Based on articles 28 (2) and 34 (3) of the Banking Act, as amended (BA), the Swiss Financial Market Supervisory Authority (FINMA) has opened on 16 January 2012 a consultation, which has come to an end on 2 March 2012, on the complete revision of the FINMA Bank Bankruptcy Ordinance (BBO-FINMA). More precisely, the BBO-FINMA is intended to be repealed and replaced by the new Ordinance of the Federal Authority on the supervision of financial markets on the Insolvency of Banks and Securities Dealers (Bank Insolvency Ordinance-FINMA, BIO-FINMA or the Ordinance). The current draft of the BIO-FINMA provides for some innovations which are worth noting and may even have an impact on the competitiveness of the Swiss financial place as regards derivatives, securities lending and repo transactions.

By François Rayroux/Christelle Conti (Reference: CapLaw-2012-31)

1) Introduction

a) Background

The revision of the BBO-FINMA is the result of the revision of the BA on the protection of deposits, which entered into force on 1 September 2011. The BIO-FINMA must also be seen in the wider context of the modifications to the BA in connection with the “too-big-to-fail” discussions which came into effect on 1 March 2012. Furthermore, FINMA’s declared intent in an international perspective is to (a) transpose and integrate into Swiss law the international initiatives arising from the Report and Recommendations dated March 2010 of the Cross-Border Bank Resolution Group (CBRG) of the Basel Committee on Banking Supervision and from the Key Attributes of Effective Resolution Regimes for Financial Institutions dated October 2011 of the Financial Stability Board (FSB) and (b) take into consideration the new bank insolvency measures introduced in other key jurisdictions, such as the United Kingdom (Banking Act 2009, implementing a specific insolvency regime), Germany (Kreditwesengesetz, as amended in 2010) and the United States (Dodd-Frank Wall Street Reform and Consumer Protection Act) and, more generally, the various consultations within the European Union on this subject.

In a nutshell, the intention behind the complete revision of the BBO-FINMA is to accelerate insolvency proceedings of banks and securities dealers and to render the same more efficient, transparent and predictable for the market participants (principle of legal security). In addition, FINMA’s intent is, by regulating in one single act both bankruptcy and restructuring proceedings, to facilitate the application of these provisions.

b) Overview of the Content and the Objectives of the BIO-FINMA

The BIO-FINMA is divided into seven chapters which we shall in essence follow for the purpose of our contribution. Chapter 1 is dedicated to the general provisions (articles 1–10), while Chapters 2 and 3 regulate two types of proceedings: bankruptcy (articles 11–39) and restructuring (articles 40–52). Chapter 4 discusses the protection of the systems and the market’s infrastructures (articles 53–55), whereas Chapter 5 deals with the suspension of the contractual termination rights (article 56). Finally, Chapter 6 relates to the closure of the proceedings (articles 57–58) and Chapter 7 embodies the final provisions (articles 59–60). These two last chapters, which are not particularly relevant for our analysis, will not be dealt with hereafter.

c) Object and Limitations of this Contribution

The object of this contribution is to highlight the salient features of, and to provide for a summary of the main amendments introduced by the BIO-FINMA. Accordingly, it does not pretend to be an exhaustive presentation. In this context, we shall put a particular emphasis on one key element of the new Ordinance: the new powers granted to FINMA as regards the suspension of contractual termination rights, regulated under Chapter 5 of the BIO-FINMA (see below Section 2) e)). By contrast, our contribution is not intended to provide for an exhaustive analysis of all issues arising in the context of the enactment of the BIO-FINMA or on bank insolvencies, or reorganisations, in general.

