They’ve got the power

A new bill gives the financial authorities a legislative framework to work within for when things go wrong. Richard Hughes and John Sayers report on how UK banks will be affected

They’ve got the power What is clear from events surrounding Northern Rock, Bradford & Bingley and Kaupthing Singer & Friedlander is the need for a permanent legislative ­framework to enable the tripartite powers of the Financial Services Authority (FSA), the Bank of England and the UK Treasury to take swift and decisive action in ­relation to UK banks in financial difficulties.

Against this backdrop, over the past eight months the Government has consulted on a permanent Special Resolution Regime (SRR) for UK banks authorised by the FSA to accept deposits, leading to the publication on 7 October of a bill for a proposed ­Banking Act 2008.  

But what does the bill propose, how much discretion is open to the authorities and what might be the impact for banks?

The SRR will create three ‘stabilisation options’ for the authorities when dealing with a bank in distress: a transfer to the private sector; a transfer to a bridge bank controlled by the Bank of England until a willing purchaser becomes available; and, as a last resort, a transfer to temporary public ownership.

The bill creates new bank insolvency and bank administration procedures for UK banks and also creates statutory powers to transfer to third-party shares in or ­property of a bank.

In pursuit of a transfer to the private sector or a bridge bank, the bill empowers the authorities to transfer only part of the ­property, assets and/or liabilities of a bank subject to isolate the healthy parts of a ­business from a residual rump. The bill ­permits the transfer of rights ­separately from their associated liabilities.

In its current form the bill places few ­limitations on such powers, providing the authorities with a wide discretion. The ­proper exercise of SRR powers will be addressed in a code of practice to be ­published in due course. The most recent consultation document suggested that the code would apply on a ‘comply or explain’ basis, but would also maintain a degree of flexibility for the authorities. The bill also provides for ­secondary legislation to restrict or set conditions for partial transfers in cases that involve security interests, set-off or netting, but drafts of such orders are not yet ­available.

The bill grants the authorities power to set aside a broad range of contractual rights, which would otherwise be triggered on entry of a bank into the SRR. A termination right would generally fall into this ­category, but what is not clear is how other rights (such as a right of acceleration under a loan, drawstops preventing further lending by counterparties or negative pledges) would be ­treated.

The property transfer powers extend to bank property outside the UK and rights and liabilities governed by ­foreign law. ­However, it is unclear to what extent a ­foreign court would enforce such provisions against ­counterparties of a UK bank subject to the SRR.

The ability to separate rights from ­associated liabilities raises particular ­difficulties in the context of finance ­transactions between a bank subject to the SRR and its counterparties. For example, can an asset be transferred free from a ­security interest existing over it? Is it ­possible for obligations subject to set-off or netting agreements to be transferred ­without first implementing the netting arrangements, leaving a counterparty with a gross rather than net exposure to the bank?

During its consultation, the Government proposed that safeguards could apply to a specified list of qualifying financial ­contracts, but no ­consensus was reached during the ­consultation process as to the composition of such a list or whether this approach would be effective in practice.

Counterparties to UK banks will need to consider the potential implications of the bill from the date it is enacted, given the implications of entry into the SRR for any pre-existing contractual arrangements. In its current form the uncertainties created by the bill increase the legal risk of such ­counterparties.

For example, a regulated financial ­institution will need to know at the
outset whether it can treat its netting ­arrangements with UK banks as legally enforceable during the SRR for the ­purposes of its regulatory capital requirements. All third parties will be concerned that ­security, ­set-off and netting arrangements ­effectively mitigate risk against counterparties to whom the SRR could apply. Any legal ­uncertainties could increase the cost to UK banks of funding themselves through ­inter-bank borrowing.

The SRR will not apply in respect of non-UK banks. However, on 8 October the ­Government utilised existing anti-­terrorism legislation in making Landsbanki and the Icelandic government the subject of a ­freezing order. It is not clear what ­implications there may be in respect of future actions taken against foreign banks in financial difficulties, but the range of ­legislative options is wider than previously appreciated.

Richard Hughes is a partner and John Sayers a managing associate at Simmons & Simmons