or
administration scenario. The Regulations do not, however, provide any
certainty to residual bank creditors that they will be paid their actual loss as a
result of the transfer. For example, the Regulations give the independent
valuer discretion to determine whether all pre-transfer creditors, or just
certain classes of pre-transfer creditors, should be paid compensation and
what amount is to be paid.
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In addition to the Third Party Regulations, which only apply to creditors of the
residual bank in a partial transfer, there are three compensation schemes to
protect the financial interests of transferors. These are the resolution fund
order under which transferors become entitled to the proceeds of the sale of
the transferred property, a compensation scheme to establish a scheme for
paying compensation to transferors and a third party compensation order.
However, none of these provisions amounts to certain protection against
loss, for affected counterparties and the timing and basis of valuation and
payment of compensation raise problematic issues.
There is also a Code of Practice which gives guidance on how and in what
circumstances the Authorities will use the SRR, in particular issues relating
to the partial transfer provision. The code covers a number of important
areas including powers in relation to bank holding companies, the use of
continuity powers and reiteration of the Authorities, regard to the SRR
objectives and legal certainty. While this Code may provide some comfort to
participants in the financial markets, it does not assist in determining the
legal rights of the parties.
Bank Insolvency Proceedings
In addition to the three stabilisation options, the SRR also contains a new
bank insolvency procedure (essentially a modified form of liquidation) and a
new bank administration procedure (a modified form of the administration
procedure).
A bank liquidator (using the bank insolvency procedure) is tasked with
marrying two stated objectives. The first is to work with the FSCS to ensure
that as soon as is reasonably practicable depositors’ accounts are
transferred to another financial institution or the depositors receive payment
from or on behalf of the FSCS. The second objective is to wind up the affairs
of the bank so as to achieve the best result for the bank’s creditors as a
whole. There will clearly be situations where a conflict of interest exists
between the two objectives. For example, it may be in the interests of
creditors for the bank liquidator to reduce costs and close certain branches,
whereas the first objective may be better achieved through keeping the
branches open and staff retained. The Act provides expressly that the first
objective should take precedence. [What is clear from this is that the
Government appears to have chosen to protect the interests of depositors
over and above the interests of all other creditors.]
The bank administration procedure has at its heart two objectives – to
support a commercial purchaser or bridge bank in its acquisition and to
rescue the residual bank as a going concern (or, as an alternative, achieve a
better realisation for the residual bank’s creditors as a whole than would be
likely in a winding up). As with the bank insolvency procedure, there clearly
exists potential for conflicts of interest to arise, although unsurprisingly the
Act provides for the first objective to take priority. The first objective requires
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the bank administrator to ensure the supply to the commercial purchaser or
bridge bank of such services and facilities as are required to enable it, in the
opinion of the Bank of England, to operate effectively. This appears to
assume that such services and facilities are under the control of the residual
bank which may not, of course, be the case – for example, essential services
may be provided to the residual bank by a third party. Quite how this is to be
managed is unclear.
As a general remark, the provisions will require a liberal dose of purposive
interpretation in the event that questions arise as to their intended meaning.
For example, in pursuing the second objective, an administrator must first
aim to rescue the residual bank as a going concern “unless of the opinion”
that either it is not reasonably practicable to achieve it or the alternative
second objective would achieve a better result for the residual bank’s
creditors as a whole. The equivalent wording in the unmodified version of
Schedule B1 to the Insolvency Act 1986, when an administrator is choosing
between objectives, is “unless he thinks”. The difference in drafting is
unhelpful, whether or not any difference in meaning was intended.
Ability to change the law
There is a controversial power under the Act to allow the Government to
modify both primary and secondary legislation by Order (i.e. without the
normal parliamentary legislative process). The power cannot, however, be
used to amend the Banking Act itself or secondary legislation under it and
can only be used for the purpose of the exercise of the SRR powers. It
cannot therefore be used by the Government for purposes wholly unrelated
to the SRR. In addition, any amendment must be approved by Parliament
within 28 days of the Order modifying the legislation. However, any action
taken as a result of the change in law during that time is valid, and the
change can have retrospective effect.
