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Part IV The International Dimension: New Challenges, 14 The Last Frontier

Eva H.G. Hüpkes

From: Financial Regulation and Supervision: A post-crisis analysis

Edited By: Eddy Wymeersch, Klaus J Hopt, Guido Ferrarini

From: Oxford Legal Research Library (http://olrl.ouplaw.com). (c) Oxford University Press, 2023. All Rights Reserved. Subscriber: null; date: 06 June 2023

Banks and cross-border issues — Financial Stability Board (FSB)

(p. 425) 14  The Last Frontier

Protecting Critical Functions across Borders*


14.01  The purpose of this chapter is to explore how critical cross-border functions performed by financial institutions with complex legal structures and operations in multiple jurisdictions could be preserved in a world where resolution regimes are essentially territorial in nature. It builds on earlier work that stresses the importance of preserving critical functions performed by financial institutions.1 Thanks to the crisis, a number of key jurisdictions now have in place special resolution regimes to resolve failing financial institutions operating within their borders. There are, however, three major hurdles to the application of these regimes if applied to a large globally active financial institution with assets spread across many countries. The first is that financial institutions typically have complex structures and are composed of many legal entities operating across many jurisdictions. The second is that resolution regimes seek to resolve institutions by legal entity and location, not by their activities or functions. The third is that invoking the powers could trigger adverse market reactions and cause contagion rather than containment.

14.02  Three complementary sets of action are needed to resolve these challenges:

  • •  the adoption of a resolution approach along functional lines that builds on robust ex ante resolution planning;

  • (p. 426) •  the cross-border recognition of resolution measures that protect local stake-holders’ interests under local laws and permit the continued performance of critical functions across jurisdictions;

  • •  changes in corporate charters and governance arrangement that provide incentives and improved capacity for achieving (pre-insolvency) workouts.

14.03  One of the lessons of the financial crisis is the need for an effective mechanism to wind down large and complex globally active financial institutions in a rapid and orderly manner. During the crisis, authorities in many jurisdictions were confronted with a binary choice: one option was to let the firm enter the applicable bankruptcy process and risk a Lehman-style disorderly failure resulting in market chaos with runs on similarly situated institutions; the other option was to use massive amounts of taxpayers’ money in an attempt to avoid the institution defaulting on its obligations and causing havoc among counterparties and in the financial system more generally.

14.04  The latter ‘rescue’ option is not only costly in fiscal terms, it also creates moral hazard. It distorts competition by providing an unpriced state guarantee to institutions that are perceived to be ‘too big to fail’, and it sows the seeds of future crises by dulling the incentive to monitor and manage risks. For these reasons it is important to search for a third option that would allow the resolution of an institution in an orderly manner and without systemic disruptions with losses being borne by the institution’s shareholders and creditors, not the taxpayers.

14.05  At recent Summits, the G20 Heads of State and Government asked the FSB to develop a policy framework to reduce the risks of moral hazard and the potential for contagion and systemic disruption associated with systemically important financial institutions (SIFIs). SIFIs are financial institutions whose distress or disorderly failure, because of their size, complexity, and systemic interconnectedness, would cause significant disruption to the wider financial system and economic activity. In 2010 in Seoul, the G20 endorsed the broad policy framework which is set out in a report to the G20 entitled ‘Reducing the moral hazard posed by systemically important financial institutions’.2 This framework consists of a requirement that SIFIs and initially in particular global SIFIs (G-SIFIs) have additional loss absorption capacity beyond the Basel III standards to reflect the greater risks that these institutions pose to the global financial system; improvements to resolution regimes to enable national authorities to resolve financial institutions whatever their size without disruptions to the financial system and without taxpayer support; more intensive and effective supervision through strengthened supervisory capacity and resources, and raised supervisory expectations for risk management functions, risk data aggregation capabilities, risk governance and internal controls; (p. 427) stronger robustness standards for core financial market infrastructures, including central counterparties (CCPs), central securities depositories (CSDs) and trade repositories; and rigorous implementation monitoring and reviews through a peer review process to evaluate consistency in the implementation of G-SIFI specific requirements.

14.06  At the Cannes Summit in November 2011, the G20 endorsed the critical elements of this framework. A core element is a new international standard for resolution—the ‘FSB Key Attributes of Effective Resolution Regimes’3 (FSB Key Attributes). The Key Attributes set out 12 essential features that should be part of resolution regimes in all jurisdictions. An objective and key function of effective resolution regimes according to the FSB standard is to ‘make feasible the resolution of financial institutions without severe systemic disruption and without exposing taxpayers to loss, while protecting vital economic functions’.

Save functions, not institutions

14.07  In line with the FSB Key Attributes, a public policy objective of any resolution regime should be to preserve the continued performance of those vital economic or critical functions. Critical functions are operations or activities whose disruption or winddown could have a material impact on the economy or the financial system as a whole in one or more juridictions. Regulatory action, ex ante or ex post, needs to ensure that a systemically important function can be insulated from a problem imperilling the viability of the institution providing the function and that the function can continue to be performed in case the institution providing the function fails. If this is achieved, authorities can effectively reduce the expectation that large international firms will be bailed out in their entirety and limit moral hazard.

14.08  The objective of a functional approach to the resolution of financial institutions is to integrate regulation and resolution regimes into one coherent whole. There are different approaches to ensuring continuity of critical functions and insulating them from failure. The choice of the measure will depend on the nature of the function.

Certain key infrastructure functions may be insulated ex ante from other risk-taking activities.4 If a financial institution operates certain proximate infrastructure-type functions (eg custodial or clearing and settlement services) or material (p. 428) economic functions (eg significant deposit taking or lending business) authorities should have the capacity to resolve the institution in a manner that ensures the continued operation of those systemically critical functions, while the institution’s other (non-essential) activities are being wound up.

