South African Bank and Bank Controlling Company Flac Instruments: Contractual Recognition of the South African Reserve Bank’s Bail-in Powers under the South African Resolution Framework and the Ranking of Flac Instruments

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Lionel Shawe

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Introduction

  1. The Prudential Authority of South Africa (the "Prudential Authority") published Draft Prudential Standard RA03 entitled "Flac Instrument Requirements for Designated Institutions" (the "Draft Flac Standard") in December 2023 setting out:

    (a) the proposed qualifying criteria for a new financial loss absorbing capacity instrument, known as a "flac instrument" ("Flac Instrument"), in which South African banks that have been designated as systemically important financial institutions ("SIFIs") and their holding companies will have to ensure that they have sufficient loss-absorbing and recapitalisation capacity available to implement an open-bank resolution strategy;1 and

    (b) the proposed quantum of Flac Instruments (and other eligible instruments) that these designated institutions will have to build to ensure sufficient loss absorption and recapitalisation capacity under financial distress.

  2. We understand that some concern has arisen among the investor community that Flac Instruments will be subject to contractual (regulatory) bail-in due to the requirement in the Draft Flac Standard2 that designated institutions must ensure that Flac Instruments contain contractual terms that promote the ability of the South African Reserve Bank (the "SARB") to conduct a resolution and for these instruments to be subject to bail-in under South African law. The concern goes further that such contractual bail-in may include a requirement for firm language that Flac Instruments will inevitably or automatically be subject to conversion in the event of the exercise of the SARB's resolution powers.
  3. Another issue appears to us to be created in the proposed ranking requirements for Flac Instruments.
  4. Both issues are considered and discussed below.

What is a Flac Instrument?

  1. The Financial Sector Regulation Act, 2017 (as amended by the Financial Sector Laws Amendment Act, 2021 (Act No. 23 of 2021)) (the "FSRA") defines Flac Instruments.3

  2. As to a "bank"4 and a "holding company"5 of a bank, a Flac Instrument is a financial instrument which:

    (a) is issued by a "designated institution" that is a bank or a holding company of a bank;

    (b) complies with the requirements prescribed by a prudential standard6 for a Flac Instrument; and

    (c) is not counted as regulatory capital of a bank or a holding company of a bank under Chapter VI of the Banks Act, 1990 (the "Banks Act") or any prudential standards made for the purposes of Chapter VI of the Banks Act.

Why are Flac Instruments required?

  1. The requirement for banks and holding companies of banks to issue Flac Instruments is being introduced within the context of the "resolution"7 framework for designated institutions introduced into South African law under Chapter 12A of the FSRA with effect from 1 June 2023.

  2. Under the resolution powers afforded to the SARB as "resolution authority" under Chapter 12A of the FSRA, if the SARB determines that it is necessary to achieve an orderly resolution of the designated institution, the SARB has the power:

    (a) as to the shares of the designated institution to:

    (i) cancel the shares of the designated institution; and/or

    (ii) issue new shares in the designated institution; and/or

    (b) as to the liabilities of a designated institution to:

    (i) reduce the amount of any liability that is or may become payable by the designated institution to any creditor;8 and/or

    (ii) convert any liability owed to a creditor of the designated institution into shares (equity) in the designated institution.9

    These powers that the SARB has in resolution are known as statutory "bail-in" powers and the effect of the exercise of these powers is known as statutory "bail-in". The SARB may not exercise its statutory bail-in powers in respect of the categories of liability described in section 166S(9) of the FSRA, but other than those protected liabilities the SARB may exercise its statutory bail-in powers in respect of, and bail-in, any liability of the designated institution in resolution.

