Too big to fail: what happens when a financial institution gets into trouble?

1. 2 December, 2008 Too big to fail: what happens when a financial institution gets into trouble?

2. Introduction • Consequences of a bank failure are (perceived to be) different from those that arise when a plc becomes insolvent: • systemic risk and potential impact on financial stability • impact on continuity of banking services • public confidence and depositor protection • international / cross-border dimension • Hence the “too big to fail” theory • But state rescues come at a cost to the taxpayer • Risk of moral hazard: should a bank ever be allowed to fail?

3. Setting the scene: 2008 • Freddie Mac/Fannie Mae nationalised • Lehmans collapse • Merrill Lynch acquired by BoA • Lloyds/HBoS merger announced • US rescue of AIG • JPM acquisition of WaMu announced • Bradford and Bingley nationalised • Benelux rescue of Fortis • Collapse of three Icelandic banks in Iceland • UK administrations of Heritable and KSF • BoE discount window facility announced • UK GBP 50bn recapitalisation scheme announced • UK guarantee of inter-bank borrowing announced • US TARP (USD 700bn) enacted • US capital purchase program (USD 250bn) enacted • US insurance program enacted • US FDIC temporary liquidity guarantee launched Northern Rock nationalised BoE SLS announced Bear Stearns acquired by JPM

4. Tools in the UK Authorities’ tool box • Private sector deal (e.g. HBoS, Alliance & Leicester) • State support • customer deposits (FSCS) • liquidity (e.g. BoE SLS and DWF) • capital (Government’s £50bn recapitalisation scheme) • guarantees of inter-bank borrowing • Emergency pre-insolvency legislation • Banking (Special Provisions) Act 2008 • Banking Bill • Insolvency proceedings • current position vs. regime under Banking Bill • ranking of depositors

5. Existing insolvency proceedings • For both investment banks and deposit-taking institutions, currently same as for any other UK corporate: • administration • liquidation • scheme of arrangement or company voluntary arrangement • EEA-wide recognition for insolvency proceedings re EEA deposit-taking institutions: • consider Icelandic proceedings re three Icelandic banks • No automatic EU recognition for insolvency proceedings re investment banks: • consider English administration of LBIE • FSCS for retail depositors: • no automatic subrogation to depositors’ interests • no priority for protected claims

6. Banking (Special Provisions) Act 2008 • Came into force in February 2008 and was used the following day to nationalise Northern Rock • Has now been used three times since then • Gives the Treasury very wide powers to transfer all or part of the assets, liabilities or shares of a UK deposit-taking institution: • to a private sector purchaser (e.g. ING) • to a nominee of the Treasury (e.g. Northern Rock, Bradford & Bingley) • to a company wholly owned by the Bank of England or the Treasury • Sunset provision: expires 20 February 2009 • Intention is to replace provisions with Banking Act 2008

7. Banking Bill: timing • Introduced to House of Commons on 7 October as a result of a lengthy consultation process (starting in October 2007) • Responses from BBA, ISDA, ILA, FMLC, CLLS and A&O all raising concerns • Been through public committee stage in House of Commons, next stage House of Lords • On-going consultation process re scope of secondary legislation and carve-outs (responses by 9 January 2009) • Proposed that it will come into force in February 2009 (when Banking (Special Provisions) Act 2008 expires) • Not too late to take action!

8. Banking Bill: application • Primary provisions will apply to UK banks: • UK incorporated deposit-taking institutions • UK incorporated banking subsidiaries of non-UK banks • any foreign branches of UK incorporated banks • BUT NOT UK branches of foreign banks • modified regime for UK building societies • what about insurance companies? • Significant cross-border issues (including how fits with existing cross-border legislation) • Suggested in Pre-Budget Report that: • new special insolvency provisions for UK investment banks pursuant to secondary legislation under the Bill (expected summer 2009) • provisions may be extended to holding companies

9. Banking Bill: an overview • Pre-insolvency stabilisation tools (the “SRR”): • transfer of all or part of the business or shares to a private sector purchaser • transfer of all or part of the business to a State-owned “bridge bank” • full-blown nationalisation (as a temporary measure) • Secondary legislation to provide safeguards in respect of partial transfers • Compensation provisions • New bank insolvency tools: • modified bank liquidation procedure • special “administration” procedure to deal with residual bank following partial transfer

