Too Big To Fail, 2.0

Canada recently adopted a "bail-in" or recapitalization regime which enhances the federal Government’s toolkit for the orderly resolution of distressed member institutions determined to be non-viable. This bulletin outlines the Government’s powers to intervene and stabilize failing financial institutions, with a focus on the new amendments relating to bail-in powers and the treatment of derivatives contracts.

What You Need To Know

• Where a federal deposit taking institution (DTI) has been found to be financially non-viable, the Canada Deposit Insurance Corporation (CDIC) has the ability to (i) take temporary control over the DTI as a receiver or shareholder, (ii) suspend all shareholder rights, (iii) force the transfer of the DTI's assets and liabilities to a third-party or bridge bank, and most recently, (iv) recapitalize the DTI through a conversion of certain eligible liabilities into common equity in the case of domestic systemically important banks (D-SIBs).
• Upon a resolution order being made, a general stay of proceedings arises preventing counterparties of the subject financial institution from terminating agreements and exercising remedies. Consistent with Canada’s bankruptcy regime, eligible financial contracts (derivatives, swaps, repos and similar contracts, or "eligible financial contracts") are excepted from the general stay triggered by a resolution order. EFCs, however, remain subject to a more limited stay, which suspends certain contractual close-out rights, but only in some circumstances relating to the resolution order and the DTI’s non-viability.

Background

Worldwide

The global financial crisis of 2008 cast a long shadow. In the United States, the policy decision to "bail out"  financial institutions deemed  too big to fail with trillions of taxpayer dollars also had a lasting, if not defining, impact on the nascent international push for financial reform that would coalesce in the following years. Two poignant and widely held narratives have emerged from the fallout of the crisis which would shape the direction of the reform to come. One, a strong aversion to any future bail-outs driven by the notion that the average citizen should not foot the bill for what was perceived as Wall Street largesse and excessive risk-taking. Second, the so-called "moral hazard" of creating an implicit government guarantee of the largest financial institutions meeting the too-big-to-fail threshold, which might embolden those institutions to take on out-sized risks in pursuit of higher profits.

In 2009, the Financial Stability Board (FSB) was established with a mandate to promote international financial stability by monitoring and making recommendations about the global financial system. In relation to bank resolution guidance, the FSB adopted the Key Attributes of Effective Resolution Regimes for Financial Institutions in 2011, which was updated in October 2014 (Key Attributes). The Key Attributes became the global standard for an effective resolution regime and have been endorsed by all of the G20 countries, including Canada. They formed the guiding principles behind the recent amendments to the resolution regime encapsulated within the Canada Deposit Insurance Corporation Act (CDIC Act).

As stated by the FSB, such a regime should:

• ensure continuity of systemically important financial services, and payment, clearing and settlement functions;
• protect depositor arrangements and ensure the rapid return of segregated client assets;
• allocate losses to firm owners (shareholders) and unsecured and uninsured creditors in a manner that respects the hierarchy of claims;
• not rely on public solvency support and not create an expectation that such support will be available;
• avoid unnecessary destruction of value, and therefore seek to minimise the overall costs of resolution in home and host jurisdictions and, where consistent with the other objectives, losses for creditors;
• provide for speed and transparency and as much predictability as possible through legal and procedural clarity and advanced planning for orderly resolution;
• provide a mandate in law for cooperation, information exchange and coordination domestically and with relevant foreign resolution authorities before and during a resolution;
• ensure that non-viable firms can exit the market in an orderly way; and
• be credible, and thereby enhance market discipline and provide incentives for market-based solutions.¹

Canada

Within Canada, the first steps toward granting CDIC resolution powers were spurred following the failures of Canadian Commercial Bank and Northland Bank in 1985. Between 1987 and 1992, 13 other member institutions failed including Standard Trust Company and Central Guaranty Trust, leaving CDIC with outstanding debt of $3.7 billion by the end of that period.² A series of policy papers, review committees and reports led to amendments to the CDIC Act in 1992 implementing the Financial Institution Restructuring Provisions (FIRP) allowing CDIC to effectively overrule owners and creditors and seize the shares of a non-viable financial institution with a view to facilitating a sale or merger of an institution without the approval of its shareholders or creditors.³ The FIRP powers were enhanced through subsequent amendments in 1996 allowing CDIC, as receiver, to take control of a member institution’s assets.

In 2009, CDIC saw its resolution powers further augmented by amendments granting it powers to incorporate a new financial "bridge institution." As discussed in more detail below, the bridge bank will serve as an additional tool in the process of allocating assets and liabilities between the failing institution and a viable third-party transferee, or facilitating the orderly wind-down and liquidation of the subject assets.