  3. Bail-in is one of the stabilisation tools available to the SARB as resolution authority under Chapter 12A of the FSRA. Bail-in is intended to ensure that investors, rather than public funds (i.e. taxpayer funds), bear losses incurred by designated institutions. Bail-in therefore enables the SARB to impose losses on shareholders and to write down and/or convert liabilities (other than protected liabilities) into equity, so the bank or the holding company of the bank can be recapitalised and continue to operate during the resolution and exit the resolution as a viable entity i.e. the recapitalisation through bail-in must be sufficient to restore the designated institution's capital to levels where it meets the prescribed regulatory capital requirements and can maintain its licence to operate.
  4. The exposure of shareholders and creditors to losses as a result of bail-in in resolution must respect the order in which they would receive distributions in an insolvency of the bank or the holding company of the bank and leave them no worse off than they would have been if the bank or the holding company of the bank had been placed into liquidation. This is a key protection for investors in, and creditors of, banks and holdings companies of banks and known as the "no creditor worse off" principle.
  5. Although Chapter 12A of the FSRA allows the SARB to bail-in all liabilities of a designated institution (other than protected liabilities) to absorb losses, it is recognised by the SARB that there are practical impediments to, or potentially adverse consequences arising from, bailing-in many of these liabilities, including time consuming operational challenges with identifying creditors or valuing liabilities subject to bail-in.
  6. To overcome these complexities and adverse consequences, the SARB, through the framework created by the FSRA, will require banks that are designated as SIFIs and their holding companies to issue Flac Instruments to ensure that these designated institutions have sufficient loss absorption and recapitalisation capacity available to implement a resolution strategy that minimises the impact on financial stability, ensures the continuation of critical functions, avoids using public funds to cover losses and saves time in implementation.
  7. The premise behind Flac Instruments is that, together with "own funds" (i.e. common equity tier 1 capital (CET1), additional tier 1 capital (AT1) and tier 2 capital (T2)), they are intended to enhance the loss absorbing capacity of designated institutions by ensuring that designated institutions maintain a sufficient amount of resources that can credibly and feasibly be used to absorb losses and recapitalise designated at the point of resolution ("POR") to a level that enables them to continue to comply with the conditions for regulatory authorisation and sustain market confidence.

What are the eligibility requirements for an instrument issued by a bank or a bank holding company to qualify as a Flac Instrument?

  1. The eligibility requirements for an instrument issued by a bank or a bank holding company to qualify as a Flac Instrument are set out in paragraph 8 of the Draft Flac Standard.
  2. The Draft Flac Standard distinguishes between "external Flac instruments" ("External Flac Instruments") and "internal Flac instruments" ("Internal Flac Instruments"). The term External Flac Instruments refers to Flac Instruments that are issued by the holding company of the designated institution, to external counterparties, outside the group of which the designated institution is a member. On the other hand, Internal Flac Instruments are Flac Instruments that are issued by a designated institution to its holding company. In other words, for South African purposes Flac Instruments issued to third party investors will have to be issued by the South African bank controlling companies under External Flac Instruments and downstreamed to the SIFI bank. A SIFI bank is expected to issue Internal Flac Instruments to its controlling company facilitating the down streaming of the funds received from the issue of External Flac Instruments, so that the Flac Instruments are funded from external sources and to ensure their availability in a resolution scenario.

  3. The proposed criteria for an instrument to qualify as a Flac Instrument are as follows:

    (a) External Flac Instruments must be issued by the holding company of designated institutions while Internal Flac Instruments must be issued by a designated institution to its holding company that has in turn issued External Flac Instruments;

    (b) External Flac Instruments must not be funded, fully or partially, by the holding company of the designated institution, or any other entity within its group of companies;

    (c) Internal Flac Instruments must be fully funded by the holding company of the SIFI bank;

    (d) all Flac Instruments must:

    (i) be fully paid;

    (ii) be unsecured;

    (iii) not be subject to set-off or netting arrangements;

    (iv) have a minimum initial maturity of 24 months;

    (v) have a minimum remaining maturity of 12 months;

    (vi) set out, in the contractual terms of the Flac Instrument, the ranking of the Flac Instrument in line with the creditor hierarchy provided for in the Insolvency Act, 1936 (the "Insolvency Act");

    (vii) not contain any derivative-linked features;

    (viii) not allow for early redemption except if:

    (1) the Flac Instrument no longer qualifies as a Flac Instrument;

    (2) the designated institution obtains the prior written approval of the SARB to:

    (I) repurchase the Flac Instruments;

    (II) repay any proceeds received from the issuance of the Flac Instruments; or

    (III) redeem the Flac Instrument before their maturity;

    (ix) contain contractual terms that promote the ability of the SARB to conduct a resolution and for the Flac Instruments to be subject to bail-in under South African law; and

    (e) External Flac Instruments that are issued under a foreign governing law must include provisions that allow for the bail-in of the External Flac Instruments under the South African law.

Contractual (regulatory) bail-in versus statutory bail-in

  1. To give effect to loss absorbency requirements under prudential laws and regulations applicable to banks and their holding companies, loss absorbing instruments either need to:

    (a) contractually incorporate into the terms of the instrument a mandatory write-off/down or conversion into common equity feature (the "contractual approach"); or

    (b) be subject to a statutory regime under the national law of the jurisdiction of the bank or holding company of the bank that produces the same outcome as the contractual approach (the "statutory approach").