14.09  The FSB Key Attributes set out the powers and tools that are needed to maintain continuity of essential financial functions in resolution. These include the following:

  • •  Bridge bank and bail-in powers. Powers to establish a temporary bridge company to continue certain essential business operations of the failing institution5supported by adequate funding arrangements6 and the capacity to convert debt instruments into equity (‘bail-in’) to recapitalize the entity that is no longer viable, or, alternatively, capitalize the newly established entity or bridge institution to which the distressed firm’s critical functions have been transferred following closure of the non-viable firm (the residual business of which would then be wound up and liquidated).7

  • •  Transfer powers. Powers to transfer assets and liabilities, including deposit liabilities, customer property, and the ownership of shares, notwithstanding any otherwise applicable requirements of consent by counterparties or shareholders,8 (p. 429) and without triggering early termination of the transferred financial contracts that continue to be performed.9

  • •  Systemic risk exception from the general principles of pari passu treatment. Powers to depart from the general principle of equal treatment of creditors of the same class if necessary to contain the potential systemic impact of a firm’s failure or to maximize the value for the benefit of all creditors as a whole and, for example, ‘cherry pick’ and transfer only those essential financial contracts, assets, and liabilities (those that preserve franchise value and are essential for the continuity of certain critical functions in the financial system) and not the ones that can be wound down without cost to society as a whole.10

In a number of jurisdictions, legislation has come into force or is being considered that provides for these powers.11

The challenge

14.10  As important as the new powers are, they remain national in scope. There has been no experience with how they would be used if a financial institution active in multiple jurisdictions and with assets spread across many countries needed to be wound down. There are three major potential hurdles to the use of these new national resolution powers to wind down such an institution:

  • •  The first is the complexity of the structure and operations of large financial institutions.

  • •  The second is the global reach of the financial institutions.

  • •  The third is that invoking the powers could trigger adverse market reactions and cause contagion rather than containment.

(p. 430) How to achieve an efficient and equitable cross-border solution

14.11  When it comes to preserving critical functions in a cross-border context, the key question is under what authority and law these functions could be preserved. Generally, more than one authority or court will assert jurisdiction over all or part of a firm’s operations. The applicable law and competent authority will be determined by a range of factors, including the locus of incorporation, the location of assets, liabilities and collateral, the domicile of the counterparties, the design and governing law of the financial contracts to which the financial institution is party.12 These criteria also determine how creditors will be treated in a resolution and what recoveries they can expect.13 And they affect the incentives of market participants, who may choose to relocate or to structure their operations differently in response to those incentives.

14.12  Conflicts in law and conflicts among national authorities in asserting jurisdiction are likely to arise as regards the control of the institution’s assets and affairs in different jurisdictions, the choice of the resolution methods and the distribution of that value, including priorities in distributions where available value does not permit full recovery by all parties.

14.13  Legal theory in the area of transnational bankruptcy law distinguishes three broad conceptual approaches to resolve these conflicts: territorialism, universalism, and contractualism. None exist in a pure form, and there is considerable debate about which will or should guide the development of resolution regimes for globally active financial firms.14 Delineating the key features of these three approaches helps to determine the ones that are needed in a framework for cross-border resolutions.

  • •  In territorialism, there are multiple proceedings in a variety of jurisdictions. Territorialism permits each jurisdiction to take control of operations and (p. 431) administer assets within its borders according to its own local laws.15 It stresses state sovereignty and respects the differences between national legal regimes and policies. Territorialism is the approach that commands the resolution of many non-financial firms and is the prevailing approach under which bank insolvencies are resolved.16

  • •  In universalism, a single forum is responsible for adjudicating all the legal issues arising from the insolvency of an internationally active firm, irrespective of the location of the counterparties or the assets. It is based in the idea that all or nearly all transactions and stakeholders should be treated identically with respect to their legal rights and duties as they relate to an insolvent entity.17 A single authority can take a global view and bind all stakeholders of the entity and exercise control over all assets, both within and outside of its jurisdiction. It determines when to ‘pull the trigger’ and decides on resolution measures (whether to restructure or to liquidate).

  • •  In contractualism, or ‘bargained bankruptcy’, the parties concerned (the firm and its counterparties) decide ex ante which forum or fora will adjudicate and what law will be applied in the event of insolvency. Contractualism respects the rights of the stakeholders (or at least those with the strongest bargaining power) to determine their fate and reduces the risk of arbitrary and unpredictable outcomes and conflicts of laws.18

14.14  Each approach has attractions:

  • •  Territoriality respects sovereignty and permits each jurisdiction to promote the public interest within its own domain.

  • •  Universality respects the unity of a business entity and would make it possible to preserve operations that span national borders.

  • •  Contractualism promotes predictability and market-efficient outcomes by reducing uncertainties about what regime will be applied.

14.15  But none of these approaches is well suited to resolving a large and complex globally active financial institution and to preserving its critical functions:

  • •  It is very difficult for national authorities to ensure continuity of functions performed by multiple entities located in multiple jurisdictions under any one (p. 432) of these approaches. Neither a territorial nor a universal approach ensures that there will be a single forum and resolution regime to handle the entire proceedings against all of the group’s entities globally. Even under a universal approach, the legal separateness and associated expectations of counterparties of the firm’s many entities would need to be respected and result in multiple entity-centric proceedings that could give rise to conflict due to inter-affiliate relationships and claims. The authorities administering them would need to coordinate their actions to be mutually supportive and consistent.

