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Cross-border recognition of resolution stays - significant compliance challenges on the horizon

A global solution to a global issue?

International efforts to ensure the resolvability of financial institutions continue. In the case of cross-border groups, the need to ensure that resolution actions taken in one jurisdiction will be recognised and promptly given effect to in other jurisdictions has been identified as "fundamental to effective resolution".1 While some resolution regimes provide for the possible recognition of third country resolution proceedings, there is usually no binding obligation to recognise such proceedings. Other than within the EU, where the application of bank resolution tools and powers set out in the EU Bank Recovery and Resolution Directive (BRRD) should be recognised as between Member States, achieving political agreement on a regime for cross-border recognition regime of statutory resolution frameworks is a herculean task. (For example, there are no recognition provisions in the U.S. under the Orderly Liquidation Authority (OLA) or Federal Deposit Insurance Act (FDIA), though U.S. courts may give comity to stays under non-U.S. special resolution regimes). As such there is no mandatory international mutual recognition and enforcement of resolution powers.

The powers with which the regulators are concerned include provisions in special resolution regimes that permit termination and other rights to be stayed for a short period of time and/or to be permanently overridden (to the extent that such rights relate to the resolution or are directly linked to the resolution). Such stay and/or override powers are designed to alleviate concerns that the simultaneous close-out of derivatives and other financial transactions during the resolution of a large, cross-border bank could hamper resolution efforts and destabilise markets.

In a cross-border context, a stay and/or override on termination or other rights in certain financial contracts under the relevant resolution regime in one jurisdiction could cause recognition issues in another jurisdiction, which may impede the relevant resolution proceedings.

Accordingly, the FSB has been tasked with enhancing cross-border co-operation on a global level and has committed to supporting contractual and statutory approaches to prevent large-scale early termination of financial contracts in resolution (see further the FSB's Principles for Cross-border Effectiveness of Resolution Actions (November 2015)).

Voluntary contractual approaches

In the past few years, there has been a focus on "voluntary" contractual approaches to the cross-border recognition issue. In November 2013, the resolution authorities of the UK, the U.S., France, Germany, Japan and Switzerland requested that ISDA amend the ISDA Master Agreement to ensure that, in the context of a cross-border transaction, any relevant stay and default override rights set out in the relevant resolution regime would be respected in the event of resolution of a counterparty. This initiative culminated in the publication of two ISDA Resolution Stay Protocols (in November 2014 and 2015, respectively) which apply to certain contracts (essentially certain ISDA Master Agreements, related credit support arrangements and certain securities financing transactions) between certain identified, systemically important entities to the extent that both parties to the relevant contract have adhered to the relevant protocol.2

Statutory resolution stay rules

One issue with a purely voluntary contractual solution is that many buy-side firms – who are largely unregulated – felt unable to voluntarily adhere to the ISDA Resolution Stay Protocols due to their fiduciary responsibilities to their clients. The FSB recognised this issue and, consequently, FSB members committed to encouraging broader adoption by introducing new resolution stay rules in their jurisdictions. Such rules would, for the most part, bite on regulated entities but would require them to obtain contractual recognition from their counterparties, even where such counterparties were unregulated. Statutory rules relating to the cross-border recognition of contractual stays are, therefore, being developed in a number of individual jurisdictions. For example, the UK PRA has published its final rules on contractual stays in financial contracts governed by a non-EU law in November 2015 (the UK PRA Stay Rules).3 U.S. regulators have recently introduced proposed regulations that, once final, will require parties to qualify financial contracts with certain banking groups to give up certain cross-default rights triggered by an affiliate (including a parent) of their direct counterparty becoming subject to a receivership, insolvency, liquidation, resolution or similar proceeding.

To aid industry in seeking to comply with these new rules, ISDA is developing another protocol – the ISDA Resolution Stay Jurisdictional Modular Protocol (the JMP). The policy aim of the JMP will be the same as that of the previous two ISDA Resolution Stay Protocols – ie to ensure that any relevant stay and default override rights set out in the relevant resolution regime would be respected in the event of resolution of a counterparty. The key difference is that parties will sign up to the JMP if there is a particular regulation that requires regulated entities to obtain the consent of their counterparties to be subject to stays on, and/or overrides of, certain termination rights under special resolution regimes in order to allow trading on a cross-border basis (as opposed to the previous ISDA Resolution Stay Protocols which operate on a voluntary adherence basis). The JMP will be drafted so as to be closely aligned with the exact requirements of the regulations relating to contractual stays in the relevant jurisdictions – ie the entities and transactions in scope of the JMP will match the scope in the relevant jurisdictional rules.

The challenge ahead

Compliance with a multiplicity of jurisdictional stay requirements will be a challenge for market participants, particularly those entities with multi-jurisdictional operations which may be required to comply with the relevant stay rules in a number of different jurisdictions. The compliance challenge is anticipated to arise in a number of ways:

  • the scope of the relevant rules may differ across jurisdictions, and as always with regulatory rules there will be questions of interpretation that will need to be considered on a jurisdiction-by-jurisdiction basis; 
  • timing for compliance with the relevant rules may differ across jurisdictions, and may be tight (for example, the UK PRA Stay Rules require compliance for third country law financial arrangements with certain financial counterparties by 1 June 2016 and all other counterparties by 1 January 2017); 
  • the rules in a number of jurisdictions are yet to be published; 
  • the effectiveness of the JMP will need to be considered under the law that governs the financial contract(s) in scope – for some institutions, this will require consideration of a broad range of legal regimes; and 
  • firms' record-keeping and management information systems may not be designed so as to capture contractual modifications to non-ISDA financial contracts which are agreed by way of an ISDA Protocol.

Whilst the JMP may facilitate the process, it is ultimately the responsibility of market participants to ensure compliance with each set of relevant jurisdictional rules. In-scope entities will need to determine which sets of rules apply to them (and their counterparties) and which contracts will be affected, and will need to ensure they have a clear understanding of each set of applicable rules in order to carry out the relevant client outreach exercise. Further, to the extent that the JMP cannot be used to achieve compliance in a timely fashion, they will need to find alternative bilateral solutions.

Footnotes

1. The U.S. Bankruptcy Code is not a special resolution regime and does not statutorily provide for stay on the exercise of direct default or cross-default rights in derivatives and other financial transactions. The FDIA also does not statutorily provide for such a stay on the exercise of cross-default rights. As a result, the ISDA Resolution Stay Protocols had to provide for one contractually (and they did so by modelling provisions on OLA)
2. See further PRA Policy Statement 25/15 (available at: http://www.bankofengland.co.uk/pra/Documents/publications/ps/2015/ps2515.pdf) and PRA Supervisory Statement 42/15 (available at: http://www.bankofengland.co.uk/pra/Documents/publications/ss/2015/ss4215.pdf). Please also refer to our briefing "The UK approach to ensuring cross-border recognition of resolution stays: refined approach or implementation nightmare?" dated 27 November 2015 for further information.

Legal and Regulatory Risk Note
Europe