  2. Under both the contractual approach and the statutory approach, the banking supervisors have the right to specify a trigger that engages the right to bail-in the loss absorbing instrument. Once the right to bail-in has been engaged:

    (a) under the contractual approach, since the loss absorption mechanism is specified in the terms of the loss absorbing instrument:

    (i) the terms of the instrument will:

    (1) determine whether the instrument will be written off/down or converted into common equity (i.e. the instrument itself will specify whether write-off/down or conversion applies); and

    (2) specify the mechanics of write-off/down or conversion;

    (ii) the bank or holding company of the bank issuing the instrument will be entitled to contractually enforce the write-off/down or conversion against the holder of the instrument (and will have to do so at the direction of the banking supervisors); and

    (b) under the statutory approach, since the loss absorbing instruments typically do not contain contractual terms providing for write-off/down or conversion into common equity:

    (i) the national law of the jurisdiction of the bank or the holding company of the bank will specify the consequences of the exercise of the bail-in power (i.e. whether the instrument will be written-off/down or converted into common equity) and in most instances the consequences will be determined in the discretion of the banking supervisors; and

    (ii) the banking supervisors will be entitled to directly enforce the write-off/down or conversion against the holder of the instrument by law and the holders will be bound by that enforcement by law and not as a matter of contract.

Bail-in of regulatory capital instruments versus FLAC Instruments in South Africa

  1. AT1 and T2 instruments are regulatory capital instruments under the South African banking prudential framework contained in the Banks Act and its related regulations and the FSRA. Flac Instruments will not be regulatory capital instruments although they will contribute to a designated institution's overall loss absorbing capacity.

  2. AT1 and T2 instruments may be bailed-in at the instance of the Prudential Authority before resolution of the designated institution, but only if the Prudential Authority obtains the SARB's prior approval to such bail-in action.10 Both AT1 and T2 instruments have a qualitative trigger point11 at which the Prudential Authority can initiate a write-off or conversion (whichever is agreed in the terms of the instruments)12 of the regulatory capital instruments to preserve the bank's or the bank holding company's viability. The qualitative trigger event occurs on the earlier of:

    (a) the decision that a write-off or a conversion (whichever is agreed in the terms of the instrument), without which the bank or the holding company of the bank would become non-viable, is necessary as determined by the Prudential Authority; or

    (b) the decision to make a public sector injection of capital, or equivalent support, without which the bank or the holding company of the bank would have become non-viable, as determined by the Prudential Authority.

    Essentially the qualitative trigger determines a "point of non-viability" ("PoNV") at which the bank or the bank holding company may no longer remain a "going concern" on its own unless appropriate measures are taken for its revival (the "PoNV Trigger"). The activation of the PoNV Trigger is at the discretion of the Prudential Authority (but subject to the concurrence of the SARB).

  3. Under South African banking regulations (and in compliance with the Basel Framework), AT1 instruments that are liability accounted must also contain a contractual quantitative trigger event requiring the AT1 instruments to be written off or converted (as agreed in the terms of the instruments) before resolution when the bank's or the bank holding company's CET1 ratio is equal to or below 5.875% (the "CET1 Trigger", and together with the PoNV Trigger, the "Contractual Triggers"). Again, the Prudential Authority may only require such a write-off or conversion if it has received the concurrence of the SARB to do so.

  4. Regulatory capital instruments may also be bailed-in in resolution. There are therefore two scenarios that apply to regulatory capital instruments:

    (a) Bail-in in resolution:

    (i) If the conditions for the commencement of resolution are satisfied under the FSRA (which may not coincide with the PoNV but are likely to),13 the Minister of Finance upon the recommendation may make a written determination placing the designated institution in resolution.

    (ii) Once the designated institution is in resolution, regulatory capital instruments may only be bailed-in (regardless of their contractual terms) in a manner contemplated by Chapter 12 of the FSRA and in a manner which respects the creditor hierarchy in insolvency and complies with the "no creditor worse off" principle.14

    (iii) Among other things the implementation of bail-in in resolution ensures that there is no value transfer from holders of AT1 instruments or T2 instruments to CET1 holders.

    (iv) Importantly, the bail-in in resolution does not occur in accordance with the contractual terms of the regulatory capital instrument other than those that determine the ranking of the relevant instrument. So even if a regulatory capital instrument contractually provides that it is to be written down/off at a PoNV, in resolution it may have to be converted into equity in the bank or the holding company of the bank to ensure that the "no creditor worse off" principle is satisfied when considering the resolution actions to be taken.

    (v) Therefore, in resolution, regulatory capital instruments will be bailed-in (as necessary) in accordance with the statutory approach and not the contractual approach which would otherwise apply outside of resolution.