2) Salient Features of the BIO-FINMA

The main amendments introduced by the BIO-FINMA can be summarized as follows:

a) Chapter 1: General Provisions

The general provisions of the BBO-FINMA will be amended to the extent necessary by those of the BIO-FINMA in order to include the restructuring proceedings (Sanierung/ assainissement) in the scope of the Ordinance. Furthermore, given the fact that central mortgage bond institutions (Pfandbriefzentralen/centrales d’émission de lettres de gage) are engaged in bank-like activities and are—at least partially—subject to FINMA’s supervision, it is justified that the provisions of the BIO-FINMA also apply to them, as they are applicable to banks within the meaning of the BA and securities dealers (article 2 (1) (c) BIO-FINMA). However, we are of the opinion that, to include these entities in the definition of the term “bank” may be an unfortunate choice. Firstly, the BIO-FINMA is an implementing ordinance of the BA in which the term “bank” has a very specific and more limited scope and, secondly, article 36a of the Stock Exchange Act (SESTA) makes articles 25 to 37l BA (and consequently their development in the BIO-FINMA) applicable to securities dealers only by analogy. With the current wording of article 2 BIO-FINMA, one may fear that this flexibility, which is necessary for a good application of law, may be lost.

Article 2 (2) BIO-FINMA specifies that natural and legal persons, exercising an activity without the requested authorization under the applicable Swiss financial market laws (i.e. as bank, securities dealer or central mortgage bond institutions), may only be subject to bankruptcy proceedings, at the exclusion of restructuring proceedings. FINMA takes indeed the legitimate position that the illegality of the activity justifies depriving the concerned person of the benefit of saving measures, unless it is in the interest of the financial market to make an exception.

The fundamental principle of the “universality of the insolvency”, which is of essence for the treatment of insolvencies in an international context, is confirmed and expanded to govern now also restructuring proceedings (article 3 (1) BIO-FINMA). In this respect, the BIO-FINMA reflects the lessons learned from the recent international bankruptcies, such as those of the Lehman or Kaupthing Groups. In this context, the obligation to treat Swiss and foreign creditors equally remains unchanged (article 3 (2) BIO-FINMA). Finally, FINMA’s competence as coordinator of insolvency proceedings which is provided for by article 9 BIO-FINMA and is key both in an international context as well as in the context of insolvencies affecting entire groups, expressly, requires from FINMA and, as a novelty compared with the BA (see article 37f (1) BIO-FINMA), also from the service providers and official bodies appointed by FINMA (i.e. the restructuring agent or the liquidator) to coordinate, as far as possible, their actions with other Swiss federal and cantonal authorities as well as with foreign authorities. The coordination with foreign authorities in particular has proven to be of essence in the context of the Lehman and Kaupthing insolvencies and has not in all instances been achieved successfully in the past.

b) Chapter 2: Bankruptcy Proceedings

Chapter 2 of the BIO-FINMA remains fundamentally unchanged, as compared to the BBO-FINMA, since the aim of the proposed draft of the BIO-FINMA is to implement more detailed provisions, in particular with respect to restructuring proceedings. However, article 24 (2) BIO-FINMA should be noted. Indeed, this provision expressly states that claims which do not reveal the beneficiaries’ names, particularly pseudonym or numbered bank accounts, in addition to the debt obligations in bearer form (already expressly mentioned under current law), do not count as “deposits” and are therefore not considered as preferential claims eligible for segregation within the meaning of article 37a BA. It is worth mentioning that this provision, which seems to be criticised by certain market participants, in particular private banks, does in our analysis not constitute a novelty, but should rather be considered as a legal clarification of FINMA’s prevailing practice.

c) Chapter 3: Restructuring Proceedings

In terms of content of the BIO-FINMA, a major focus has been made on the detailed regulation of restructuring proceedings and the restructuring plan (Sanierungsplan/ plan d’assainissement), which are not regulated in the BBO-FINMA. The fully revised text can be summarized as follows:

i. Pursuant to article 28 (1) BA, in the case of a well-founded prospect of restructuring or of maintaining some banking services, FINMA may order restructuring proceedings. Pursuant to article 40 BIO-FINMA, a “well-founded prospect” exists when there are, at the time of the assessment, sufficient reliable indices based on which one may conclude that the restructuring plan may be approved. The analysis to be conducted here must be underpinned by the principle “no creditor worse off than in liquidation” (article 31 (1) (b) BA). By contrast, there is no right of an insolvent entity to be granted the benefit of a restructuring plan. This decision remains in the entire discretion of FINMA.

