I. Introduction
- The failure of a credit institution bears, depending on its size and interconnectedness with other relevant financial institutions and insurance companies, a significant systemic risk for the financial system of a country and potentially the global financial system itself. In particular, in the aftermath of the post-Lehman global financial crisis it became obvious that most jurisdictions were lacking the appropriate tools to deal with failures and distress of large and interconnected credit institutions acting on an international scale. Restructuring, insolvency or even liquidation of large credit institutions appeared to be legally difficult if not impossible.To avoid a severe impact on the global financial system and the “real economy”, distressed credit institutions and certain types of investment firms (“Institutions”) were stabilised through public funding (so called “bail-outs”). Consequently, investors were saved from losses which were instead carried by the public sector. These “implied sovereign guarantees” for failing Institutions were met with criticism on the basis that they would incentivise inappropriate risk taking and increase moral hazard within the relevant Institutions. Hence, after a first wave of “bail-outs” of certain Institutions it became politically more and more unpopular for national governments to support “bail-outs”. In the recent past, distressed situations of the various Cypriot banks, the Portuguese Banco Espirito Santo, or the Austrian HETA Asset Resolution AG (the “bad bank” of former Hypo Alpe Adria Group) evidenced a shift from the original willingness of the European sovereigns to bail-out towards the so called “bail-in”, meaning that shareholders and subordinated investors of an Institution should bear its losses in the first instance.
- In order to better deal with financially distressed Institutions, the member states of the European Union decided to implement (as one of the pillars of the European Banking Union) the Regulation for a Single Resolution Mechanism and a Single Resolution Fund (EU) No. 806/2014 (“SRM-Regulation”) as well as the Bank Resolution and Recovery Directive 2014/59/EU (“BRRD”) in order to provide among other things an European-wide minimum standard of adequate recovery and resolution tools to deal effectively with unsound or failing Institutions. On 1 January 2015, the German Recovery and Resolution Act (Sanierungs- und Abwicklungsgesetz – “SAG”), came into effect, implementing the BRRD into German law. Unlike certain other European jurisdictions such as Portugal or Austria, where apparently the BRRD has been implemented into national law with some tweaks, the German SAG quite closely followed the provisions of the BRRD.
- In November 2015, the German legislator harmonised the SAG with the SRM-Regulation and furthermore introduced certain amendments of the relevant German laws applicable to Institutions, such as the German Banking Act (Kreditwesengesetz – KWG), through the Resolution Mechanism Act (AbwMechG), which, amongst other things, will statutorily subordinate claims under certain unsecured debt instruments to general senior unsecured obligations in case of insolvency of an Institution. As a result, from 1 January 2017 certain types of securities including bearer bonds (Inhaberschuldverschreibungen), order bonds (Orderschuldverschreibungen) and similar tradable capital market instruments as well as promissory note loans (Schuldscheindarlehen) and registered bonds (Namensschuldverschreibungen) issued by such Institutions will be capable of being bailed-in prior to other senior unsecured liabilities. This new statutory subordination is a particular feature which has been included in the German “bail-in” implementing legislation which goes beyond the requirements of the BRRD and which will need to be taken into account by investors when investing in unsecured debt instruments of German Institutions.[1]
II. Recovery and Resolution Tools
1. Resolution Objectives: The BRRD’s standardised recovery and resolution tools in particular are aimed at (i) preventing a threat to the financial system resulting from a threat to the existence of a particular “systemically relevant” Institution[2] and (ii) protecting public funds (i.e. tax payer money) from being utilised to stabilise distressed Institutions. Instead, investors shall carry the losses resulting from stabilisation and financial restructuring of such Institutions in the first instance, provided that, as an overarching principle, no investor should be put in a worse position then it would be in the case of a (hypothetical) bankruptcy of the troubled Institution. Resolution actions may, however, only be taken by the competent resolution authorities if the following conditions are met:
(i) the determination that the Institution is failing or is likely to fail has been made by the competent authority or the resolution authority;
(ii) there is no reasonable prospect that any alternative private sector measures or supervisory action taken in respect of the Institution would prevent the failure of the Institution within a reasonable time frame; and
(iii) a resolution action is necessary to protect the public interest, i.e. if it is necessary for the achievement of and is proportionate to one or more of the Resolution Objectives (as defined below) and the winding up of the Institution under bankruptcy
proceedings would not meet those Resolution Objectives to the same extent.