    (b) Bail-in outside resolution:

    (i) The PoNV Trigger and (in the case of AT1 instruments) the CET1 Trigger under the contractual terms of a regulatory capital instrument may not fully coincide with the conditions for the commencement of resolution under Chapter 12 of the FSRA. The Prudential Authority and the SARB regard the PoNV Trigger and the CET1 Trigger and the POR as separate points although they concede that in some cases they may converge in practice.15

    (ii) Upon the occurrence of a Contractual Trigger, the Prudential Authority may (if it has the approval of the SARB) direct the designated institution to implement the write-off or conversion of the regulatory capital instrument (whichever is agreed in the terms of the instrument16).

    (iii) Once directed by the Prudential Authority, the bank or the holding company of the bank must implement the agreed bail-in mechanism in accordance with the contractual terms of the instrument. In such a circumstance and if write-off is the agreed contractual bail-in mechanism write-off without the wipe out of CET1 may occur (i.e. a transfer of value from AT1 or T2 instrument holders to holders of CET1 may occur).

  5. Unlike regulatory capital instruments, Flac Instruments will not be subject to bail-in prior to the designated institution being placed in resolution. Unlike the requirements for regulatory capital instruments, the terms of a Flac instrument need not specify whether the Flac Instrument will be written off or converted into the most subordinated form of equity at the occurrence of a trigger event. Therefore, while conversion of a Flac Instrument into equity is an option available to the SARB in resolution, it is not a certainty that conversion will occur in resolution as the actual resolution action to be taken will be determined by the circumstances. So while conversion of a Flac Instrument to equity is a possibility, this outcome is uncertain given the possibility of a write-off/down.
  6. We highlight the distinction between regulatory capital instruments and FLAC Instruments to illustrate that in resolution there is no bail-in under a contractual approach for regulatory capital instruments or Flac Instruments. The resolution action is taken in the discretion of the SARB subject to respecting the hierarchy of the instruments insolvency and adhering to the "no creditor worse off principle". The contractual aspect that is relevant to the statutory approach to bail-in is the agreed ranking of the relevant instruments which determines their order of write-down/off or conversion and their value in resolution for the purposes of applying the "no creditor worse off" principle.
  7. In summary, all bail-in actions in resolution follow from the exercise of statutory powers by the SARB and not from the enforcement of contractual rights by the designated institution save that the contractual agreement of the investor to the ranking of the relevant instrument determines how the bail-in action applies to that instrument. The powers of the SARB will cut across any company law, competition law, the designated institution's constitutional documents, the JSE Listings Requirements or any law that would otherwise restrict or prevent the implementation of any transaction under the exercise of the SARB's power. The bail-in action taken, and the outcome of the bail-in action, follow purely from the exercise of statutory powers and not from the contractual terms of instrument (save as to ranking in insolvency).

What is contractual recognition of bail-in and when and why is it needed?

  1. A key challenge for resolution authorities in cross-border scenarios is ensuring the effectiveness of resolution powers (such as suspension of termination rights, asset transfers and bail-in) outside the home jurisdiction of the designated institution.
  2. When a liability of a designated institution is governed by the law of the home jurisdiction (whether by an express agreement to such jurisdiction or inferred from the circumstances), the bail-in of that liability will be effective as a matter of law in the home jurisdiction. All home law governed liabilities will be subject to the resolution powers of the resolution authority under the resolution laws without anything more regardless of the terms of the contract. No express recognition or consent to the resolution laws is required of a counterparty to a contract, a creditor or an investor in respect of a home law governed liability.
  3. However, some liabilities (for example, debt securities) may be governed by the law of another jurisdiction. In that event, there is considered to be a risk that in the absence of a regime to secure the effectiveness of an application of the home country resolution powers (including bail-in) of the home country resolution authority (whether under the local law of another jurisdiction or under an international agreement) it is possible that the courts of the other jurisdiction may not recognise the effect of the application of the resolution powers by the home country resolution authority.
  4. Consequently, the reason that banking regulators require contractual recognition of bail-in powers in non-home jurisdiction law governed contracts is that it is thought that if a counterparty expressly consents to bail-in, the exercise of bail-in powers is likely to be less susceptible to challenge in a non-home jurisdiction court. Otherwise the resolution of a home country financial institution under the home country resolution framework potentially could be threatened if it has significant non-home country law governed liabilities and creditors in those non-home countries brought proceedings where, as a matter of that non-home country law, the bail-in was not effective and so did not as a matter of that non-home country governing law bind them – in effect, holding the financial institution to its original deal with its creditors despite the purported bail-in. A refusal to recognise the application of the bail-in powers could undermine the effectiveness of actions on the part of the home country resolution authority to restore the financial condition of a relevant institution to address a threat to financial stability and/or protecting the interests of depositors.
  5. Banking regulators therefore require in-scope institutions to include a contractual term in relevant non-home country laws governed agreements by which the creditor or counterparty to the agreement creating the liability expressly recognises that liabilities may be subject to the write-off/down and conversion powers of the resolution authority and agrees to be bound by any reduction of the principal or outstanding amount due, conversion or cancellation that is effected by the exercise of those resolution powers by the home country resolution authority.
  6. The requirement to include a contractual term recognising the bail-in powers of the resolution authority would typically not apply when the home country resolution authority determines that liabilities or instruments governed by the law of another jurisdiction can be subject to the bail-in powers of the home country resolution authority under: (i) the law of the other jurisdiction, or (ii) a binding international agreement concluded with the other jurisdiction.
  7. It is worth noting that a failure to include a contractual recognition of bail-in clause in an agreement or the terms of an instrument will not preclude a bail-in under the applicable resolution regime. But the inclusion of such a contractual recognition of bail-in clause is not a guarantee that a bail-in of the liabilities of the in-scope entity under the contract or instrument will be fully immune from challenge under the laws of the non-home jurisdiction. Ultimately, whether the bail-in is enforceable in the non-home jurisdiction is a question for the laws of that non-home jurisdiction and a contractual recognition bail-in clause simply aims to reduce the likelihood of a creditor successfully challenging the effect of the bail in. However, irrespective of its likely effectiveness in a non-home country, compliance should be required for all in-scope entities.