  • •  Secondly, these approaches do not resolve the tensions that arise when there is a lack of alignment between the interests of home and host jurisdictions.19 They do not resolve the tension between the need to protect the legitimate expectations of local creditors and broader considerations of fairness and equity as regards the treatment of stakeholders worldwide. Local creditors, in particular small retail customers, are likely to expect the protection that, according to local law, is provided to similarly situated creditors of local firms. Treating them according to priority rules under a foreign law (eg law of the home jurisdiction), could easily dash these legitimate hopes. Retail customers are unlikely to be sufficiently informed about foreign law and would have difficulty evaluating their risk and exposure under foreign law and with respect to a firm’s global operations. They could be forced to participate in (costly) foreign proceedings to defend their interests under foreign law. Host jurisdictions will be constrained in taking action to protect local creditors and reliant on timely and effective action by the foreign home or lead authority. The protection of local creditors and local policies is the most common justification for denying the effects of universalist foreign bankruptcy proceedings.20

  • •  Territorialism may provide for the adequate protection of domestic interests, but may fail to achieve equitable results where operations span several jurisdictions. The location of assets in the different jurisdictions will be particularly important (though fortuitous and difficult to ascertain) and determine the outcome for creditors in a territorial regime. Authorities will have a strong incentive to ensure that the assets of a local branch of a foreign firm that is in distress exceed local liabilities and to place restrictions on cross-border asset transfers.21 As a result, countries may require sufficient assets to be held locally where they can be ring-fenced in the event of a failure.22 Territorialism could (p. 433) discourage the operations of cross-border functions and encourage a separation of organizations into self-sufficient separately capitalized and funded national, not functional, silos through subsidiarization and ring-fencing.

  • •  Finally, none of these approaches resolve the many practical challenges of how to ensure continuity, avoid adverse market reactions, and maintain or restore market confidence. Irrespective of whether one authority takes the lead in orchestrating a resolution for the entire firm, or whether several national authorities are in charge of resolving its individual component parts, it is important to address the practical challenges relating to ascertaining asset value, obtaining information, identifying assets, liabilities and counterparties by legal entity or jurisdictional location, determining claims under different national laws, and obtaining control over assets.

Towards a framework for cross-border resolution

14.16  What is proposed here is an approach that combines features of all three theoretical approaches to cross-border resolution. It seeks to facilitate ‘universal’ solutions for those components of the firm that perform critical functions in multiple jurisdictions, but permits the winding down of other parts of the firm according to local laws and recommends the use of a contractual approach to encourage private-sector (pre-insolvency) restructurings. It consists of three components:

  • •  a functional approach to resolution planning which requires authorities to identify ex ante a financial institution’s critical or core functions and resolution options that maintain their continued operation in resolution;

  • •  an agreement on the cross-border recognition of resolution measures that permit the continued performance of the critical functions across jurisdictions while protecting local stakeholders’ interests (‘negotiated or functional universality’); and

  • •  enhanced corporate charters and governance arrangement that provide strong incentives and improved capacity for achieving pre-insolvency workouts.

Functional approach to resolution

14.17  Corporations are organized to optimize economic outcomes and minimize regulatory and fiscal burdens. Large cross-border financial institutions are generally organized as groups, often with a significant number of subsidiaries, banks, or (p. 434) other regulated or unregulated financial firms.23 Subsidiaries are bound together by interlocking non-cross-affiliate credit relations as well as by other business and functional relationships (eg centralized treasury, IT systems, back office functions).24

14.18  Corporate form is a social construct that has costs as well as benefits. The Lehman Brothers case illustrated that the greater the integration of individual entities into the operations of the wider group, the greater the challenges in resolution.25 Treating duly incorporated companies as anything other than separate legal entities would introduce significant uncertainty and undermine the capacity of market participants to make choices about risk. Existing national legal regimes and current judicial practice suggest that departures from the general legal principle of corporate separateness will remain rare.26

14.19  Instead of trying to alter or dissolve the complex legal structures in an insolvency proceeding, financial institutions could be required to structure their operations ab initio in a manner that corresponds more closely to operations and activities. Such action would add transparency and logic to a firm’s operations, facilitate supervision and enable authorities to identify the group’s critical functions. It would help achieve the twin objectives of reducing complexity and facilitating the preservation of critical functions.

14.20  Cumming and Eisenbeis (2010)27 take this approach to its logical extreme. They propose that large institutions with resources in excess of a threshold of US$ 100 billion or more and/or meeting other criteria for interconnectedness and externalities in the event of failure be required to operate as a single legal entity without parent holding company or affiliates or subsidiaries.

14.21  A more modest approach would be to encourage a streamlining of group structure along functional lines, but to preserve legal separateness when justified by public policy objectives. The institution’s core functions would be concentrated in one or a few legal entities. Unregulated affiliates established for tax and regulatory (p. 435) arbitrage purposes to support operations of other affiliates would be required to be consolidated with the relevant regulated legal entity within the group. A simple but radical rule would be to discourage institutions from having more legal entities than business lines, unless separately incorporated legal entity were also self-contained.28 Firms that continue to operate along business lines cutting across legal entities would be required to map their business to legal entities and demonstrate how their core functionalities could be preserved in a resolution.

14.22  Legal separation would require a separation in terms of the balance sheet so that the same capital pool could not be used by several affiliates. However, it would not require a full operational and technological separation. Legal entities would be able to rely on others for support services or outsource activities and operations to other firms on the basis of clear and explicit service level agreements, which should withstand resolution.29

14.23  Although large finance groups would continue to have many legal entities, there would be a logic to their structure. A reform along these lines will not be easy; it will run up against the strong incentives financial firms have to create tax efficient structures, respond to client preferences, and to arbitrage capital and other regulatory requirements. For this reason, authorities would need to understand and address the fiscal, legal, and regulatory incentives that led financial institutions to set up separate legal entities in order to encourage more streamlined and ‘resolvable’ structures in the future.

14.24  Having a simpler structure and greater clarity about what the critical functions are and how their continuity could be ensured in a crisis will be a great step forward. It would make it easier to apply different resolution techniques to different business lines of a group.