The “Resolution Objectives” are (i) to ensure the continuity of critical functions, (ii) to avoid significant adverse effects on financial stability, (iii) to protect public funds by minimising reliance on extraordinary public financial support, (iv) to protect depositors and investors covered by Directive 2014/49/EU or Directive 97/9/EC, and (v) to protect client funds and client assets.
2. Liability Cascade: The following order of investor participation applies in connection with the recovery of a distressed Institution, the so called “liability cascade”:
(i) shares and other instruments of the common tier 1 capital;
(ii) instruments of the additional common tier 1 capital;
(iii) instruments of the supplementary tier 2 capital; and
(iv) eligible liabilities.
The ranking between the various types of eligible liabilities mirrors their respective ranking in a bankruptcy of the Institution. However, certain types of debt and liabilities are excluded from the bail-in under the BRRD (see paragraph III. 3 below).
3. Recovery and Resolution Instruments: Against this background, the following categories of BRRD recovery and resolution instruments have been implemented by the SAG:
a.) Recovery Plans: Recovery plans (Sanierungspläne) have to be established and updated annually by the Institutions and must describe, amongst other things, the specific business model, critical functions as well as potential options in case of a financial crisis of the Institution;
b.) Resolution Plans: Resolution plans (Abwicklungspläne) have to be established by the resolution authority[3] and provide for an individual instruction manual if the relevant Institution has to be liquidated outside a regular insolvency proceeding;
c.) Early Intervention: Early intervention measures, which can be applied by the supervisory authority[4] if the financial stability of an Institution deteriorates significantly, including implementation of measures under the recovery plan, change of business strategy or of legal and operative structures, exchange of management or appointment of a temporary administrator; and
d.) Resolution Tools: Resolution tools[5], comprise: (i) transfer tools, allowing the resolution authority to effect a sale of (parts of) the Institution or its assets without shareholders’ consent to third parties (Unternehmensveräußerung), to a bridge institution owned and controlled by the resolution authority or other public authority (Brückeninstitut) or to an asset management entity controlled by the resolution authority (Vermögensverwaltungsgesellschaft) (together the “Transfer Tools”); and (ii) “bail-in” tools empowering the resolution authority to convert certain capital or debt instruments owed by the troubled Institution into equity and/or to write-off such instruments (Beteiligung der Anteilsinhaber und Gläubiger).
4. SRM-Regulation and SRB: The SRM-Regulation became effective on 1 January 2016. It provides for, amongst other things, the newly established Single Resolution Board (“SRB”), which is responsible for resolution planning and resolution decisions relating to “significant” institutions supervised by the European Central Bank and other cross-border groups.[6] For these institutions and groups, the SRB has the role of a European resolution authority while for the other institutions, the national resolution authorities will have an analogous role.[7] The details of the resolution procedure pursuant to the SRM-Regulation are complex, involving cooperation between the European Central Bank, the SRB, the European Commission, the European Council as well as the relevant national resolution authority.[8]
For the purposes of this article, it is important to understand that, if, at the end of the process, the decision has been taken to place the relevant institution under resolution and to carry out a specific resolution scheme, the SRB will instruct the relevant national resolution authority to implement the relevant resolution measures by exercising its resolution powers. In such case, the German resolution authority will implement the relevant resolution scheme by using the resolution tools under the SAG, including, if applicable, the German Bail-in Tools described below.
III. German Bail-in
1. Conversion and Write-Off: In particular, the application of the “bail-in” can have a severe impact on the position of investors in a distressed Institution. The “bail-in” instrument comprises a conversion tool and/or a write-off tool (together the “Bail-in Tools”). By application of the conversion tool, the resolution authority is empowered to convert equity and/or debt instruments into common equity instruments of the Institution (i.e. usually into ordinary shares). In addition, by application of the write-off tool, the authority may force a write-off of the relevant instruments in whole or in part.