The approach to the recognition of bail-in in the Draft Flac Standard

  1. The Draft Flac Standard contains two provisions that stipulate requirements relating to the bail-in powers of the SARB as follows:

    (a) Paragraph 8.4 of the Draft Flac Standard provides that:

    "Designated institutions must ensure that Flac instruments contain contractual terms that promote the ability of the Reserve Bank to conduct a resolution and for these instruments to be subject to bail-in under South African law."

    (b) Paragraph 8.5 of the Draft Flac Standards provides that:

    "External Flac instruments that are issued under foreign law must include provisions that allow for the bail-in of Flac instruments under the SA law."19

  2. Paragraph 8.4 of the Draft Flac Standard will require contractual terms that promote the SARB's ability to conduct a resolution and for Flac Instruments to be subject to bail-in under South African law. This requirement is, however, unnecessary for South African law governed Flac Instruments as these would be subject to the resolution powers (including the bail-in powers) of the SARB even without any contractual recognition, consent or acknowledgment. The resolution framework under Chapter 12 of the FSRA is part of South African law and therefore applies to the South African law governed instruments (including Flac Instruments) without any requirement for contractual terms envisaged by paragraph 8.4 of the Draft Flac Standard.
  3. Consequently, paragraph 8.4 of the Draft Flac Standard could be deleted without any impact on the SARB's ability to conduct a resolution and/or exercise its bail-in powers under the resolution framework. It is submitted that paragraph 8.4 of the Draft Flac Standard should be deleted as the provisions of the paragraph add nothing to the SARB's already extensive resolution powers under the resolution framework.
  4. Furthermore, the requirement to include these provisions in the contractual terms of local law governed Flac Instruments runs the risk of undermining the rationale for incorporating the bail-in powers into a statute in the first place. The point of incorporating bail-in powers into local law is so that contractual provisions are not required for local law governed liabilities which may vary or be open to interpretation by a court in the event of a dispute about the contractual terms of the liability. This potentially undermines the objectives of resolution. To achieve these objectives, providers of capital must be left with no grounds to doubt that the bail-in powers are immediately effective and cannot be credibly challenged. This is most effectively and robustly achieved through statutory bail-in of local law governed instruments and does not require contractual recognition. Essentially, once an instrument is agreed to be a Flac Instrument and is issued subject to South African law (which includes the resolution powers and bail-in powers of the SARB under Chapter 12 of the FSRA) the resolution regime under Chapter 12 of the FSRA will automatically apply the bail-in powers of the SARB to the Flac Instrument and its holders.
  5. The position is different for foreign law governed Flac Instruments. Whenever the designated institution and all the relevant creditors are located in a single jurisdiction, simple legislation in that jurisdiction will suffice. But this is not – and will never be – the case for any designated institutions whose failure would give rise to significant systemic concern since such designated institutions will invariably have creditors and investors in multiple jurisdictions whose contractual arrangements are not necessarily governed by the laws of the home jurisdiction. The challenge is therefore to construct a legal solution which employs various legal techniques to achieve a robust outcome without falling into impossible demands for global harmonisation of bank resolution legislation. The hybrid solution is to require the designated institution to ensure that, for any bail-in of in-scope liabilities governed by any other law, there is included in the foreign law governed agreement with that creditor/investor a term to the effect that the creditor/investors agrees to be bound by any bail-in effected under the law of the home jurisdiction as if their rights under the agreement were governed by the law of the home jurisdiction, and to obtain legal opinions that the term would be recognised under the applicable law of the agreement.
  6. Paragraph 8.5 of the Draft Flac Standard seeks to give effect to the requirement for contractual recognition of the SARB's bail-in powers in the case of foreign law governed Flac Instruments. This requirement coincides with what would be expected in relation to instruments that can be bailed-in and are governed by a foreign law to ensue the effectiveness of the South African resolution regime. It is noted that a similar requirement is not mandated for AT1 instruments and T2 instruments at present to ensure that AT1 and T2 instruments issued under a foreign governing law are subject to effective bail-in under the South African resolution regime.20