Functional universality

14.25  How can the continuity of a critical function that operates across borders be preserved when the provider of the functions fails and is placed into resolution? National competence does not extend to assets situated in other countries, and any extra-territorially orientated measure requires cooperation with other relevant jurisdictions. Recognition of the legal status of actions by foreign courts or authorities has long been a feature of judicial and supervisory cooperation. Yet, with few (p. 436) exceptions,30 it requires formal recognition procedures that involve reciprocity and public interest considerations. It is tempting to call for a universal approach that requires host jurisdictions by law or treaty to defer to a home jurisdiction’s resolution proceedings. However, a host jurisdiction will not be willing to give up its prerogatives to take independent action unless it is assured that its public policy objectives can be achieved. In the absence of sufficient certainty, a host jurisdiction will likely assert jurisdiction over local operations and take protective measures to protect domestic stakeholders’ interests.31

14.26  Host authorities may be willing to accept the rulings of the resolution authority in the home jurisdiction if the interests of stakeholders in both home and host jurisdictions will be protected equally and fairly. If host authorities can be assured that the operations in their jurisdiction will continue, they should have no reason to treat the home authority’s action as an event of default and intervene and take action that would disrupt attempts by the home authority to continue those operations (eg by ordering closure and withdrawing the operating licence).

14.27  The home authority assuming control may find that more value can be preserved by funding not only the domestic but also the cross-border components of the critical function(s), as opposed to a disorderly liquidation along national borders.32 If this is the case, the host authority should be prepared to accept the concept of universality and refrain from any ring-fencing measure that could disrupt continuity as long as local creditors’ interests are protected.

14.28  The following scenario illustrates how functional universality could work in practice. The home resolution authority takes full control of the financial (p. 437) institution upon its failure. It applies the resolution tool that is best suited to dealing with the financial firm and preserving its critical functions, eg bail-in of domestic debt, transfer of critical functions to a newly established bridge institution, wind-down of residual ‘non-essential’ operations. The resolution authority or a newly appointed interim management continues operating those critical activities and those with significant franchise value through a restructured firm or a bridge institution. The resolution authority or a resolution fund provides temporary funding to ensure the continued seamless operation of the functions most critical to its financial system.33 A foreign host authority would usually treat the intervention by the home authority as event of default. It would take control of local operations, withdraw operating licences, and seek to ring-fence local assets to protect local creditors’ interests. Counterparties of the failing firm would seek to protect their interests by terminating contracts and seizing collateral in anticipation of such measures. Such action can be disruptive and result in the discontinuity of functions that rely on operations located in different jurisdictions.

14.29  Under what circumstances could a different outcome be achieved and the critical functions be continued? If the home resolution authority provided assurances that ongoing obligations and customer liabilities will continue to be met, the host authority would have no reason to ring-fence or take other protective measures that would disrupt the continued performance of critical functions. And it would have no reason not to recognize the foreign bridge company as new controller or operator of local operations. The host resolution authority could use its powers to support the resolution carried out by a foreign home authority to make it as seamless as possible, for instance, by recognizing the foreign restructured firm or newly established bridge bank as the new owner of local subsidiaries or as operator of local branch operations and by disallowing the exercise of close-out rights that are premised solely on a resolution action occurring.34

(p. 438) 14.30  Such an arrangement could be negotiated between home and host authorities as part of their joint resolution planning. It would limit the concept of universality to home country resolution measures under which domestic stakeholders’ interests will be preserved. It would require some changes in national laws so that authorities have the discretion to refrain from actions, such as licence withdrawal and other protective measures, in circumstances where domestic stakeholders interests are preserved and superior outcomes can be achieved through cooperation.35

14.31  There are possible variants of the above scenario:

  • •  Home and host authorities could agree to jointly ensure continuity of the operation of a certain function operated by a failing financial institution that both deem ‘systemically important’. They may also agree to share the responsibility for providing temporary funding, if needed, to ensure continuity.

  • •  Alternatively, where there is no prospect for such arrangement, for instance because a firm’s operations are systemically important in the host country but not in the home country, the host may insist on greater control and separability in the host country, possibly through ex ante measures, such as separate incorporation and autonomous funding of host country operations.

14.32  An arrangement of negotiated or functional universality could form part of an extended understanding between home and host authorities as regards their respective roles and responsibilities both in supervising a financial institution operating in their jurisdictions as well as in managing and resolving its failure.36 Such an understanding may initially take the form of a bilateral or multilateral cooperation agreement.37 A critical element is an understanding of the mechanisms through which temporary funding can be provided to support the continued (p. 439) provision of the critical function in a cross-border context.38 Host authorities would need to state their capacity and willingness to refrain from ring-fencing or other protective measures inconsistent with the foreign home jurisdiction’s resolution action, should the home authority make a clear commitment to maintain continuity of certain essential components of the firm in a manner that protects the interests of counterparties in both the home and host jurisdiction.

14.33  An arrangement of functional universality or any possible variant affects supervisory incentives and will therefore require consistent and integrated regulatory, supervisory, and resolution policies. A prerequisite for such an arrangement is that home and host authorities have jointly identified those essential functions of the firm that should be continued. The process of recovery and resolution planning that is underway in a number of jurisdictions39 and the work of the Crisis Management Groups (CMGs),40 which should be established for all globally systemically important financial institutions, should help lay the foundations for functional universality. It should lead to the identification of those critical functions, operations, and services that are needed to ensure continuity and the most suitable methods for ensuring their continued performance.

The quest for continuity—market-based mechanisms

14.34  Authorities have a strong preference for solutions that ensure continuity through private-sector negotiated restructurings that takes place without the invocation of special resolution powers.41 Only when these fail or when there are no (p. 440) prospects for a successful private sector solution, should the official resolution regime kick in as a measure of last resort.42 The current debate in academia and among policy-makers about contingent capital and bail-in mechanisms that internalize losses and rely on private resources for recapitalization43 illustrates the quest for less disruptive restructuring methods that avoid a break up of the financial institution and the frictions and non-linearities associated with closure and liquidation.

14.35  This debate is often based on the distinction between a ‘going concern’ and a ‘gone concern’, with ‘going concern’ restructurings being seen as preserving the institution’s legal identity and ‘gone concern’ resolution as a measure that results in the institution’s closure and ends its legal existence. In practice, the distinction between the two is not hard and fast. A ‘going concern’ restructuring can lead to changes in operations that are just as radical as those that occur in a gone concern resolution. It can also lead to equally extreme changes in the value of the claims of different stakeholders with, for example, shareholders being wiped out or subjected to significant dilution. Likewise, a ‘gone concern’ resolution that ends an institution’s legal existence does not necessarily have to end the institution’s business operations, which may be continued by a bridge company or transferred to another market participant.

