Contractual stays in financial contracts governed by third-country law

Policy Statement 25/15 | Consultation Paper 19/15

Published on 13 November 2015

Contractual stays in financial contracts governed by third-country law – PS25/15

This Prudential Regulation Authority (PRA) policy statement (PS) provides feedback to responses to CP19/15 ‘Contractual stays in financial contracts governed by third-country law’.

It sets out final rules intended to both reduce the risk of contagion from the failure of a relevant firm and support its orderly resolution by ensuring that resolution action taken in relation to a relevant firm would not immediately lead to the early termination of its financial arrangements (or those of its subsidiaries) governed by third-country law while similar financial arrangements governed by the laws of the United Kingdom or another European Economic Area (EEA) jurisdiction are stayed. 

This PS is relevant to PRA-authorised banks, building societies, PRA-designated investment firms and their qualifying parent undertakings, which for this purpose comprise UK financial holding companies and UK mixed financial holding companies.  

The PS is also relevant to credit institutions, investment firms and financial institutions that are subsidiaries of those firms listed above, regardless of the jurisdiction of incorporation or establishment of the subsidiary, to the extent that the subsidiary enters into a financial arrangement governed by non-EEA  law which contains termination rights or security interests, the exercise of which could be suspended or prevented or the application of which would be disregarded under the Special Resolution Regime (SRR) under the Banking Act, if the contract were governed by UK law (third-country law financial arrangement).

The rules are also relevant to counterparties of the above-listed entities to the extent that counterparties have financial arrangements with such entities governed by non-EEA law.

Background

A key aspect of effective resolution is ensuring that, once a firm enters resolution, its counterparties in derivatives and other financial contracts (such as repo or reverse repo, securities lending and other similar transactions subject to contractual set-off and netting arrangements) cannot terminate and ‘close out’ their positions solely as a result of the firm’s (or a related entity’s) entry into resolution. 

The rules are part of a coordinated effort among member authorities of the Financial Stability Board (FSB) to improve cross-border recognition of resolution stays by obliging firms to adopt contractual solutions where statutory recognition regimes are lacking.  

Summary of the rules

The rules prohibit in scope firms from creating new obligations or materially amending existing obligations under certain financial arrangements unless the counterparty has agreed in an enforceable manner to be subject to similar restrictions (or ‘stays’) on early termination and close-out to those that would apply as a result of a UK firm’s entry into resolution, or the write-down or conversion of a UK firm’s regulatory capital at the point of non-viability, if the financial arrangement were governed by the laws of any part of the UK.  

Supervisory Statement 42/15 ‘Contractual stays in financial contracts governed by third-country law’ (Appendix 2) sets out the PRA’s expectations in respect of the rules.

Changes to the rules following consultation 

In light of feedback received to CP19/15, the PRA revised some of its proposals and clarified others.  The main changes and clarifications include:

  • restricting the scope of the rules to apply only to third-country law financial arrangements containing termination rights or rights to enforce security interest that could be subject to the SRR if the contract were governed by the laws of a part of the United Kingdom. The intention of this amendment is to exempt third-country law financial arrangements which:
    • do not contain termination rights or rights to enforce a security interest; or
    • are entered into by subsidiaries whose obligations are neither guaranteed nor otherwise supported by a UK firm.
  • delaying the effective dates of the rules until 1 June 2016 in respect of counterparties that are credit institutions or investment firms and until 1 January 2017 in respect of all other counterparties;
  • expanding the definition of ‘excluded person’ to cover all third-country financial market infrastructure (including central counterparties and payments systems), regardless of designation, and to clarify that any agency or branch of a central governments is also excluded;
  • replacing the requirement for the counterparty to agree in writing with a requirement for the counterparty to agree in an enforceable manner;
  • clarifying that qualified parent undertakings are only in-scope to the extent they have a registered office or head office in the United Kingdom;
  • clarifying that the rules apply in relation to third-country law financial arrangements which contain security interests or default event provisions, the enforcement of which could be suspended, prevented or would be disregarded under the SRR;
  • clarifying that a reference to securities should be interpreted as a reference to ‘transferable securities’; and
  • amending the definition of ‘financial arrangement’ to make clear that is an exclusive list, and creating a new term ‘third-country law financial arrangement’ for the sake of clarity.