  7. However, paragraph 8.5 of the Draft Flac Standard does not specify what is meant by "provisions that allow for the bail-in of Flac instruments under the SA law". It is submitted that such provisions would require these elements in relation to a Flac Instrument governed by a foreign law:

    (a) an acknowledgment and acceptance by the holder the Flac Instrument that the liability under the Flac Instrument may be subject to the exercise by the SARB of its bail-in powers

    (b) a description of the bail-in powers of the resolution authority, in particular the powers to:

    (i) reduce, in full or in part, the amount that is or may become payable under the Flac Instrument;

    (ii) convert, in full or in part, the Flac Instrument into shares of the designated institution or another person (including a "bridge company"21); and/or

    (iii) cancel the Flac Instruments;

    (c) an acknowledgment and acceptance by the holder of the Flac Instrument that:

    (i) it is bound by the effect of the application of the SARB's bail-in powers including:

    (1) any reduction in the amount that is or may become payable under the Flac Instrument; and

    (2) any conversion into shares, that may result from an exercise by the SARB of its bail-in powers;

    (ii) the terms of the Flac Instrument may be varied as may be necessary to give effect to the exercise of the SARB's bail-in powers and that the holder of the Flac Instrument will be bound by such variations; and

    (iii) the holder of the Flac Instrument will accept any shares into which the liability under the Flac Instrument may be converted; and

    (d) an "entire agreement" clause is drafted as to these matters.

  8. The SARB should specify either in the final Flac Instrument prudential standard or a separate prudential standard what the contractual recognition of the bail-in powers of the SARB should entail to ensure (i) consistency, and (ii) that the bail-in powers of the SARB can be applied effectively with regard to Flac Instruments governed by the laws of another jurisdiction.
  9. What is important to note, however, is that the requirement for contractual recognition of the SARB's bail-in powers (whether under paragraph 8.4 or paragraph 8.5 of the Draft Flac Standard and noting that paragraph 8.4 should, it is submitted, be deleted) does not change the position that bail-in of Flac Instruments is intended to occur under the statutory approach to bail-in and not the contractual approach. Consequently, including these recognition provisions does not mean that Flac Instruments will be subject to contractual bail-in.
  10. Furthermore, the terms of Flac Instruments will not require firm language that they will as a matter of certainty be converted to equity at the PoR. This would be impermissible under the resolution regime as it would amount to a fettering of the discretions of the SARB to take other actions it deems fit in resolution and also potentially create grounds for dispute about the way the SARB's powers may be exercised. The eligibility requirements for Flac Instruments suggest no such firm language is required. That the SARB may have suggested that Flac Instruments will be converted to equity in interactions with investors and designated institutions cannot bind the SARB in any resolution situation. The SARB will be empowered to take the resolution actions it considers fit subject to compliance with the requirements of Chapter 12 of the FSRA including the "no creditor worse off" principle. This may of course result in the conversion of Flac Instruments to equity, which is one of the powers the SARB possesses.

Ranking of Flac Instruments

  1. Paragraph 8.2(h) of the Draft Flac Standard states that the contractual terms of a Flac Instrument must set out the ranking of the Flac Instruments in line with the creditor hierarchy provided for in the Insolvency Act.
  2. The first point to note about this requirement is that the Insolvency Act does not cater for the ranking of Flac Instruments. In other words, Flac Instruments are not provided for in the hierarchy set out in the Insolvency Act.

