"Bail-in" clauses, which have become a standard feature of contracts between European financial institutions and non-European parties, stipulate that European financial regulators have the power to write down, cancel or convert to equity the obligations of the financial institution.
The bail-in rules form part of a comprehensive package of measures under EU law designed to permit orderly rescue or wind-down of distressed banks. The power of European regulators to invoke the bail-in option is recognized by the law of all EU member states and should be respected by any court in those countries, whether or not the relevant contract includes bail-in language. However, courts in other countries ("third countries") might rule differently.
For that reason, EU bail-in legislation requires certain regulated financial institutions to include bail-in language in certain obligations subject to the law of a third country (such as those subject to New York law) entered into after Jan. 1, 2016, including new contracts or material amendments of older contracts.
The bail-in mechanism is one of several measures created by the EU "Bank Resolution and Recovery Directive" (BRRD) of May 15, 2014, establishing "a framework for the recovery and resolution of credit institutions and investment firms." The BRRD sets out requirements for legislation to be adopted by countries in the European Economic Area, i.e., the 28 EU Member States (all of which have enacted corresponding legislation), plus Iceland, Liechtenstein and Norway.
Along with other measures, the BRRD established four "tools" that regulators can use in a "resolution" proceeding to deal with financial institutions in distress:
The "sale of business" tool, allowing authorities to sell the distressed institution.
The "bridge institution" tool, allowing them to ring-fence compromised assets in a new institution - typically, a "bad bank" - while permitting the distressed institution to continue operations with its remaining assets.
The "asset separation" tool, which allows spinning off certain assets, typically in an asset-management vehicle.
The "bail-in" tool, used in conjunction with one or more of the other tools and that allows reducing, canceling or converting the rights of creditors.
How a Bail-in Is Supposed to Operate
In theory, if a bail-in occurs, the extent to which rights of creditors (and shareholders) will be compromised is limited by operation of the "No Creditor Worse Off Than Under Liquidation"...