The restructuring plan can be drawn up by FINMA and be approved immediately, that is to say along with approving the commencement of the proceedings (article 41 (2) BIO-FINMA). There is, in other words, no obligation to conduct a “two phase procedure”, where FINMA would first approve the reorganisation procedure and where only in a second step a restructuring plan would be elaborated. This obviously drastically accelerates the entire process, but may also limit the information of counterparties as to the existence of a pending reorganisation procedure.

As a rule, the opening of proceedings must be published immediately (article 41 (3) BIO-FINMA). However, FINMA has the ability to postpone the publication during ten days, if FINMA considers that this facilitates the elaboration of the restructuring plan (article 41 (4) BIO-FINMA). The time flexibility granted by article 41 BIO-FINMA constitutes an essential component of the new insolvency law, but is very delicate in terms of the protection of the creditors’ interests. Indeed, creditors entering into transactions or other relationships with the insolvent entity within this period, where the publication is postponed, may be caught into the insolvency proceedings, even though they were bona fide relying on the fact that the bank is still in good operating conditions. Experience shows that this may indeed lead to a situation where counterparties enter into transactions with the insolvent, while the competent bodies within the same insolvent bank have already lost their power to dispose of the assets and to transact on behalf of the bank. Those creditors’ claims rank then pari passu with all other claims of unsecured creditors entered into before the “undisclosed” date of the insolvency. For this reason, and to protect the market participants, FINMA should in our analysis not have the right to postpone the publication, but should be obliged to proceed with the publication as a rule as soon as possible, respectively without delay.

ii. Article 42 BIO-FINMA (article 28 (3) BA) is dedicated to the restructuring agent (Sanierungsbeauftrager/délégué à l’assainissement). Indeed, although not mandatory, a restructuring agent may be appointed by FINMA. He has official powers, but does not have any authority to issue orders within the meaning of the Federal Act on Administrative Procedure of 20 December 1968.

iii. Pursuant to article 43 BIO-FINMA (article 31 BA), the basic features of the restructuring plan are to be publicly announced and to provide information about all the important facts relating to the restructuring (inventory stating the assets and liabilities, prudent assessment of the balance sheet, presentation of the future organisation and of the positions of the bank’s creditors, key components of the restructuring, etc.). If banking services are to be continued, in-depth information must be provided (see article 51 BIO-FINMA). The restructuring plan, whose approval falls within the competence of FINMA (article 44 BIO-FINMA), may be rejected within a period of ten days by the unsecured creditors holding the majority of capital (article 45 BIO-FINMA and article 31a BA in connection with article 8 BIO-FINMA). This right to reject lies not with the creditors of a systematically important bank (article 31a (3) BA).

iv. In order to achieve the level of capital required for the restructuring, FINMA will be granted the power to apply new reorganisation instruments. To this effect, article 31 (3) BA, in force since September 2011, allows as an ultima ratio FINMA to adopt in the restructuring plan the following measures:

(1) A decrease of the company’s equity capital and the creation of a new equity capital (articles 46–47 BIO-FINMA and article 31 (3) BA): As mentioned in the explanatory report of FINMA (Bankeninsolvenzverordnung, FINMA Erläuterungsbericht dated 16 January 2012—only available in German—the Explanatory Report), the decrease and creation of equity capital should, as a rule, intervene before a conversion within the meaning of articles 48–49 BIO-FINMA (or exceptionally, but as a practical matter, simultaneously) since losses must logically be born by “owners” (i.e. mainly shareholders) before creditors (article 31 (1) (c) BA)). In this context, article 47 BIO-FINMA grants FINMA the power, under certain circumstances, to withdraw the preferential subscription rights from the existing owners. FINMA is of the view that, as the Swiss Banking Act is based on the principle “no creditor worse off than in liquidation” (article 31 (1) (b) BA), there is a sufficient legal basis for the suppression of these preferential subscription rights at the level of an implementing ordinance (i.e. without a so called “formal legal basis”).