14.36  The traditional formal restructuring processes under bankruptcy regimes, such as ‘Chapter 11’ reorganizations, typically entail an extended bargaining process between the firm and its various classes of creditors. If successful, such a process results in the confirmation of a reorganization plan that scales back the firm’s debt, either by reducing the claims or converting some or all of certain claims into equity, thus transferring shareholding powers to the firm’s creditors. Reorganization that relies on a negotiated process involving some or all stakeholders of an institution have generally been viewed as unsuitable for use in the financial field.44 Speed is essential, and uncertainty about the outcome once the proceeding has been initiated can rapidly lead to an erosion of confidence and losses that erode the remaining value of the firm. Since solutions have to be found quickly—essentially between the close of business in the United States on Friday and the opening (p. 441) of business in Asia on Monday—there is little time for a formalized negotiated process.45

14.37  The Swiss Banking Act provides for an accelerated restructuring procedure and empowers the regulatory authority to ‘force’ a reorganization, that is to impose a capital and liability restructuring, with only limited participation of existing shareholders and creditors in the process.46 The new German Bank Restructuring Act of 9 December 201047 likewise establishes a formal reorganization procedure for financial institutions which may provide for interference with creditors’ and shareholders’ rights, and a write-down of claims or a partial or full conversion of debt into equity.48 The reorganization procedure requires an affirmative majority vote of creditors and, where required under corporate law, a shareholder vote to approve the restructuring plan, and confirmation by the court within one month following its adoption by the majority of the creditors. The approval requirement may, however, be waived provided the creditors receive at least what they would have received in the absence of reorganization.49

14.38  A formal restructuring of cross-border group structures is likely to encounter a range of cross-border coordination issues. Unless these can be addressed, it will be difficult to achieve a group-wide reorganization and creditor recapitalization while ensuring the continuity of critical functions.

14.39  Supervisors have long pursued going-concern restructurings through quietly arranged recapitalizations, mergers, or asset sales outside of formal reorganization and statutory bankruptcy processes. It may therefore be useful to begin thinking about how crisis management and reorganization processes could be facilitated through corporate governance arrangements. The objective would be to overcome the coordination problems and the territorial limitations to the exercise of resolution powers and bridge differences among national legal frameworks by way of contractual arrangements. They may be easier to achieve than to change the fabric of national legal systems.

(p. 442) 14.40  The recent crisis illustrated how corporate law and governance arrangements can complicate or stymie private sector restructurings in an emergency situation. For instance, in jurisdictions with shareholder-centric corporate law, statutory requirements for shareholder consent may limit the chances of achieving a market-based solution.50 As the institution’s capital declines, the responsibilities of the board of directors should become broader and reflect the fiduciary duty that the board of directors owes to the institution’s creditors. When the institution’s viability is at stake, shareholders’ interests should no longer be the directors’ only concern.51

14.41  It would be desirable to review the legal framework in which corporate governance decisions are made in order to determine whether changes are needed to facilitate the use of private contractual mechanisms to achieve an effective, speedy, and socially optimal restructuring in an emergency. In undertaking such a review, it would be necessary to balance the need to provide adequate protection for shareholders and the need to prevent shareholders from stopping actions that are in the interest of creditors and the public at large. It would also be necessary to consider how to provide incentives, through compensation policies and other mechanisms, for the board and management to undertake early restructurings and make changes that address the underlying causes of the financial problem through a review of a firm’s strategy and business model well before the firm becomes unviable.

14.42  Other issues that warrant attention are whether changes or derogations to national corporate laws are required or whether the objectives can be achieved by altering firms’ articles of association, encouraging the common use of shareholder resolutions, and developing contracts among affiliates that place strong duties on firms’ management and directors to act in times of stress.

14.43  The recent reform in Switzerland52 provides an example of how changes in existing corporate governance arrangements can facilitate a restructuring in times of stress. The reform provides for specific exceptions to shareholder protections provided under Swiss corporate law, which are designed to facilitate rapid recapitalizations (p. 443) in times of stress.53 It creates two new capital instruments in the form of reserve capital and convertible capital: reserve capital would enable an institution’s board of directors to increase the share capital of the firm in a crisis situation quickly and without shareholders’ approval and, under certain condition, with the exclusion of shareholder pre-emptive rights.54

14.44  Recovery plans and changes to corporate governance arrangements that provide incentives and enhanced capacity for the board of directors and management to achieve a restructuring, provide for an additional line of defence. However, they are no substitute for effective national resolution regimes. Indeed, an effective and credible resolution regime is a prerequisite for such a private sector approach to work. The knowledge that statutory resolution powers will be invoked if a market-based solution is not should focus the minds of the institution’s board, management, and its counterparties and provide a strong incentive for achieving effective pre-insolvency work-outs.


14.45  One of the major challenges facing the international regulatory and legal community is how to develop a framework for the resolution of complex financial institutions active in many jurisdictions and with assets spread across many countries. Thanks to the crisis, national authorities now have important new resolution powers that permit them to preserve a failing firm’s critical functions. However, there are significant challenges to their use in a cross-border context. A practical way to address these challenges involves a process based on negotiated functional universality that preserves critical functions and respects the need of national authorities to achieve their statutory public policy aims. It should be complemented with contractual arrangements and a corporate governance framework that provides incentives for the institution’s board of directors and management to act early to preserve critical functions and facilitate work-outs.

(p. 444) 14.46  None of this will be easy. Tax regimes provide enormous incentives to create complex legal structures. Countries ring-fence operations because it provides certainty and protects their domestic stakeholders. But the costs of crises are also huge, and if authorities can credibly commit to actions that will preserve those critical functions performed by global firms, such as putting in place effective resolutions plans, there is some hope that crises will be fewer and the costs lower.