Most recently, Bill C-15 came into force on June 22, 2016, which among other things, implemented amendments to the CDIC Act introducing the 'bail-in' powers of the CDIC and new rules affecting stays of proceedings in respect of derivatives contracts. Both are discussed in more detail below.

Restructuring of Federal Member Institutions under the CDIC Act

Process

Upon receiving a report from the Superintendent of Financial Institutions (the Superintendent) that a financial institution has ceased or is about to cease to be viable, CDIC may make a recommendation to the Minister of Finance (the Minister), who may then recommend one or more resolution orders to the Governor in Council. On the recommendation of the Minister, the Governor in Council would then determine which resolution order(s), if any, should be made. That determination would be communicated publicly at the outset of the resolution process in order for it to be made clear to all market participants which combination of tools and stabilization measures would be brought to bear.⁴

Resolution Powers

The Governor in Council has the power to make the following orders as a means of giving CDIC control over the DTI:

• Vesting Order. An order may be made vesting in CDIC the shares and subordinated debt of the subject DTI free from  adverse claims (other than personal claims). Secured creditors holding shares or subordinated debt of the subject DTI as collateral are entitled to seek compensation where such collateral is compromised by the order.  Upon such an order, all shareholder rights to vote or give approvals are suspended and enure to CDIC.
• Receivership Order. An order may be made appointing the CDIC as receiver in respect of the subject DTI, granting the CDIC the power to: (i) take possession and control the assets of the DTI; (ii) dispose of the assets by private or public sale; (iii) arrange for the assumption by a third person of all or any part of the DTI’s liabilities; (iv) carry on the business of the DTI; and (v) do all such other things necessary or incidental to the foregoing. Upon such an order, all shareholder rights to vote or give approvals are suspended and enure to CDIC.

Open Bank Resolution (Stabilize the existing bank)

• Bail-in Order.  Applicable only to member institutions designated as D-SIBs, an order may be made giving CDIC the powers to convert, in whole or in part, certain prescribed liabilities of the D-SIB into common equity of the D-SIB or any of its affiliates. Regulations providing details of the conversion mechanism have yet to be published, but a consultation paper released by the Department of Finance proposes that D-SIB liabilities eligible for conversion would be senior unsecured debt that is tradable and transferable with an original term to maturity of at least 400 days.⁵ The conversion powers would only apply to D-SIB liabilities that are issued, originated or amended after an implementation date to be prescribed. The consultation paper also proposes that the conversion power could only be exercised upon satisfaction of the following two pre-conditions: (i) the Superintendent has made a determination that the D-SIB has ceased or is about to cease to be viable; and (ii) there has been a full conversion to equity of the D-SIB’s non-viability contingent capital in accordance with the terms of the underlying instruments.

Bridge Bank Resolution (Good bank, bad bank)

• Upon CDIC being appointed receiver of a non-viable DTI, an order may be made to establish a CDIC-owned bridge institution for the purposes of taking on and preserving the critical functions of the DTI. A bridge institution may remain in place and operative for up to five years, and CDIC is required to provide sufficient financial assistance to the bridge institution as is necessary to discharge its obligations. After a maximum of five years, the bridge institution would be terminated through a sale of assets or shares or by way of an orderly wind-down of its business.
• As receiver, CDIC would determine which "good assets" of the DTI would be transferred to the new bridge institution, and which “bad assets” would remain with the failed DTI, to be placed into liquidation. All insured deposits would be transferred to the bridge institution. With respect to eligible financial contracts, the transfer process would be subject to the "no cherry-picking" rule requiring that no less than all eligible financial contracts between the DTI and a counterparty either be assigned to the bridge institution or remain with the DTI.

Forced Sale Resolution

• Once CDIC has control of a non-viable member institution by way of an order appointing CDIC as receiver of the institution or acquiring its shares as described above, CDIC may order the assignment of some or all of the institution’s assets and liabilities to a third party. In order to be eligible to take an assignment of eligible financial contracts, the third party must certify that: (i) it has all material licenses and registrations necessary to operate its business; (ii) it is balance-sheet solvent; (iii) it will be able to meet its obligations as they come due under the eligible financial contracts to be assigned; and (iv) its credit-worthiness is the same or better than that of the non-viable institution immediately before the initial resolution order was made. As with transfers to a bridge bank, assignments to a third party are also subject to the "no cherry-picking" rule.