  3. The ranking of Flac Instruments is in fact contained in section 166W(2) of the FSRA which provides that, notwithstanding any law (which would include the Insolvency Act), if a designated institution is placed in liquidation, the trustee or liquidator must:

    (a) after payment of any preferred creditors provided for in the Insolvency Act, and before the payment of any unsecured creditors, apply the balance of the "free residue"22 in liquidation in the payment of any claims proved against the estate which were covered as a covered deposit in terms of the FSRA with interest calculated as provided for in section 103(2) of the Insolvency Act;

    (b) after payment of any unsecured creditors, apply the balance of the free residue in liquidation in the payment of any claims proved against the estate arising in connection with Flac Instruments; and

    (c) after the payment of Flac Instruments or, if no claims in connection with Flac Instruments have been made, then after the payment of unsecured creditors, apply the balance of the free residue in liquidation in the payment of any claims proved against the estate arising in connection with the amounts in terms of debt instruments designated as regulatory capital in terms of a financial sector law in the order prescribed in the financial sector law (i.e. towards T2 and AT1 instruments (in that order) for a bank or bank holding company).

  4. Section 166W(2) of the FSRA therefore places Flac Instruments into the creditor hierarchy for the purposes of South African insolvency law. This ranking of Flac Instruments under section 166W(2) of the FSRA then informs the application of the provisions for the valuation of liabilities in resolution under section 166Q of the FSRA and the "no creditor worse off" principle under section 166V of the FSRA applies.
  5. Given that Flac Instruments are provided a statutory ranking under section 166W(2) of the FSRA it is not necessary to set out the ranking of the Flac Instruments in the contractual terms of a Flac Instrument. All that is in fact required is that the contractual terms of the Flac Instrument state that the Flac Instrument is issued as a Flac Instrument and ranks in a winding up or liquidation of the designated institution as set out in section 166W(2) of the FSRA.
  6. Given that the ranking of a Flac Instrument would only apply in the winding-up or liquidation of the designated institution and for the purposes of the exercise of a resolution power (including a bail-in power) would have that ranking, it is submitted neither necessary nor legally correct to refer in the Draft Flac Standard to the Flac Instruments as being "subordinated debt instruments".
  7. When a liability is subordinated, it presupposes (among other things) that the liability is not payable by the debtor unless a particular condition is fulfilled. This is not the case for Flac Instruments. First, the ranking of a Flac Instrument only applies in liquidation or winding-up (which in turn informs the ranking for resolution purposes). Second, the claim of a holder of a Flac Instrument is not stated to be conditional in a liquidation or winding up of the designated institution i.e. it is not conditional on the assets of the designated institution exceeding its liabilities. If it were, then the liability would likely not be capable of being proved in a liquidation or winding up of the designated institution as it would not be a conditional claim within the meaning of section 48 of the Insolvency Act. This outcome would not, it is submitted, accord with section 166W(2) of the FSRA.
  8. What is intended under section 166W(2) of the FSRA is that the full claim under the Flac Instrument may be proved in a liquidation or winding-up of the designated institution but the distribution from the free residue of the insolvent estate towards liabilities that are Flac Instruments is limited to what is remaining of the free residue after unsecured creditors are paid. One would classify this claim under a Flac Instrument, it is submitted, a senior non-preferred concurrent or unsecured claim rather than as a subordinated claim because the entitlement to have the claim settled in liquidation is only to that portion of the free residue remaining after unsecured creditors have been paid in full. It would not be correct to term Flac Instruments as "senior unsecured" instruments, as has been suggested in some quarters, since it would be misleading in light of their ranking in liquidation to use this terminology. A recognition of the ranking stated in section 166W(2) of the FSRA should be included in the terms of foreign law governed Flac Instruments.
  9. For the above reasons, it is submitted that references to Flac Instruments being "subordinated" in the Draft Flac Standard should be deleted.

Conclusions

  1. Flac Instruments are central to South Africa's efforts to ensure that systemically important banks can absorb losses and be recapitalised without the need for taxpayer-funded bailouts. Their introduction will mark a significant step in aligning with global best practices for resolution of such banks in distress scenarios.
  2. Unlike traditional regulatory capital instruments (e.g. AT1 and T2 instruments), Flac Instruments are distinct in that they are designed primarily for use in resolution scenarios. They are not intended to be activated in the ordinary course of business but rather serve as a critical buffer in times of financial crisis (either for a particular institution or in a systemic crisis).
  3. Flac Instruments represent a proactive measure to safeguard South Africa's financial system, offering a structured and legally sound approach to managing systemic risks. Their successful implementation will depend on careful consideration of legal, regulatory and market dynamics, as well as continued alignment with international standards. The contractual recognition requirement for local law relating to Flac Instruments and the ranking eligibility requirement highlighted in this note are two elements of the implementation of the South African Flac Instruments requirements that if not undertaken correctly run the risk of making raising of the loss absorbing capital challenging for South African banks.