*  This chapter was prepared for the Thirteenth Annual International Banking Conference held at the Federal Reserve Bank of Chicago on 23–24 September 2010. The views expressed are those of the author in her personal capacity and do not necessarily reflect the views of the FSB or its members.

1  Eva Hüpkes, ‘“Too Big to Save”—Towards a Functional Approach to Resolving Crises in Global Financial Institutions’ in D. Evanoff and G. Kaufman (eds), Systemic Financial Crisis: Resolving Large Bank Insolvencies (World Scientific Publishing, 2005).

2  FSB, Reducing the Moral Hazard Posed by Systemically Important Financial Institutions, 20 October 2010, available at <http://www.financialstabilityboard.org/publications/r_101111a.pdf>.

3  Key Attributes of Effective Resolution Regimes for Financial Institutions, October 2011, available at <http://www.financialstabilityboard.org/publications/r_111104cc.pdf>.

4  An example for this approach is the creation of Continuous Linked Settlement (CLS) bank which insulates the clearing and settlement function for foreign exchange contracts from failure of individual market participants. The efforts underway to expand central counterparty (CCP) clearing into OTC derivatives markets, including the credit default swap (CDS) market, and to move as much trading as possible to an organized exchange are another example. In the United Kingdom, the Independent Commission on Banking (ICB) in its final report of September 2011 proposed structural measures that insulate retail activities from other activities within financial institutions.

5  Key Attribute 3.4 ‘Resolution authorities should have the power to establish one or more bridge institutions to take over and continue operating certain critical functions and viable operations of a failed firm, including: (i) the power to enter into legally enforceable agreements by which the authority transfers, and the bridge institution receives, assets and liabilities of the failed firm as selected by the authority; (ii) the power to establish the terms and conditions under which the bridge institution has the capacity to operate as a going concern, including the manner under which the bridge institution obtains capital or operational financing and other liquidity support; the prudential and other regulatory requirements that apply to the operations of the bridge institution; the selection of management and the manner by which the corporate governance of the bridge institution may be conducted; and the performance by the bridge institution of such other temporary functions as the authority may from time to time prescribe; (iii) power to reverse, if necessary, asset and liability transfers to a bridge institution subject to appropriate safeguards, such as time restrictions; and (iv) the power to arrange the sale or wind-down of the bridge institution, or the sale of some or all of its assets and liabilities to a purchasing institution, so as best to effect the objectives of the resolution authority.’

6  FSB Key Attribute 6.3 stipulates that ‘[j]urisdictions should have in place privately-financed deposit insurance or resolution funds, or a funding mechanism for ex post recovery from the industry of the costs of providing temporary financing to facilitate the resolution of the firm.’

7  See Key Attributes 3.5 ‘Powers to carry out bail-in within resolution should enable resolution authorities to (i) write down in a manner that respects the hierarchy of claims in liquidation (see Key Attribute 5.1) equity or other instruments of ownership of the firm, unsecured and uninsured creditor claims to the extent necessary to absorb the losses; and to (ii) convert into equity or other instruments of ownership of the firm under resolution (or any successor in resolution or the parent company within the same jurisdiction), all or parts of unsecured and uninsured creditor claims in a manner that respects the hierarchy of claims in liquidation; (iii) upon entry into resolution, convert or write-down any contingent convertible or contractual bail-in instruments whose terms had not been triggered prior to entry into resolution…’ and 3.6.

8  Key Attribute 3.3 ‘Resolution authorities should have the power to transfer selected assets and liabilities of the failed firm to a third party institution or to a newly established bridge institution. Any transfer of assets or liabilities should not (i) require the consent of any interested party or creditor to be valid; and (ii) constitute a default or termination event in relation to any obligation relating to such assets or liabilities or under any contract to which the failed firm is a party’ (see Key Attribute 4.2).

9  Provided the obligations under the contract, including payment and delivery obligations, and provision of collateral, continue to be performed following transfer of the contract. See Key Attribute 4.3 and Annex IV.

10  FSB Key Attribute 5.1 ‘Resolution powers should be exercised in a way that respects the hierarchy of claims while providing flexibility to depart from the general principle of equal (pari passu) treatment of creditors of the same class, with transparency about the reasons for such departures, if necessary to contain the potential systemic impact of a firm’s failure or to maximise the value for the benefit of all creditors as a whole. In particular, equity should absorb losses first, and no loss should be imposed on senior debt holders until subordinated debt (including all regulatory capital instruments) has been written-off entirely (whether or not that loss-absorption through write-down is accompanied by conversion to equity).’

11  Basel Committee on Banking Supervision, Report on progress on resolution policies and frameworks issued by the Basel Committee, 6 July 2011, available at <http://www.bis.org/press/p110706.htm>.

12  For instance, in all likelihood the law of the jurisdiction where the assets are located will govern the tangible property and the law of the jurisdiction that is the situs of the contract or the law chosen by the parties will govern the contractual rights. It is important to distinguish between the creation of rights and the validity of claims under the law designated as applicable law in accordance with the conflict of law rules of the forum or as agreed by contract, and the treatment that these rights and claims receive in case of insolvency, which is be determined by the insolvency law of the forum.

13  See for more details E. Hüpkes, ‘Rivalry in Resolution: How to Reconcile Local Responsibilities and Global Interests?’ in (2010) 7(2) European Company and Financial Law Review 216–39.

14  See discussion in Basel Committee on Banking Supervision. 2010, Report and Recommendations of the Cross-Border Bank Resolution Group (March). Basel: Bank for International Settlements <http://www.bis.org/publ/bcbs156.htm>; Paul Tucker, ‘Resolution of Large Complex Financial Institutions—the Big Issues’, Speech at the European Commission’s Conference on Crisis Management, Brussels, 19 March 2010; T.C. Baxter, J.M. Hansen, and J.H. Sommer, ‘Two Cheers for Territoriality: An Essay on International Bank Insolvency Law’ (2004) 78(1) American Bankruptcy Law Journal 57–92.

15  L.M. LoPucki, ‘The Case for Cooperative Territoriality in International Bankruptcy’ (2000) 98 Michigan Law Review 2216.