Provisions for investment banks
While the Act does not apply to investment banks as such (although it does
of course apply to banks which provide investment firm services), it does
provide for secondary legislation to establish new rescue and insolvency
procedures. Provisions envisaged include a new role similar to the liquidator
or administrator and/or a trustee of clients assets, including an indemnity for
the quasi-administrator. In addition, it would provide for a mechanism for
identifying client assets and how to deal with them and the recovery of
assets transferred in error.
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Part II – Potential Impact of the Act
Shareholders and other holders of securities
Shareholders of a bank that is placed in the SRR may effectively lose all of
their rights as a result. As discussed above, the share transfer provisions
apply to the holding company of a bank if the holding company itself is taken
into temporary public ownership, so may equally affect securities and
shareholders in bank holding companies in such a context. Although
shareholders may receive compensation for the transfer of their shares, it is
likely that such an amount will provide minimal compensation.
While the total loss of an investment is part of the commercial risk any
shareholder takes when purchasing shares (and the Act does not change
this commercial reality) the extension of the scope of a share transfer order
to non-equity securities represents a significant change to the expectations
of investors. This is because the share transfer provisions allow the BoE or
the Treasury to convert debt securities that are transferred into equity
(whether ordinary shares or other type of shares), thereby effectively
cancelling their payment rights and the value of the debt security.
Alternatively, the debt securities could remain in the residual bank, and the
holders left with a claim in the administration of that bank (unlikely to give
rise to a meaningful payment) and a claim for compensation, including under
the Third Party Compensation Regulations. However, there is no certainty
that pre-transfer creditors would receive compensation under these
Regulations. Any compensation investors would receive is unlikely to provide
adequate protection against loss.
The potential impact of the SRR on holders of debt securities may adversely
affect the funding of UK banks at a time when bank funding is under
pressure (although holders of debt securities issued by UK banks as part of
the Credit Guarantee Scheme which benefit from a UK Government
guarantee should still have a claim against the Government for full
repayment). Although the Government may choose to leave debt securities
outside the scope of the share transfer when exercising a stabilisation option
in relation to a particular bank, as happened with Northern Rock and
Bradford and Bingley, investors cannot be certain that this will always be the
case.
In addition, given the ability of the BoE to transfer securities free from any
security and make provision about its extinguishment, holders of collateral
which includes shares or debt securities of UK banks may consider
reviewing their security documentation to check that the security attaches to
any compensation proceeds that the secured creditor may receive.
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Unsecured creditors and contractual counterparties including
corporate borrowers
Parties whose transactions are transferred to a new bank/private sector
purchaser
As explained in Part I above, the Authorities may, when exercising the bridge
bank or private sector stabilisation option, transfer all or part of a bank’s
property, rights and liabilities. If the liability or contractual position is
transferred to a private sector purchaser then the creditor will have a claim
against or liability to, the relevant transferee entity. It is likely that such a
transfer would represent the best outcome for a creditor or counterparty.
By way of example, in the case of a corporate borrower who has an existing
loan with the failed bank which is transferred to a new bank or financial
institution, the new bank will effectively replace the transferor bank in relation
to the loan in all respects and will be subject to the same contractual rights
and obligations as the transferor, provided those terms have not been
modified by the Authorities. If the loan is not fully drawn down, or is a
revolving loan or other commitment, the new bank will be obliged to fund
amounts under the loan agreement with respect to that bank. If the borrower
is unhappy with the identity of the new bank, it could attempt to replace the
new bank or terminate the loan agreement, provided the loan agreement
allowed for the borrower to take such action. For example, in the case of a
syndicated loan, by use of the “yank the bank” provisions, if they cover this
situation, or in the absence of contractual rights, by the use of appropriate
rights available to the borrower under general law. If a corporate borrower
has a deposit with the bank in SRR, and the deposit is transferred to a new
bank, the company should be able to access the deposit on the same terms
as the original deposit agreement.