Termination Rights and Stay of Proceedings

• General Stay Upon Resolution Order. Where a resolution order has been made with respect to a member financial institution, creditors of that institution are stayed from pursuing any court action or pursuing other remedies against the institution or it assets, including rights of set-off (the General Stay), but subject to the exceptions outlined below.
• Termination Rights Limited. Counterparties of the non-viable institution are prohibited (subject to the exception for eligible financial contracts described below) from terminating or amending any agreements with the institution solely by reason of: (i) the insolvency or impaired financial condition of the institution; (ii) a non-monetary default which pre-dates the order; (iii) a monetary default which pre-dates the order but that is subsequently remedied within 60 days after the making of the order; (iv) the assignment or assumption of the agreement to or by a bridge institution or a third party; (v) the transfer to a third party of all or part of the assets or liabilities of the institution; or (v) a conversion of the institution’s liabilities in accordance with their terms or pursuant to a "bail-in" resolution. The foregoing restrictions apply notwithstanding any provision of an agreement to the contrary, which is rendered of no force or effect.
• EFCs Excepted from General Stay. Subject to the Limited Stay described below, Counterparties to eligible financial contracts with a non-viable institution are not prevented from taking the following actions in accordance with the terms of those contracts: (i) terminating or amending the contract; (ii) accelerating payment under the contract; (iii) exercising remedies for a failure to pay an amount due under the contact; (iv) exercising netting or set-off rights under the contract; or (v) selling or liquidating collateral to be applied against amounts due under the contract (the remedies described in the foregoing clauses (i), (ii) and (v) are referred to as the Specified Remedies).
• Limited Stay – Bridge Institution Orders. Notwithstanding the exception for eligible financial contracts from the General Stay, where a resolution order directing the incorporation of a bridge institution has been made, a one-day stay of proceedings arises prohibiting action in respect of the Specified Remedies by reason solely of the following events (a Limited Stay): (i) the insolvency or impaired financial condition of the institution; (ii) the making of a resolution order appointing CDIC as receiver or directing the formation of a bridge institution; or (iii) the eligible financial contract being assigned to the bridge institution. The one-day Limited Stay is extended if CDIC undertakes to assign the subject eligible financial contracts to the bridge institution within the one-day stay period. Conversely, the general eligible financial contract exemption remains available (i.e., no stay applies) to permit termination and close-out remedies triggered by any manner of default (payment or non-payment) arising before the resolution order is made, and payment defaults at any time whether before or after the resolution order is made. Furthermore, the Limited Stay does not prevent payment netting under the related contract (as distinguished from close-out netting, which is subject to the Limited Stay).
• Limited Stay – Other (Non Bridge Institution) Orders. Where an order is made other than directing the incorporation of a bridge institution, then a stay applies in respect of any Specified Remedies solely by reason of: (i) the insolvency or impaired financial condition of the institution; (ii) the eligible financial contract being assigned to the bridge institution; (iii) the making of the related order or any change of control or ownership resulting therefrom; or (iv) a conversion of the institution’s liabilities in accordance with their terms or pursuant to a “bail-in” resolution. Notably, in these circumstances, the Limited Stay would be operative indefinitely. However, in the case where all or substantially all of the member institution’s assets will be transferred to a third party, Cabinet has discretionary power to declare by order that the stay is terminated at any time after one business day following the day the initial resolution order was made. As with bridge institution orders, the Limited Stay arising upon other resolution orders does not apply to prevent: the exercise of remedies triggered by payment or non-payment defaults which pre-date the order; remedies triggered by payment defaults at any time (pre or post order); or ordinary course payment netting.
• No Stay for Payment Defaults or Payment Netting. Importantly, counterparties to eligible financial contracts are not stayed—even temporarily—from exercising any termination or close-out rights for reasons that are not related to a resolution order, nor are such remedies stayed in any circumstances on account of payment defaults.

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¹ See Key Attributes of Effective Resolution Regimes for Financial Institutions; available here: http://www.fsb.org/wp-content/uploads/r_111104cc.pdf

² See http://www.cdic.ca/en/about-cdic/Documents/our-history.pdf

³ "CDIC Granted Extraordinary Powers over Troubled Institutions"; by Blair W. Keefe and Wesley Isaacs. Banking & Finance Law Review, Vol. 24, Issue 3, 2009.

⁴ See Guidance on Exercise of Eligible Financial Contracts: Close-out Rights in a Resolution Scenario, published November 14, 2016; http://www.cdic.ca/en/financial-community/legislation-bylaws/Documents/summary-cdic-resolution-plan-guidance.pdf

⁵ See Taxpayer Protection and Bank Recapitalization Regime: Consultation Paper, published August 1, 2014: https://www.fin.gc.ca/activty/consult/tpbrr-rpcrb-eng.asp