(2) The conversion of borrowed capital into equity capital without contractually agreed conversion (debt-to-equity swap or bail-in; articles 48–49 BIO-FINMA and article 31 (3) BA): In line with new intervention rights for financial market regulators applicable in other important jurisdictions, FINMA will be granted the power to decide in its discretion on the timing for a haircut that would affect all bondholders alike. Bail-ins are based on the principle of the discretionary intervention of the supervisory authority. This novelty is the most important measure introduced by the BIO-FINMA in the field of restructuring proceedings. Before proceeding with such a “forced” conversion, and for the purposes of article 48 BIO-FINMA, contractually created convertible capital must have been converted and the share capital fully reduced to set-off existing losses. Debt-to-equity swaps and bail-ins are in other words intended to be “subsidiary” in nature and considered as an ultima ratio. One possible way for banks to ensure a possible future recapitalisation is to seek to raise capital in the new financial environment in the form of Contingent Convertibles Bonds (CoCos), which—by contrast to bail-in—automatically convert into shares if the equity ratio falls below a certain threshold. These instruments are also activated when there is a reasonable concern that the bank is reaching the point of non-viability, what will be evaluated and determined by FINMA.

As a rule, any debt may be converted, except for a number of claims expressly listed in article 49 BIO-FINMA. Claims of the owners must be converted before those of the creditors (article 31 (1) (c) BA). Moreover, subordinated claims must be converted in priority in accordance with article 49 (4) BIO-FINMA. According to the Explanatory Report, FINMA considers that it has the authority, as an ultimate measure, to pronounce also the conversion of claims arisen before the entry into force of article 31 (3) BA, that is to say, before 1 September 2011.

In parallel or in lieu and place of the measures mentioned in articles 46 to 49 BIO-FINMA, FINMA is empowered to take other capitalization measures, such as to pronounce the partial or total waiver of claims or the suspension of the interest payments (article 50 BIO-FINMA).

A major innovation is the power conferred to FINMA not only to restructure the entire bank, but more importantly to transfer individual essential banking services to another legal entity, including a so-called “bridge bank” (the Recipient; articles 51–52 BIO-FINMA; article 30 (2) BA). This possibility, which has to be expressly provided in the restructuring plan, aims at protecting the clients (by ensuring they have access to their deposits and loans) as well as the financial system and the economy as a whole.

All assets, liabilities and contractual relationships linked to the banking activities, which have been identified as essential activity and are connected from a legal or economic perspective, have to be transferred together simultaneously to the Recipient. There is in other words no “cherry picking” as to the assets and liabilities which are the object of the transfer. Furthermore, the restructuring plan has to include a commitment of the failing bank to take all the necessary measures in order to ensure that all the assets to be transferred can effectively be delivered to the Recipient. In this respect, the Explanatory Report specifies, in line with the “principle of universality”, that the different location of the assets or the applicable law is of no relevance and, accordingly, should from a Swiss law perspective not affect the transfer.

Once the restructuring plan has been approved, as mentioned above, all the assets and contractual relationships, including all the related rights and obligations, are transferred to the Recipient (article 51 (2) BIO-FINMA). In other words, FINMA’s approval of the restructuring plan is considered as a contractual undertaking (Verpflichtungsgeschäft/ acte générateur d’obligation) and, at the same time as an act of disposition (Verfügungsgeschäft/acte de disposition). Pursuant to article 51 (3) BIO-FINMA, the approval of the restructuring plan supersedes the usual mandatory registrations in the official registers. This position aims at accelerating the procedure and also serves the principle of security of law. As an example, an entry in the land register or the commercial register will, in this context, be purely of a declaratory nature. This notably means that, for the transfer of real estate, FINMA’s approval shall be considered as an authentic instrument (Urkunde/acte authentique). Finally, it should be noted, that the provisions of the Swiss Merger Law do not apply (article 30 (3) BA).