The Bail-in Tools may be applied in connection with (i) a recapitalisation of the troubled Institution if its capital structure is restored by such measure, or (ii) the application of any of the Transfer Tools. Any losses or recapitalisation of the relevant Institution shall be borne in accordance with the “liability cascade” determined by the BRRD (see paragraph II. 2 above), i.e. firstly, by its shareholders, secondly, by its subordinated creditors, and, thirdly, by certain of its other creditors.
In November 2015, the German legislator harmonised the SAG with the SRM-Regulation and also introduced certain amendments to the German laws applicable to Institutions through the Resolution Mechanism Act (AbwMechG). The effect of those amendments is to statutorily subordinate claims under certain unsecured debt instruments (as described in the next paragraph below) to general senior unsecured obligations in the case of insolvency of an Institution[9]. With respect to the “liability cascade”, these senior unsecured debt instruments will be bailed-in prior to other senior unsecured liabilities (being ordinary claims of unsecured creditors (Insolvenzgläubiger))[10]. However, these senior instruments will (still) rank ahead of and will therefore only be bailed-in after the claims of subordinated creditors (nachrangige Insolvenzgläubiger), which include statutorily or contractually subordinated claims.[11] The relevant provisions in the German Banking Act (KWG) regarding mandatory subordination will become effective on 1 January 2017 and will apply to all insolvency proceedings opened thereafter.[12] It is currently unclear what effect the mandatory subordination will have on the eligibility of such instruments as collateral for Eurosystem credit operations of the European Central Bank.
The mandatorily subordinated instruments will generally include (i) bearer bonds (Inhaberschuldverschreibungen), order bonds (Orderschuldverschreibungen) and similar tradable capital market instruments, (ii) promissory note loans (Schuldscheindarlehen) and (iii) registered bonds (Namensschuldverschreibungen), provided that, with respect to the instruments of (ii) and (iii) only, they do not qualify as covered or eligible deposits[13]. Explicitly excluded from mandatory subordination will be so called “exempted liabilities”, i.e. certain types of debt and liabilities excluded from bail-in under the BRRD and the SAG (see paragraph III. 3 below), debt instruments issued by such public law institutions (Anstalten des öffentlichen Rechts) that are not subject to insolvency procedures[14], and money market instruments (Geldmarktinstrumente)[15]. Furthermore, the mandatory subordination will not apply to certain other debt instruments where practical difficulties, particularly around the valuation, would occur in connection with the implementation of the Bail-in Tools, e.g. instruments where the specific amount of principal or interest is uncertain at the time of issuance or where the claim will not be fulfilled by a cash-payment.[16]
The application of the write-off tool generally has a more severe impact on the investor compared to the application of the conversion tool. At least theoretically, the conversion into equity is carrying an option value for the affected investor allowing for participation in a potential future success of the restructured Institution. Thus, a write-off is only permitted to the extent it is required to ensure that the net asset value of the Institution equals zero or, in case of an expected loss, that the net asset value does not fall below zero.[17]
2. Third Party Obligors and Security Providers: The rights of affected investors against joint obligors, guarantors or any other third parties securing the instruments issued by the troubled Institution shall not be affected by the application of the Bail-in Tools. Instead, such parties generally remain fully liable to the relevant investors. In this context, the Institution is fully discharged from any (recourse/subrogation) claims of such third parties resulting from an application of any Bail-in Tool.
3. Exempted Liabilities: Certain types of debt, including (i) covered deposits, (ii) secured liabilities (but only to the extent effectively covered by the value of the security interests), (iii) short-term liabilities owed in the interbank market or to clearing systems, (iv) client assets or client monies, and (v) operational liabilities owed to employees, trade creditors, deposit guarantee schemes and tax or social security authorities do not qualify as “eligible liabilities” (berücksichtigungsfähige Verbindlichkeiten)[18] and thus, any such debt is excluded from the application of the Bail-in Tools. Further, special provisions apply with respect to liabilities resulting from derivatives. Under certain circumstances, the resolution authority may expressly exclude specific liabilities from a “bail-in”.