  4. In summary:

    (a) the requirement for recognition of the SARB's resolution and bail-in powers should not apply for local law Flac Instruments as it is not required as a matter of South African law and may create legal risks if it appears that the bail-in powers require contractual buy-in in a South African context to be effective;

    (b) the requirement for recognition of the SARB's resolution and bail-in powers for foreign law governed instruments should be clarified and specify either in the final Flac Instruments prudential standard or a separate prudential standard what the contractual recognition of the bail-in powers of the SARB should entail to ensure (A) consistency, and (B) that the bail-in powers of the SARB can be applied effectively with regard to Flac Instruments governed by the laws of another jurisdiction; and

    (c) the ranking requirement for Flac Instruments should be reconsidered in light of section 166W(2) of the FSRA which affords a statutory ranking to Flac Instruments.

1 An "open-bank resolution strategy" refers to the way the South African Reserve Bank intends to deal with a failing bank or holding company of a bank that is a systemically important financial institution ("SIFI"). The main aim of this strategy is for the SIFI bank or holding company to remain open in resolution and continue providing critical functions (instead of closing the SIFI bank or holding company and using mechanisms such as liquidation).
2 See paragraph 8.4 of the Draft Flac Standard.
3 Section 1 of the FSRA.
4 The definition of "bank" in the FSRA includes a "bank" as defined in the Banks Act.
5 Defined in section 1 of the FSRA as "a holding company as defined in section 1 of the Companies Act, being a company incorporated in South Africa".
6 Prudential standards are made by the Prudential Authority under section 105 of the FSRA.
7 "Resolution" is defined in section 1 of the FSRA, in relation to a "designated institution" as "the management of the affairs of the designated institution as provided for in Chapter 12A" of the FSRA.
8 Section 166S(7) of the FSRA.
9 Section 166T of the FSRA.
10 Section 166D(1)(k) of the FSRA.
11 A qualitative trigger point is a contractual clause that provides for a trigger other than a breach of a specified CET1 ratio.
12 Noting that if conversion is the contractual bail-in mechanism, the Prudential Authority may require a write-off to occur if the conversion cannot be implemented.
13 The conditions to the commencement of resolution are that (a) the SARB is of the opinion that (i) a designated institution is, or will likely be, unable to meet its obligations, irrespective of whether or not the designated institution is insolvent, and (ii) it is necessary to ensure the orderly resolution of the designated institution to (A) maintain financial stability, or (B) in the case of a bank or a member of a group of companies of which a bank is a member, to protect depositors of the bank, and (b) the SARB has recommended to the Minister of Finance that the designated institution be placed in resolution.
14 Section 166V of the FSRA.
15 See the SARB Discussion Paper entitled "Ending too big to fail: South Africa's intended approach to bank resolution" published in July 2019 and the proposed directive published by the Prudential Authority for comment on 28 March 2024 entitled "Loss absorbency requirements for additional tier 1 and tier 2 capital instruments".
16 Guidance Note 6 of 2017, issued on 14 August 2017 by the SARB, providing guidance on the loss absorbency requirements for AT1 and T2 instruments states that the contractual terms must clearly indicate whether the instruments will be written off or converted into the most subordinated form of equity at the occurrence of a trigger event. This requirement is proposed to be carried into the new directive to be published by the Prudential Authority entitled "Loss absorbency requirements for additional tier 1 and tier 2 capital instruments" (see footnote 14 above).
17 Limitations on the exercise of the SARB's powers are contained in Chapter 12 of the FSRA in relation to protected contracts and liabilities. Furthermore, the exercise of the SARB's powers will generally be subject to review under the applicable South African constitutional and administrative law principles including the principle of legality.
18 See, for example, Article 55 (Contractual recognition of bail-in) of the EU Bank Recovery and Resolution Directive (2014/59/EU) as read with.
19 "External Flac instruments" are defined in the Draft Flac Standard as "Flac instruments that are issued by the holding company of the designated institution, to external counterparties, outside the group of which the designated institution is a member".
20 In practice, however, South African bank holdings companies issuing AT1 and T2 instruments in foreign markets have been including contractual recognition of the SARB's bail-in powers in the terms of these instruments.
21 A "bridge company" is a company incorporated under section 166F of the FSRA.
22 The term "free residue" is defined in the Insolvency Act as "that portion of the estate which is not subject to any right of preference by reason of any special mortgage, legal hypothec, pledge or right of retention". In other words it is the portion of the insolvent estate remaining after the claims of all secured creditors are paid out of the proceeds of the assets over which they hold security interests.

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This article is prepared for the general information of interested persons. It is not, and does not attempt to be, comprehensive in nature. Due to the general nature of its content, it should not be regarded as legal advice.

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