Effective dates

The rules are effective from 1 June 2016 in respect of financial arrangements with counterparties that are credit institutions or investment firms, and from 1 January 2017 in respect of financial arrangements with all other counterparties.

PDFPolicy Statement 25/15

Appendix

PDFStay in resolution instrument 2015 (PRA 2015/82)

Supervisory Statement 42/15  


Published on 26 May 2015

Contractual stays in financial contracts governed by third-country law – CP19/15

A key aspect of effective resolution is ensuring that, once a firm enters resolution, its counterparties in derivatives and other financial contracts (such as repo/reverse repo, securities lending and other similar transactions subject to contractual set-off and netting arrangements) cannot terminate and ‘close out’ their positions solely as a result of the firm’s (or a related entity’s) entry into resolution.

The Banking Act 2009 (Banking Act) gives the Bank of England, as resolution authority, the power to suspend (or ‘stay’) temporarily the termination rights of a party to a contract with a firm in resolution, provided that the UK institution continues to perform its payment and other substantive obligations under the contract (the temporary stay).   It further provides that a resolution action (or pre-resolution action) by the Bank of England, the Prudential Regulation Authority (PRA) or the Financial Conduct Authority (FCA) cannot give rise to a counterparty’s right to terminate a contract with a UK credit institution or investment firm or to exercise rights over collateral (the general stay).

The Bank Recovery and Resolution Directive (Directive 2014/59/EU) (BRRD) ensures that a UK stay would automatically be recognised and given effect throughout the European Union (EU).  Where a contract is governed by the law of a non-EU jurisdiction, however, it is unclear that a court in that jurisdiction would enforce the UK stay over the contractual terms unless the law of that jurisdiction expressly recognises foreign resolution actions.

The proposal is part of a coordinated effort among member authorities of the Financial Stability Board (FSB) to improve cross-border recognition of resolution stays by obliging firms to adopt contractual solutions where statutory recognition regimes are lacking.

This consultation is relevant to UK banks and building societies, PRA-designated investment firms and their qualifying parent undertakings, which for this purpose comprise financial holding companies and mixed financial holding companies; as well as credit institutions, investment firms, and financial institutions that are subsidiaries of these firms.  The consultation and proposed rule are also relevant to counterparties of the above-listed entities to the extent that counterparties have financial contracts with such entities governed by non-EEA law.

Summary of the proposals covered by the CP

This consultation paper proposes a new rule for the PRA Rulebook requiring the contractual adoption of UK resolution stays in certain financial contracts governed by the law of a jurisdiction outside the European Economic Area (EEA) (a ‘third country’).

The proposed rule would apply to UK banks, building societies and designated investment firms as well as their qualifying parent undertakings (‘firms’) in respect of financial contracts (such as for derivative, repo/reverse repo or securities financing transactions) governed by the law of a non-EEA jurisdiction.  It would prohibit firms from creating new obligations or materially amending an existing obligation under such a financial contract without the required counterparty agreement.  The prohibition applies unless the counterparty has agreed in writing to be subject to similar restrictions on termination, acceleration, close-out, set-off and netting as would apply as a result of the firm’s entry into resolution, or the write-down or conversion of the firm’s regulatory capital at the point of non-viability, if the contract were governed by the laws of the UK (and, where the relevant firm is not a credit institution or investment firm, as if it were one).

Firms would also be obliged to ensure that, where their subsidiary credit institutions, investment firms and financial institutions trade in these products under third-country law, the subsidiaries, regardless of location, also obtain agreement to the stay from their counterparties.

Responses

This consultation closed on Wednesday 26 August 2015.

PDFConsultation Paper 19/15

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