Parties to transactions that remain in the residual bank
Some creditors and contractual counterparties will, however, find that as a
result of a partial transfer, some or all of their transactions or arrangements
remain in the residual bank, which is likely to be subject to the bank
administration process. In such a case, creditors and counterparties whose
transactions remain in the residual bank will be subject to the general
moratorium on enforcement in an administration and will have to rely for
recovery of any outstanding amounts owed by the failing bank, on making a
claim in the administration of the residual bank and a claim for compensation
under the Act.
What are the options available to a corporate borrower whose loan
agreement remains in the residual bank? The borrower should have a right
under the Act to claim for compensation as a result of non-performance by
the bank of its obligations under the loan (e.g. non-funding). In addition, a
borrower may be able to exercise other contractual and legal rights. If the
loan is a syndicated loan, rather than a bilateral loan, one of the other
syndicate lenders may replace the affected lender and assume the funding
Banking Client Alert | 09 March | 2009
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obligations (for example, if the loan is a revolving loan or undrawn committed
facility) of the failed bank. The replacement would depend on whether the
loan agreement provided for termination and replacement and whether these
mechanisms are switched off as a result of contractual default override
powers. If the terms of the agreement do not allow the borrower to replace
the affected bank, the borrower will need to continue to pay fees, interest
and principal repayments to the residual bank (or the agent for the account
of the residual bank) unless it can establish that the bank has repudiated the
agreement, which it may be able to do if the residual bank breaches its
funding obligations. In addition, if the loan is covered by a set-off or netting
arrangement, the borrower may be able to exercise its right to set-off
amounts owed to it by the bank against amounts owed by it, although most
market standard syndicated loan agreements do not allow borrowers to setoff amounts due from the lenders.
As regards any deposit that a company has with the bank which is not
transferred (an unlikely but possible occurrence), the deposit will not benefit
from the UK deposit insurance scheme as this is only available to retail
deposits. Therefore the company will simply have a claim for repayment of
the deposit in the administration of the residual bank.
Drafting of pre-SRR termination rights
While most parties factor the risk of non-payment or insolvency into their
decision of whether to lend money or do business with a company, and the
Act does not materially change this commercial risk, most counterparties
attempt to ensure that their contractual arrangement allows them to
terminate and enforce their contractual rights before the other party goes into
insolvency. Under English law, unlike some other jurisdictions, termination or
acceleration rights triggered by insolvency or insolvency-related or preinsolvency events are enforceable. The Act changes this legal position by
providing that parties may not be able to exercise their contractual rights in
certain circumstances.
In order to mitigate the effect of this power, counterparties with UK banks
may consider drafting pre-SRR events of default which could indicate the
financial decline of a bank. The problem with such provisions, however, is
that new liquidity requirements proposed by the FSA which are due to apply
later this year to UK banks will require firms to mitigate any contractual terms
that may allow parties to terminate funding or other assets just at the time
when banks require such funding. Banks may therefore potentially refuse to
include such clauses in agreements on the basis of the adverse impact on
their liquidity profile.
Creditors and contractual counterparties with credit risk mitigation
arrangements
Under current English law, and indeed the laws of most developed
jurisdictions, credit risk mitigation arrangements (such as security and
Banking Client Alert | 09 March | 2009
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netting/set-off arrangements) are largely protected in the event of insolvency
and similar procedures. Indeed, such arrangements are only commercially
useful, and generally only recognised for regulatory purposes to the extent
that they are enforceable in insolvency, as that is of course where they are
most valuable. To this end, the European regulatory capital requirements
oblige institutions to ensure that credit risk mitigation arrangements are
backed up by “clean” legal opinions on the effectiveness of the arrangement
in all circumstances including insolvency.