16  A.M. Kipnis, ‘Beyond Uncitral Alternatives to Universality in Transnational Insolvency’, 3 July 2006, available at SSRN: <http://ssrn.com/abstract=913844>. Notable exceptions are the European Directives on the Reorganisation and Winding-up of Credit Institutions of 4 April 2001 and of Insurance Undertakings of 19 March 2001.

17  J.L. Westbrook, ‘A Global Solution to Multinational Default’ (June 2000) 98 Michigan Law Review 2276.

18  R.K. Rasmussen ‘A New Approach to Transnational Insolvencies’ (1997) 19 Michigan Journal of International Law 1; P. Wallison, Debtor Selection: Resolving Insolvent Globally Active Financial Institutions (American Enterprise Institute for Public Policy Research, March, 2010).

19  For instance, when a function provided by a financial institution is critical in one jurisdiction but not in another, but depends on services and operations provided by entities in other jurisdiction.

20  LoPucki, see n 15; Baxter et al, see n 14.

21  S. Claessens, R. Herring, and J.D. Schoenmaker, A Safer World Financial System: Improving the Resolution of Systemic Institutions, Geneva Reports, Centre for Economic Policy Research, July 2010.

22  C. Cumming and R. Eisenbeis, ‘Resolving Troubled Systemically Important Cross-Border Financial Institutions: Is a New Corporate Organizational Form Required?’ in R. Herring (ed), Issues in Resolving Systemically Important Financial Institutions (Wharton Financial Institutions Center, 2010).

23  According to J.P. Morgan, ‘Global Banks—Too Big to Fail? Big Can (also) Be Beautiful’ (17 February 2010), 40. Bank of America has 2,321 legal entities, Deutsche Bank has 2,250, and even AIG had over 4,000 legal entities.

24  The Economist, 9 September 2010, observed that the guarantee claims by Lehman affiliates on Lehman’s holding company as of March 2010 amounted to US$223.9 bn.

25  According to the Basel Committee, see n 14, the Lehman Brothers Group consisted of 2,985 legal entities in 50 countries. The lines of business did not necessarily map to the legal entity lines of the companies. The group was organized so that some essential functions, including the management of liquidity, were centralized.

26  D. Staehlin, ‘No Substantive Consolidation in the Insolvency of Groups of Companies’ in H. Peter, et al (eds), Challenges of Insolvency Law Reform in the 21st Century (Schulthess Verlag, 2006).

27  Christine Cumming and Robert A. Eisenbeis, ‘Resolving Troubled Systemically Important Cross-Border Financial Institutions: Is a New Corporate Organizational Form Required?’, Federal Reserve Bank of New York Staff Reports, no 457, July 2010.

28  The OECD proposed the creation of a holding-type structure where each financial activity (banking, securities trading, fund management, etc) would be conducted out of a separately capitalized entity. See OECD, The Financial Crisis Reform and Exit Strategies (2009).

29  The FSB Recommendations (2010) stipulate that service agreements are appropriately documented and cannot be abrogated by the service provider in resolution. See also Notice of Proposed Rulemaking, ‘Special Reporting, Analysis and Contingent Resolution Plans at Certain Large Insured Depository Institutions’ FDIC Release RIN 3064–AD59 (11 May 2010), 75 Fed Reg 27464 (17 May 2010), available at <http://www.fdic.gov/news/board/May01.pdf>.

30  eg under the European Winding Up Directive, the administrative or judicial authorities of the home Member State are be empowered to decide on the implementation of reorganization or liquidation measures with respect to a credit institution, including branches established in other Member States. The measures will be fully effective in accordance with the legislation of that Member State throughout the Community without any further formalities, including as against third parties in other Member States, even where the rules of the host Member State applicable to them do not provide for such measures or would otherwise make their implementation subject to conditions which are not satisfied.

31  The Basel Committee (2010) observes that ‘National resolution authorities will seek, in most cases, to minimise the losses accruing to stakeholders (shareholders, depositors and other creditors, taxpayers, deposit insurer) in their specific jurisdiction to whom they are accountable. For financial institutions in which the public purse or a public or quasi-public fund is often called upon for institutional support or protection of certain creditors (at a minimum, insured depositors), the likelihood of the application of measures that seek to protect local interests and stakeholders is increased by the public and policy pressure to allocate financial resources in a way which reduces the burden for their own taxpayers.’

32  Scott Alvarez, General Counsel of the Board of Governors of the Federal Reserve system in his statement before the Financial Crisis Inquiry Commission on the acquisition of Wachovia Corporation by Wells Fargo & Co, 1 September 2010, observed that ‘…if the least-cost resolution did not support foreign depositors, the resolution would end what was a significant source of funding for several other major U.S. financial institutions’.

33  The Dodd-Frank Wall Street Reform and Consumer Protection Act provides that the FDIC receives a senior claim to recoup any financial assistance provided. Dodd-Frank Wall Street Reform and Consumer Protection Act, s 204. It also permits the FDIC to seek assessments from the financial industry. Assessments are first imposed on those creditors who received additional payments from the FDIC pursuant to its authority to treat certain creditors better than others.

34  See FSB Key Attribute 7.3 ‘The resolution authority should have resolution powers over local branches of foreign firms and the capacity to use its powers either to support a resolution carried out by a foreign home authority (for example, by ordering a transfer of property located in its jurisdiction to a bridge institution established by the foreign home authority) or, in exceptional cases, to take measures on its own initiative where the home jurisdiction is not taking action or acts in a manner that does not take sufficient account of the need to preserve the local jurisdiction’s financial stability. Where a resolution authority acting as host authority takes discretionary national action, it should give prior notification and consult the foreign home authority.’

35  See FSB Key Attribute 7.2 ‘Legislation and regulations in jurisdictions should not contain provisions that trigger automatic action in that jurisdiction as a result of official intervention or the initiation of resolution or insolvency proceedings in another jurisdiction, while reserving the right of discretionary national action if necessary to achieve domestic stability in the absence of effective international cooperation and information sharing.’