To prevent Institutions from structuring their liabilities in a manner that could jeopardise the effectiveness of the Bail-in Tools, each Institution is obliged, at the request of the resolution authority, to meet at all times a minimum requirement of regulatory “own funds” (regulatorische Eigenmittel)[19] and eligible liabilities.[20] To satisfy the minimum requirement percentage, the relevant liabilities need to fulfill certain criteria, e.g. liabilities with a remaining minimum period of one year until maturity, which are not secured or financed by the Institution. To ensure that the Bail-in Tools can be applied effectively to liabilities governed by the laws of countries which are not members of the European Economic Area (EEA), the Institutions are obliged to agree with the relevant creditors the application of the Bail-in Tools for all relevant capital instruments and eligible liabilities issued after 1 January 2015.
4. Valuation: Given the amount and variety of assets and liabilities of an Institution, it is not realistic to carry out an extensive valuation and assessment prior to the implementation of the relevant resolution tool. Therefore, the SAG stipulates that a final valuation and assessment will only be made afterwards. In addition, there is only limited legal protection available for affected investors against applied resolution tools.[21]
IV. Recognition of Foreign Resolution and Recovery Measures in Germany
Questions around the recognition of resolution measures taken by a foreign resolution authority affecting German law governed claims have, in the recent past, gathered significant public attention in connection with the Austrian “bad bank” HETA Asset Resolution AG (“HETA”). The relevant Austrian resolution authority proclaimed a moratorium and has suggested implementing a financial restructuring of a significant part of the outstanding debt of HETA through the Austrian Bank Recovery Act (BaSAG). The implementation of the BRRD through the BaSAG itself has become subject to fierce disputes between investors and HETA, as contrary to the BRRD, the BaSAG seems to apply also to a bad bank without a banking license, such as HETA. As BaSAG’s compliance with the BRRD has been questioned, it has been argued that to the extent the debt affected by the resolution measures is governed by German law, the German courts would not recognise the respective measures taken pursuant to the BaSAG. This view has been confirmed in the HETA case by the Munich district court in the first instance (N.B. the decision has been appealed). The question whether the BaSAG is in compliance with the BRRD has been in the meantime referred by the Frankfurt district court to the European Court of Justice.
Without getting into the details of the various arguments and merits made in the various HETA court cases, we would like to clarify some general principles around the recognition of foreign resolution and recovery measures in Germany:
1. Recognition of Resolution Measures: The recognition of EU member state resolution measures in Germany is addressed in the SAG. The explicit recognition pursuant to the SAG is limited to the Bail-in Tools and the Transfer Tools (which is all that is explicitly required by the BRRD); it does not address the recognition of ancillary measures, including for example a moratorium.
2. Recognition of Ancillary Measures: However, the European Bank Reorganisation Directive (the “EBRD”) and the German Banking Act (KWG) address the recognition of bankruptcy and reorganisation proceedings regarding credit institutions within the EU. The EBRD has also been amended in connection with the BRRD. In particular, the definition of reorganisation measures in the EBRD has been amended to include in general measures taken under the BRRD (i.e. it is not specifically limited to the Bail-in Tools and the Transfer Tools). The German legislator has therefore amended the German Banking Act accordingly. The the new provision in the German Banking Act is a bit ambiguous and the materials do not give any further explanation on the purpose of the amendment. However, it appears that the relevant provision effectively could be interpreted in a way that measures which are taken by non-German resolution authorities, in particular the exercise of ancillary powers under the BRRD, would be recognised in Germany (as is required under the amended EBRD), provided that the relevant institution qualifies as a relevant Institution under the BRRD (N.B. it is currently still under question if a “bad bank” like HETA constitutes a relevant Institution under the BRRD).
V. Conclusion
The German legislator has implemented the BRRD into German law, thereby generally closely following its provisions, including its recovery and resolution instruments. The “bail-in” instrument applicable to troubled Institutions comprises a conversion tool and/or a write-off tool. Both tools may only be applied in accordance with the “liability cascade” pursuant to which losses shall be borne firstly by shareholders, secondly by subordinated creditors and thirdly by certain of the other creditors of the relevant Institution.