Netting and set-off arrangements could become ineffective if the Authorities
exercised their power to effect a partial transfer of the business of a bank, on
the basis that if the obligations to be netted or set off were now located in
two different entities, the requisite mutuality would be destroyed. The
Safeguards Order prevents this from happening, subject to the exclusions
described in the paragraph entitled “Partial property transfers and
Safeguards Order” of Part I above. There are however areas of concern in
relation to aspects of those exclusions in Safeguards Order and the impact
of the SRR on those arrangements which are discussed below.
Netting and set-off arrangements
As noted in Part I above, the Safeguards Order broadly prevents, in a partial
transfer, the cherry picking of rights and liabilities which are the subject of
netting and set-off arrangements. This means that (subject to exclusion) a
counterparty to a bank can be certain that the transactions subject to any
netting or set-off arrangement are all transferred together, or all not
transferred at all (thereby remaining in the residual bank). There are
however exclusions from this protection which seem likely to create
concerns.
The exclusion for retail deposits or liabilities, which includes those of small
companies, means that agreements between a bank and a small firm would
not achieve net regulatory capital treatment. This may impact on the cost of
loans to such companies and the availability of cash pooling and other
similar facilities to such borrowers. It will also require maintaining of controls
at the border of the relevant retail definitions to see whether, at any point,
they fall within or outside the relevant exclusions.
The scope of the definition of “financial instrument” (in the context of the
exclusion for a contract entered into outside the course of carrying on a
business relating to relevant financial instruments) would appear to cover
most, but not all financial contracts which are the subject of netting and setoff arrangements. By referring to the Markets in Financial Instruments
Directive definition of “financial instrument”, there is uncertainty whether
certain types of financial transactions may fall outside the scope of the
definition, including spot and forward foreign exchange transactions. Spot
FX transactions are commonly included in netting arrangements and
uncertainty as to the exclusion of such arrangements from the netting
protection may have adverse regulatory capital implications for such
transactions.
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One further area of concern is the use of the word “solely” (in the exclusion
for contracts entered into outside the course of carrying on a business which
relates “solely” to a relevant financial instrument). The effect of this would
appear to be that if a master netting agreement covered one agreement that
fell within the exclusion, all the agreements covered by that master
agreement would then fall outside the scope of the protection in the
Safeguards Order. This would have adverse regulatory and commercial
implications for master agreements that contain an excluded contract.
Additionally, it seems odd that the exclusion for contracts entered into by a
bank outside the course of carrying on a business relating to relevant
financial instruments is not mirrored in the exclusion for claims for damages
or claims under an indemnity in relation to such business. Instead the
relevant wording excludes claims which arise in connection with the carrying
on by the bank of an activity which relates solely to relevant financial
instruments. It is difficult to understand why contracts outside the course of
carrying on a business solely relating to financial instruments are excluded
from protection, but claims in connection with such contracts are the only
ones not excluded.
One further point to note in relation to netting and set-off arrangements is a
restriction on the ability of a counterparty to close out and exercise rights of
set-off where its rights and liabilities subject to netting or set-off
arrangements have been transferred in a whole bank transfer. This is
because the Safeguards Order does not apply to whole bank transfers.
Counterparties to a netting and set-off arrangement whose transactions were
transferred to a new transferee would therefore only be entitled to close-out
and terminate against a transferee bank for non-transfer-related termination
events or future defaults by the transferee.
The Safeguards Order was designed to ensure that lawyers would not need
to qualify netting and set-off legal opinions as a result of the Act coming into
force. Qualification of these opinions would have detrimental impact upon
the regulatory capital treatment of these arrangements. The general market
view is that the Safeguards Order has for the most part achieved this aim,
but (as discussed above) gaps in the protection remain.
Security Arrangements
Secured creditors are protected in a partial transfer from their collateral
being transferred to the bridge bank or private sector purchaser, while the
liability remains with the residual bank. This accords with the current position
under English law by protecting the proprietary interest of a secured creditor.
However, the ability of the Authorities to prevent enforcement of the security
on transfer, if the enforcement event was triggered by the transfer itself, is
new (although an enforcement event that is triggered as a consequence to
the transfer would still be effective). Secured creditors may wish to consider,
as with unsecured creditors, providing for pre-SRR enforcement events, but
it is likely that most banks will resist the inclusion of such events. If the
security falls within the scope of the Financial Collateral Regulations
Banking Client Alert | 09 March | 2009
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however, secured parties should be able to enforce despite the contractual
override.