36  The existing Basel Concordat and subsequently developed Basel principles governing cross-border supervision, which make cross-border banking subject to the existence of effective supervisory arrangements in home and host countries, would need to be revised to make cross-border banking subject to effective crisis management and resolution arrangements in home and host countries. A financial firm would be granted access to a market only if it had a recovery and resolution plan and it were established on this basis that its operations could be wound down in an orderly manner. See Hüpkes, see n 13.

37  Key Attribute 9.1 calls for institution-specific cooperation agreements to be in place at a minimum for all G-SIFIs. It stipulates that the agreement provide, amongst other elements, ‘an appropriate level of detail with regard to the cross-border implementation of specific resolution measures, including with respect to the use of bridge institution and bail-in powers.

38  See Key Attributes Annex I (Essential elements of institution-specific cross-border cooperation) and Key Attribute 7.2 (iii) which requires cooperation to set out the available ‘funding arrangements in home and host jurisdictions to support the implementation of the resolution measures and restore market confidence’.

39  The UK Financial Services Act 2010 places a duty on the FSA to make rules requiring the production of recovery and resolution Plans (RRPs). In August 2011, the UK FSA published a Consultation Paper and Discussion Paper on its proposals for Recovery and Resolution Plans. Under s 165(d) of the Dodd-Frank Act, the Federal Reserve Board (FRB) must require each FRB-supervised non-bank financial company and bank holding company with at least $50 billion in total consolidated assets to report periodically to the FRB, FSOC, and FDIC on its plan for rapid and orderly resolution in the event of material financial distress or failure. The plan must include information on the manner in which affiliated insured depository institutions are adequately protected from risks of other activities; a description of ownership structure, assets, liabilities, and contract obligations; the identification of cross-guarantees on securities, major counterparties, and process for determining to whom collateral is pledged.

40  CMGs, which consist of representatives from supervisory agencies, central banks, and resolution authorities from the key home and host jurisdictions, have been established for the major international financial firms. The objective of these groups is to promote the elaboration of firm-specific recovery and resolution measures and to assess these firms’ resolvability. See FSB report to the G-20 Finance Ministers and Governors, April 2010.

41  Charles Goodhart has referred to this as the ‘time inconsistency’ problem in resolution and noted that authorities may be reluctant to apply even the best resolution tools out of concern about adverse systemic consequences of their actions. Charles Goodhart, ‘Remarks at the European Commission’s Conference on Crisis Management’, 19 March 2010.

42  See Statement by Thomas C. Baxter, Jr, Financial Crisis Inquiry Commission, 1 September 2010.

43  Such a reorganization procedure would transform the firm’s capital and liability structure, with capital being written down and certain categories of the liabilities (depending on their seniority) being transformed into equity so that the firm can absorb the losses that led to the need for intervention and continue to operate as a going concern. See T. Huertas, ‘The road to better resolution: From bail-out to bail-in’, paper presented at the Euro and the Financial Crisis conference, hosted by The Bank of Slovakia on 6 September 2010; Squam Lake Working Group on Financial Regulation, An Expedited Resolution Mechanism for Distressed Financial Firms: Regulatory Hybrid Securities, Working Paper, April 2009.

44  Baxter, see n 14, noting that ‘banks in advanced jurisdictions seldom enter reorganisation’.

45  See Report of the Contact Group on the Legal and Institutional Underpinnings of the International Financial System, Insolvency Arrangements and Contract Enforceability, September 2002, available at <http://www.bis.org/publ/gten06.htm noting that bank resolution proceedings are typically official-centred.

46  See Art 29 Swiss Banking Act of 1934 (as amended in 2011). In Switzerland, the Swiss regulator FINMA initiates reorganization proceedings. Reorganization can provide for a write-down of equity and debt claims, and may also provide for a conversion of debt into equity. The reorganization plan is not subject to shareholder vote, even if it affects their rights. Also, it does not need to be formally approved by the creditors, subject to the condition that creditors do not receive less in a restructuring than they would in a liquidation.

47  Credit Institution Reorganisation Act (Gesetz zur Reorganisation von Kreditinstituten).

48  Section 9 of the German Credit Institution Reorganisation Act. A debt-to-equity conversion requires creditor consent.

49  Section 19(2) and (3) of the German Credit Institution Reorganisation Act.

50  For instance, UBS needed to hold an extraordinary shareholders’ meeting to increase the capital of the bank to deal with its subprime exposure. In the Fortis case, Belgian shareholders brought a case before the Belgian Commercial Court claiming that the sale to BNP Paribas, which had already been agreed by contract, required shareholder approval. In the AIG case, it was possible to invoke an exception to a shareholder approval requirement under the New York Stock Exchange’s Shareholder Approval Policy.

51  An amendment of 2 June 2010 to the Belgian Law of 22 March 1993 concerning the status and supervision of credit institutions empowers the board of directors to act in derogation of restrictions arising from the statutes of the institution to the extent that their acts are necessary to avert systemic risks to the financial system (see §8).

52  Swiss Commission of Experts for limiting the economic risks posed by large companies, Final Report, Swiss Department of Finance, 4 October 2010.

53  Articles 11 and 12 of the Swiss Banking Act of 1934 as amended in September 2011 provide that the shareholders could delegate all aspects of the issuance of contingent convertible bonds, including determination of amounts, triggers, and conversion rates, to the board of directors. The articles of incorporation must determine the maximum amount of the share issue, the share type, including any pre-emptive rights, and any limitation to the transferability of new registered shares. The general meeting of shareholders may also delegate the determination of these aspects to the board of directors. The amount and the duration of the reserve capital is not limited by law.

54  The general meeting of shareholders has the power to determine the share type, including any pre-emptive rights, any limitation to the transferability of the shares, and the principles according to which the issue amount is to be calculated, but can delegate the authority to determine these aspects to the board of directors in the articles of incorporation. See Art 13 of the Swiss Banking Act of 1934 as amended in September 2011.