UK Banking Regulator Finalizes Rules Requiring Adherence to Contractual Stay

by Eversheds Sutherland (US) LLP

On November 13, the Bank of England’s Prudential Regulation Authority (PRA) published a final policy statement titled “Contractual Stays in Financial Contracts Governed by Third-Country Law” (the PRA Policy Statement). These final rules create restrictions on contractual termination rights for certain UK-jurisdictional entities. Although the PRA Policy Statement only applies directly to the UK firms and the subsidiaries specified in the final rules (and discussed below), it will indirectly impact all firms, including those based in the United States, that enter into derivatives, securities, physical commodity and other transactions with such UK firms and their subsidiaries.

Policy and Background

Following the 2008 financial crisis, the European Union developed comprehensive bank recovery and resolution regimes, including those set forth in the EU Bank Recovery and Resolution Directive (BRRD). The BRRD was intended to provide tools for handling future cross-border bank failures, and to reduce the potential public cost of future financial crises.  

A key component of the BRRD was to ensure that, once a jurisdictional firm entered resolution, its counterparties in derivatives and other financial contracts could not terminate their positions solely as a result of the firm’s (or affiliate’s) entry into resolution. A suspension of early termination rights, also known as a “stay,” is one purported way to avoid a disorderly, uneconomical closeout and liquidation of these contracts. Under the BRRD, the Bank of England was authorized to temporarily suspend the termination rights of any party to these financial contracts, so long as the UK firm in resolution continued to perform its payment and other substantive obligations under the contract.  

Although the BRRD ensures that the UK temporary stay would be recognized throughout the EU, there is no similar guaranty that any other jurisdiction would enforce the UK stay in favor of contractual terms, unless the law of that jurisdiction expressly recognized foreign resolution actions. Therefore, counterparties under contracts governed by “third-country law” (meaning the law of any jurisdiction outside the European Economic Area) would potentially be able to exercise early termination rights in resolution, while counterparties to contracts governed by UK or another EU country’s law would potentially be prevented from doing so. This disparity would potentially have a negative impact on a UK firm’s resolution.

The PRA Policy Statement is part of a coordinated effort by member countries of the Financial Stability Board (FSB) to avoid this disparity and improve cross-border recognition of resolution stays by obliging industry participants to adopt contractual solutions where statutory recognition regimes are lacking. The PRA first proposed rules along these lines in May 2015 (the PRA Consultation Paper), and the PRA Policy Statement represents the final version of these rules, incorporating feedback received from industry participants during the open comment period.  

Summary of the PRA Policy Statement

The PRA Policy Statement prohibits UK Banks from entering into or materially amending a “third-country financial arrangement,” (i.e., agreements with third country counterparties that are governed by a third countries laws) unless their counterparty agrees to be subject to the UK resolution stay or similar restrictions on early termination and close-out. For purposes of the PRA Policy Statement, “UK Banks” include PRA-authorized banks, UK building societies, PRA-designated investment firms, and the foregoing entities’ parent companies to the extent that they are UK financial holding companies or UK mixed financial holding companies. Under the PRA Policy Statement, UK Banks are also obligated to ensure that any subsidiary that is a credit institution, investment firm or financial institution (the UK Bank Subsidiaries) abide by the same restrictions, regardless of their jurisdiction of formation.  

For purposes of the PRA Policy Statement, a “financial arrangement” is considered to include securities contracts (including repo and reverse repo transactions), physical commodities contracts and any kind of derivatives contract. In other words, once the PRA Policy Statement is effective, any entity that wishes to enter into a securities, derivative or physical commodities contract with a UK Bank or a UK Bank Subsidiary will effectively be required to adhere to the UK resolution stay, or agree to an equivalent suspension of termination rights.   

Third-country financial arrangements are only subject to the PRA Policy Statement to the extent they contain a termination right or security interest, the exercise or enforcement of which could be suspended or prevented or the application of which would be disregarded under the Special Resolution Regime of the UK Banking Act 2009 if the financial arrangement were governed by the laws of the United Kingdom. The prohibitions set forth in the PRA Policy Statement do not apply to third-country law financial arrangements with any “excluded person,” including exchanges, central banks, central counterparties and central governments.

The PRA Policy Statement will become effective on June 1, 2016 for all UK Bank Subsidiaries that are credit institutions or investment firms, and on June 1, 2017 for all other UK Banks and UK Bank Subsidiaries.

Summary of Noteworthy Changes Made in the Final PRA Policy Statement

In response to comments received on the PRA Consultation Paper, the PRA revised the final rules to include:

(i)    Exempting third-country financial arrangements that (a) do not contain termination rights or rights to enforce a security interest or (b) are entered into by subsidiaries whose obligations are neither guaranteed nor otherwise supported by a UK firm;
(ii)   Delaying the effective date as set forth above;
(iii)  Expanding the definition of “excluded person” to include all third-country market infrastructure (e.g., central counterparties and payment systems), regardless of designation, and all agencies or branches of a central government;
(iv)  Replacing the requirement that a counterparty agree to a requirement in writing to instead agree in an “enforceable manner”; and
(v)   Clarifying that the PRA Policy Statement applies only to third-country law financial arrangements containing security interests or default event provisions, the enforcement of which could be suspended, prevented or would be disregarded under the UK Special Resolution Regime.

Impact on U.S. Companies

As noted above, the PRA Policy Statement does not create any affirmative obligations for U.S. companies. However, the PRA Policy Statement will apply to any financial arrangement that a U.S. entity enters into with a UK Bank or a UK Bank Subsidiary. In other words, beginning on the applicable effective date, any U.S. firm entering into a new contract or materially amending a contract deemed to be a “financial arrangement” with HSBC, the Royal Bank of Scotland, Barclays, Standard Chartered and others should be mindful that it will have to agree to terms that may not allow for immediate termination and liquidation rights in the event that its counterparty enters into resolution.  

The International Swaps and Derivatives Association (ISDA) 2014 Resolution Stay Protocol is a non-governmental initiative supported by the Bank of England and other FSB member jurisdictions as an example of a contractual solution to the disparate termination rights problem.  The ISDA Protocol applies to bilateral swaps documented under the 1992 and 2002 ISDA Master Agreement, and similar industry solutions may also be developed in the near future for securities financing and repo transactions. Many international banks have signed on to the ISDA Protocol, and other U.S. companies should review this protocol closely to determine whether they may also choose to adhere.  

In preparation for the June 2016 and June 2017 staggered effective dates of the PRA Policy Statement, U.S. companies entering into securities, derivative and physical commodity contracts with UK Banks and UK Bank Subsidiaries (among other counterparties) should expect requests in the coming months to modify any standard termination rights that do not account for the UK temporary stay.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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