As discussed in the paragraph entitled “Share and Property transfer” of Part
I, a property transfer instrument may modify the terms on which property is
to be held on trust and or provide for the trust to be removed. While there are
strong arguments to support the proposition that this power should be
restricted to property of the bank held on trust, not property of third parties
for which the bank is trustee, there is no such explicit limitation in the Act.
This could adversely affect those security trust arrangements under which
the failing bank, acts as security trustee (for example, in relation to secured
syndicated loan agreements).
Structured Finance – Transactions and counterparties to those
arrangements
The impact of Act and the Safeguards Order on structured finance
transactions will depend on the role of the bank subject to the SRR in the
relevant structured finance transaction. Banks currently perform a myriad of
roles, including originators and servicers/cash managers of traditional
securitisations, issuers of covered bonds, swap counterparties, liquidity
providers, paying agents, custodians, and account banks.
As mentioned above, the Safeguards Order broadly protects structured
finance arrangements (including true sale transactions where the bank sold,
for example, mortgages) by prohibiting the transfer of some, but not all, of
the rights and liabilities between a particular person and a bank which form
part of a capital market arrangement to which the bank is a party. “Capital
market arrangement” is defined broadly in the same way as under the
Insolvency Act 1986, and covers structured finance transactions in which
debt securities are issued which are rated, listed or traded.
It is possible, therefore, that a transferee bank could “inherit” a securitisation
from another bank subject to a SRR, with presumably legal title in the
securitised assets vesting in the transferee bank and the transferee bank
acting as servicer and possibly performing other roles. In these
circumstances, it might not be possible for the SPV to perfect its title in the
transferred assets. Such a transfer could prejudice the securitisation cash
flows. Consequently, rating downgrade triggers could become additional
perfection events and servicer termination events in more bank-originated
securitisation asset classes.
Where the bank is swap counterparty, paying agent, account bank,
custodian or cash manager, often a rating downgrade below A1/P1 will
require that bank to be replaced (or to post collateral, or to find a A1/P1
rated guarantor). This replacement right should be unaffected by the bank
being subject to an SRR.
The Safeguards Order also prevents any rights and liabilities between a
bank and a special purpose vehicle or limited liability partnership, which form
Banking Client Alert | 09 March | 2009
18
part of a capital market arrangement, from being modified or terminated
under the continuity powers under the Act. This is intended to address
concerns about the continued bankruptcy-remote status and/or solvency of
these vehicles.
Group Arrangements
The continuity obligations in the Act have implications for any group
company of a bank in an SRR. The Authorities can require group members
to provide services and facilities to enable a transferee to operate the
transferred business effectively, which would doubtless include IT and
payroll and other operational services, but the provisions could possibly be
used by the Authorities widely to look to group companies for funding and
credit support of the bank. In addition, the Authorities can modify or alter any
contracts. Although they have to aim to provide reasonable consideration for
such modification, they are not obliged to. This poses a risk to group
members and such members may need to consider the accounting and
business impact of this risk.
Impact on Disclosure
It is expected that disclosure documents and offering memoranda of affected
issuers will, as a matter of course, contain disclosure as to the Act and the
potential consequences for investors of any action that may be taken under
it.
Banking Client Alert | 09 March | 2009
19
Editors:
David Ereira, email: [email protected]
Charles Clark, email: [email protected]
Brian Gray, email: [email protected]
Benedict James, email: [email protected]
Allegra Miles, email: [email protected]
This publication is intended merely to highlight issues and not to be comprehensive, nor to provide legal advice. Should
you have any questions on issues reported here or on other areas of law, please contact one of your regular contacts, or
contact the editors.
© Linklaters LLP. All Rights reserved 2009
Please refer to www.linklaters.com/regulation for important information on our regulatory position.
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