11. Special resolution regime: points to note (1) • Transfers of securities • compensation provisions for disenfranchised shareholders but much of detail is missing • provisions wide enough to cover hybrid capital instruments and bonds • allows Authorities to de-list securities or convert debt to equity • overrides any contractual restrictions on transfer, voting and consultation rights etc • can disapply any events of default triggered by the transfer, even in contracts to which the bank is not a party (consider CDS) • consider impact on shareholders, holders of hybrid capital instruments, bondholders

12. Special resolution regime: points to note (2) • Transfers of property • powers purport to extend to foreign property but may be recognition issues in practice • overrides any contractual restrictions on transfer • consider impact on exposure limits where counterparty already has exposure to the transferee • can disapply any events of default triggered by the transfer, even in contracts to which the bank is not a party (consider CDS) • consider impact on securitisations if transfer order affects ability of SPV to call for a transfer of legal title in the mortgage loans • consider impact of partial transfers on set-off, netting and security …

13. Safeguards for partial transfers • Partial transfers are the most contentious aspect of Bill • November consultation paper proposes safeguards for: • set-off and netting (with certain exceptions) • security interests (without exception) • structured finance (no details) • third party compensation (“no creditor worse off” principle) • Draft secondary legislation with consultation paper but still needs a lot of work: • essential that in force at same time as Banking Bill • Safeguards do not solve problem of Henry VIII clause (clause 72 of Banking Bill)

14. Set-off and netting • Massive issue if counterparties had to account for credit exposure on a gross, rather than a net, basis • Original suggestion: protection for “qualifying financial contracts”: • would have been arbitrary and stifled development of products • Now broader protection for all contracts containing netting provisions subject to specific carve-outs: • foreign property – should be all or nothing • debt securities including bonds – should just be subordinated bonds • deposits – should just be deposits covered by FSCS • regulated mortgage contracts – impact on offset mortgages? • liabilities – not clear why and inconsistent with EU law • Better to provide for protections on a counterparty by counterparty basis?

15. Compensation provisions • No creditor worse off (NCWO) principle: • following a partial transfer, no creditor should be in a worse position than that in which it would have been in a liquidation of the bank • No detail as to how this will be funded – presumably through FSCS? • Independent valuer to be appointed to assess level of compensation ignoring: • any partial transfer • any financial assistance given by Bank of England or Treasury • Devil will be in the detail but likely to be difficult in practice to assess what recoveries would have been in a liquidation • On the basis that a liquidation would not prevent close-out netting, set-off and enforcement of security, presumably these rights are to be taken into account in assessing the level of compensation

16. New bank insolvency procedure • Modified form of liquidation • Can be commenced by Bank of England, FSA or Secretary of State (trumps normal liquidation) • Bank must be unable to pay its debts, likely to become so or in default of payment obligation • Primary objective: to work with FSCS to ensure transfer of deposits or payment to depositors • Secondary objective: to wind up the affairs of the bank so as to achieve the best result for the creditors as a whole • In practice, gives depositors priority? • Until primary objective achieved, control by liquidation committee comprising Bank of England, FSA and FSCS • Winding up proceeding for purposes of EEA legislation?

17. Bank administration • To be used following a partial transfer to a bridge bank or private sector purchaser • Only Bank of England can commence • Primary purpose: to ensure continued supply of essential services to purchaser • Purposes of “normal” administration (rescue and better result for creditors) are subordinated to primary purpose • Until primary purpose achieved, various powers can only be exercised with consent of Bank of England • Compare approach taken in special insolvency legislation re PPP companies (Metronet) and protected railway companies (Railtrack) • Administrator has the power to disclaim onerous contracts and bring wrongful and fraudulent trading claims • Henry VIII clause (clause 150) • Reorganisation measure for purposes of EEA legislation?

18. Questions? These are presentation slides only. The information within these slides does not constitute definitive advice and should not be used as the basis for giving definitive advice without checking the primary sources. Allen & Overy means Allen & Overy LLP and/or its affiliated undertakings. The term partner is used to refer to a member of Allen & Overy LLP or an employee or consultant with equivalent standing and qualifications or an individual with equivalent status in one of Allen & Overy LLP's affiliated undertakings. Jennifer Marshall Partner, restructuring Telephone: 020 3088 4743 Email: jennifer.marshall@allenovery.com