d) Chapter 4: Protection of the Systems and the Market’s Infrastructures

Articles 53–55 BIO-FINMA are dedicated to the protection of financial market infrastructures (payment and securities settlement systems) which is strengthened in the Ordinance by more specific implementing provisions. These amendments must be seen in connection with the EU Settlement Finality Directive in Payment and Securities Settlement Systems (Directive 98/26/EC and Directive 2009/44/EC). In this context, article 55 (1) BIO-FINMA’s object is to define what is to be understood under the term “netting arrangements” within the meaning of article 27 (3) BA. We note pro memoria that article 27 (3) BA expressly states that all the provisions of Sections 11 and 12 BA are not intended to affect in any manner the legal enforceability of both netting agreements and agreements entered into with a view to realise collateral by private sale. In our view, the narrow language used in article 55 BIO-FINMA is dispensable, may lead to difficulties in its application and, in our analysis, also to a potential unequal treatment among creditors. We consider even more that the narrow definition of the term “netting agreements” of article 55 BIO-FINMA may be in contradiction with the clear legislative intent and wording of article 27 (3) BA. It is also contrary to the principles elaborated by the Bank of International Settlement. Indeed, netting arrangements can be found in various forms across different contractual arrangements, whether in Master Agreements, published in line with industry practice in the field of derivatives, securities lending and repo transactions, or even loan agreements, which incorporate provisions which are similar to those developed in the aforementioned Master Agreements. As newly defined in article 55 (1) BIO-FINMA, the term of “netting arrangements” clearly implies the risk that certain agreements, typically Master Agreements, may be caught by the relevant provisions applicable to such netting schemes, while other similar provisions, in different contractual arrangements, will not be affected by the same. In particular, as regards the suspension of the contractual termination rights which is of essence for counterparties of an insolvent bank, this may lead to an unequal treatment among creditors depending on the type of agreements which they have entered into. There may be even situations, where industry practice Master Agreements, the use of which is recommended by the Basel Committee on Banking Supervision of the Bank for International Settlements, will be discriminated.

e) Chapter 5: Suspension of the Contractual Termination Rights

Chapter 5 contains one single article (article 56 BIO-FINMA) which deserves to be discussed in more details. Pursuant to article 56 BIO-FINMA, when the transfer of individual essential banking services to another legal entity is ordered, FINMA may temporarily, that is to say for a maximum of 48 hours, suspend existing contractual termination rights of the bank’s counterparties (temporary stay on early termination rights). According to FINMA, such a measure is aimed at decelerating the downfall of the bank and increasing the chances to achieve a successful restructuring.

First of all, the question arises if there is a sufficient legal basis in the BA for article 56 BIO-FINMA, with such an invasive content into the parties’ freedom, to structure contractual agreements and in particular the applicable termination modalities. In this context, we note that the Explanatory Report refers to article 26 BA in connection with the articles 28 ff BA. Article 26 BA provides for a non exhaustive list of protective measures which can be taken by FINMA. The ratio legis which prevailed before the recent amendment of the BA was the protection of the clients of the failed institution. FINMA takes the view that the new articles 28 ff BA, which relate to restructuring proceedings, should additionally attempt to protect the financial system and the financial stability as a whole. In view of the above, and through a teleological interpretation of articles 26 and 28 ff BA, FINMA considers that it is entitled to pronounce a temporary stay on contractually agreed early termination rights. However, in our analysis, the BA, as currently in force, does not provide for a sufficient legal basis. The measure provided for in article 56 BIO-FINMA limits the freedom of the parties, while both are solvent, to freely agree on the consequences of one party becoming subsequently, at a certain point of time, insolvent. In the Explanatory Report, FINMA explains that article 56 BIO-FINMA satisfies one of the requirements of the Financial Stability Board (FSB). However, it is worth noting that the Key Attributes of Effective Resolution Regimes for Financial Institutions of the FSB are only recommendations to the attention of the national legislators, but not binding instructions. Thus, considering the absence of a sufficient legal basis in the BA, we believe that Annex IV (entitled “Temporary stay on early termination rights”) of the recommendations of the FSB could only be implemented under the laws of Switzerland by the Swiss Parliament through an amendment of the BA, which so far has not been undertaken.