From 1 January 2017, certain unsecured debt instruments will be bailed-in prior to other senior unsecured liabilities. These mandatorily subordinated instruments will generally include (i) bearer bonds, order bonds and similar tradable capital market instruments, (ii) promissory note loans and registered bonds. This is a special German law feature which has been included in the German “bail-in” beyond the requirements of the BRRD. Investors will need to take this statutory subordination into consideration when investing in unsecured debt instruments of German Institutions.
FOOTNOTES:
[1] For more details see III.1 below.
[2] In this context, there will be a threat to the system if the threat to the existence of an Institution or its group has a materially negative impact on the specific market situation or other financial market participants, the financial markets, or the overall confidence of depositors and other market participants in the functionality of the financial system or the real economy.
[3] In the first step, the Financial Market Stability Authority (Bundesanstalt für Finanzmarktstabilisierung – FMSA) assumes the role of the resolution authority in Germany. This role will subsequently be merged into the German Federal Financial Supervisory Authority (Bundesanstalt für Finanzdienstleistungsaufsicht – BaFin) by way of a so called “institution within an institution”. With respect to the Single Resolution Board as responsible resolution authority for “significant” European institutions, see paragraph II. 4 below.
[4] The supervisory authority is the European Central Bank or, as the case may be, the German Federal Financial Supervisory Authority.
[5] The competent resolution authority has to assess whether the Resolution Objectives are met in connection with the application of a resolution tool. It considers, in particular, the nature and the level of liabilities of the Institution, its interconnectedness with other market participants and the expected consequences of a break-down of the Institution towards other market participants. Only if the application of an insolvency proceeding is ruled out due to the presence of a threat to the system, the resolution authority will be entitled to implement a resolution tool.
[6] In addition, the SRB will adopt the relevant resolution scheme if the resolution requires the use of the European Single Resolution Fund, which has also been established by the SRM-Regulation. It shall be funded by contributions raised from “significant” institutions and be used to ensure effective resolution, particularly to finance the institution under resolution, a bridge institution or an asset management vehicle.
[7] For details see Article 7 of the SRM-Regulation.
[8] For details regarding the resolution procedure see Article 18 of the SRM-Regulation.
[9] See Section 46f of the German Banking Act (KWG), particularly new paragraphs (5) to (7), and Section 38 of the German Insolvency Code (Insolvenzordnung – InsO).
[11] For details see Section 39 of the German Insolvency Code (InsO).
[12] These changes will split the current senior unsecured debt class and create a new class of tradable senior unsecured debt which will be used, together with regulatory capital, as loss-absorbing liabilities. The new mandatory subordination will mitigate legal and practical risks and enhance the implementation of the Bail-in Tools. It is also relevant with a view to the Total Loss Absorbency Capacity (“TLAC”) of global systemically important banks and the minimum requirement for own funds and eligible liabilities (“MREL”) set by the competent resolution authority (see also paragraph III. 3 below), which may result in a reduction of the required amount of contractual bail-in instruments.
[13] Within the meaning of Section 46f, paragraph (4) numbers 1 or 2, of the German Banking Act (KWG).
[14] The exemption from mandatory subordination does therefore not apply to debt instruments issued by e.g. German savings banks (Sparkassen) or German state banks (Landesbanken).
[15] Within the meaning of Section 1, paragraph (11) sentence 2 of the German Banking Act (KWG).
[16] See Section 46f, paragraph (7), of the German Banking Act (KWG).
[17] As a consequence, in case a positive net asset value is given, the resolution authority is only entitled to apply the conversion tool, e.g. in order to restore the required common equity ratio.
[18] See Section 91, paragraph (2), of the SAG.
[19] Pursuant to articles 25 et sec. Regulation (EU) No 575/2013 on prudential requirements for credit institutions and investment firms.
[20] The minimum requirement (MREL) is determined as a percentage of total own funds and eligible liabilities towards total own funds and total liabilities and is specified for each individual Institution.
[21] The relevant resolution order will be made as a general ruling (Allgemeinverfügung) and will be publicly announced. It can generally only be challenged by an application for annulment before the competent Higher Administrative Court, which is the first and final instance in such context.