Irrespective of the debate related to the existence of a sufficient legal basis for the suspension of contractually agreed early termination rights, article 56 BIO-FINMA, as it presently reads, could lead to serious and undesirable practical implications in relation with close-out netting provided for in Master Agreements. Indeed, we believe that the terms of article 56 BIO-FINMA contradict not only the clear terms of article 27 (3) BA, but also the very essence and purpose of industry practice Master Agreements, which precisely have been developed at the end of the 1980’s to provide, for regulatory reasons, for “netting” to reduce capital adequacy requirements. These Master Agreements are widely used by market participants, in many cases on a mandatory basis, mostly on the model of the widely used International Swaps and Derivatives Association Master Agreement for over-the-counter derivatives (the ISDA Master Agreement).

We see in light of the prevailing Swiss legal framework and of both the international and regulatory importance of netting agreements no justification for the invasive provisions of article 56 BIO-FINMA. Close-out netting aims, in case of events of default, at reducing counterparty credit risks and, accordingly, capital adequacy requirements, by allowing counterparties to aggregate and net the positive and negative market values of financial instruments. Close-out netting can be considered as the primary means of mitigating credit risks associated with over-the-counter derivatives, repo transactions and securities lending. For this reason, and in view of the key role of Master Agreements, the Swiss legislator has expressly stated in article 27 (3) BA that the insolvency rules in the BA should in no case affect the effectiveness of netting arrangements. Accordingly, we feel that article 56 BIO-FINMA, which does not provide for any exception for the netting arrangements contained in Master Agreements, is in contradiction with the clear text and intent of article 27 (3) BA. Furthermore, it should be clearly stated that article 56 BIO-FINMA may only be applied if the cause for close-out netting is triggered by insolvency measures exclusively. In case there are other events of default, such as the non performance of the Master Agreement or a default in the payment of collateral, then we believe that article 56 BIO-FINMA should not lead to a situation where FINMA is entitled to suspend the termination rights contained in Master Agreements. In other words, other causes for the termination of Master Agreements can not be limited or affected by article 56 BIO-FINMA. The current draft of article 56 BIO-FINMA seems to be unclear in this respect. We further believe that it is unclear whether article 56 BIO-FINMA may limit automatic early termination provisions, which legally, based on the parties common agreement, enter into effect one “logical second” before insolvency and, accordingly, can not be caught by an intervention of FINMA (as automatic termination leads legally in any case to a termination before the intervention of FINMA). Furthermore, the question is not clarified, whether the parties may terminate the Master Agreement after the transfer of the assets and liabilities to a new bank, or to a bridge bank (e.g. if they do not have a relationship with the new entity), or if a termination would only be possible if a new event of default occurs. Finally, we doubt whether the provisions of article 56 BIO-FINMA are enforceable under Swiss law. Indeed, most Master Agreements are subject to choice of law and choice of jurisdiction provisions, which provide for the application of laws other than Swiss law and the jurisdiction of courts outside Switzerland. It is doubtful whether the suspension of termination rights in accordance with article 56 BIO-FINMA would be recognized by such foreign courts under applicable foreign laws.

All these questions arising in the context of article 56 BIO-FINMA are complex and would require a further analysis which goes far beyond the limited scope of this contribution. It is however very likely that, if adopted in the current form and within the proposed content, article 56 BIO-FINMA could lead foreign counterparties to be restrictive and reluctant to enter into Master Agreements with Swiss counterparties. This would clearly not be in the best interest of the Swiss financial market as a whole. It would limit not only the number of available counterparties for banks, but also for corporate clients, which need to enter into derivative transactions, in particular in the context of the hedging of their financial and other risks.

3) Conclusion

In its broad lines, the current draft of the BIO-FINMA deserves approval. However, we are of the view that article 56 BIO-FINMA should be deleted without substitution in the current draft of BIO-FINMA, given the lack of a clear legal basis in the BA. Our view is corroborated by the fact that article 56 BIO-FINMA is in contradiction with the clear text and legislative intent of article 27 (3) BA.

Article 56 BIO-FINMA in its current form is also highly problematic as a matter of substance. Indeed, we fear that it may seriously impact the attractiveness of Swiss counterparties in the context of derivatives, securities lending and repo transactions. In other words, article 56 BIO-FINMA, as it presently reads, is not in line with the interest of the Swiss financial market itself and is very likely to affect the competitiveness of Swiss banks, which of course is regrettable.