Financial crisis: Q&A (UK)

Practical Law UK Articles 9-383-6743 (Approx. 59 pages)

Financial crisis: Q&A (UK)

by PLC Corporate, PLC Finance, PLC Financial Services and PLC Dispute Resolution

Banks and credit markets

What caused the financial crisis?

The crisis started in the summer of 2007 and was initially referred to in the media as the "credit crunch" or "credit crisis". This referred to the lack of availability of credit in the industrialised world. At the outset, lack of liquidity was widely viewed as the main problem but the crisis has proved longer-lived than expected and has escalated. In September and October 2008, a number of US and European financial institutions collapsed while others were nationalised or merged with government assistance.

Most commentators highlight the rising rate of defaults on subprime mortgages in the US (as interest rates rose and house prices fell) as the trigger for the crisis. Many subprime mortgages had been securitised (and then resecuritised via collateralised debt obligation vehicles) and sold internationally to investors so the potential losses spread far beyond lenders involved directly in the subprime market. As defaults increased, investors reassessed the risk of their investments in structured financial instruments giving exposure to subprime mortgages. It became difficult to value these assets as investors feared that rising defaults on subprime mortgages would lead to widespread foreclosures which would further depress property prices. In this downward spiral of confidence, investor-appetite for structured financial instruments fell dramatically.

Given the lack of transparency about which institutions were exposed to subprime-linked assets and the size of the losses to which those exposures would give rise, financial institutions became unwilling to lend to each other. This liquidity shortage exposed underlying structural weaknesses within the banking system, including over reliance by some banks on wholesale funding rather than savers' deposits to fund their business and the inadequate capitalisation of many banks.

A number of high-profile financial institutions (such as Fannie Mae, Freddie Mac and Lehman Brothers) perceived to be undercapitalised or with a significant exposure to the subprime sector failed in the summer and early autumn of 2008. Market stress increased rapidly. Parties tried to limit their exposure to financial institutions as fears of further failures rose, leading to the announcement by the UK government of a package of measures to tackle systemic issues (see What measures have been taken by the UK government, Bank of England and the regulatory authorities to support the banks and the interbank lending market?). Similar measures were adopted internationally.

Other contributing factors to the financial crisis include:

Ample liquidity and low interest rates. This led to a "search for yield" by investors in financial markets, which in turn drove the development of complex financial instruments using leverage to generate higher returns for investors.
Decline of lending standards. The widespread securitisation of loans (and other receivables) under an "originate to distribute" model meant originating lenders did not have to keep lending standards high as they could transfer the risk of the underlying contracts. In the US subprime sector, unsound lending practices were also possible because of a weak regulatory regime and high demand from investors.
Undervaluation of risk. Competition for highly leveraged structured financial instruments led to credit risk being mispriced; the price reflected competition for the assets rather than a genuine assessment of underlying credit quality. Additionally, economic conditions were benign for an extended period which led to expectations that they would remain so. In these buoyant conditions highly leveraged instruments remained attractive.
Remuneration. Bonus structures in financial institutions encouraged risk-taking; rewarding short-term gains even if these would be reduced or wiped out by losses in the longer term.
Mark to market accounting. As financial institutions rushed to improve their capital position, they started to sell off assets. This forced selling caused asset prices to fall. Due to the mark to market accounting rules, financial institutions had to readjust asset values in their accounts to reflect the latest market prices, which further weakened their capital position.
Credit rating agencies. Investors relied too heavily on credit ratings assigned to products by the credit rating agencies (CRAs) without doing any independent risk analysis or, in fact, understanding what they were buying. Many investors misunderstood the fact that ratings only measure credit quality and do not capture the risk of a decline in market value or liquidity of an instrument. When the ratings agencies started downgrading instruments in the summer of 2007, many investors lost faith in ratings and stopped buying complex instruments altogether.

It is likely that a number of these contributing factors will be addressed by regulation (see What are the key areas for regulatory reform?).

What impact has the financial crisis had on credit markets?

The financial crisis has resulted in:

Decreased liquidity in the interbank market. Financial institutions have been lending to one another far less in the interbank market than usual. This is because they have been concerned about the solvency of other institutions or have wanted to keep cash reserves for themselves.
Decreased wholesale funding to banks. The availability of wholesale funding (for example via money market mutual funds) to banks decreased as investor-appetite for commercial paper issued by banks fell and such investors moved their money to perceived safe havens, such as gold and sovereign debt.
Decreased lending and bond issuance. Financial institutions have hoarded cash to meet their existing obligations and have generally been less willing to extend credit to businesses and individuals. Data from Dealogic showed that US$401 billion of new international syndicated facilities were signed in the third quarter of 2008 compared to a peak of US$768 billion in the second quarter of 2007. Similarly, net bond issuance declined with the third quarter of 2008 seeing the lowest level of net issuance since the third quarter of 2005. More recently the bond market has started to pick up. The Financial Times reported on 18 January 2009 that European companies had sold record volumes of bonds so far in the year, with US$15.2 billion of bonds sold by non-financial European companies in the second week of January 2009, and the first issuance in the European junk bond market since mid-2007.
Higher borrowing costs. Despite historically low base rates, lending margins and bond spreads have increased. For example, the Financial Times reported on 1 December 2008 that National Grid had issued six-year bonds at 3.3% above the interbank lending rate (about seven times what it was paying prior to the credit crunch) and Daimler had issued three-year bonds at 6% above the interbank lending rate (nearly 20 times what is was paying in 2005).

In response, the UK government and the Bank of England have taken various measures to try to reinvigorate the credit markets (see What measures have the UK government, Bank of England and the regulatory authorities taken to support the banks and the interbank lending market?).

What impact has the financial crisis had on existing credit facilities?

The financial crisis has affected existing credit facilities in a number of ways, including the following:

Interest rates

The interest rate payable on credit facilities is commonly based on BBA LIBOR. Since the start of the financial crisis, banks have been reluctant to lend to each other and so BBA LIBOR has been much higher above the base rate for the relevant currency than usual, although recently the gap has started to reduce. However, this does not necessarily give the full picture as the Financial Times reported on 3 June 2009 that there are wide differencies between the rates at which individual banks can borrow. Larger institutions can fund themselves at around LIBOR levels, while smaller institutions have to pay, in some cases, more than 100 basis points above LIBOR. Prior to the credit crunch this was not usually the case; all financial institutions used to be able to borrow at similar rates in the interbank market.

Additionally, there has been concern that the rates provided by panel banks for the purposes of calculating the displayed screen rates for LIBOR have not, in all cases, reflected the true cost of funds for those banks. A bank may be motivated to understate its true cost of borrowing so as to signal to the market that it is creditworthy.

As a consequence of the above developments:

Some lenders may make a loss on lending if their actual cost of funds is higher than the LIBOR-based interest rate charged to the borrower.
Market disruption clauses may be invoked by lenders to re-price facilities to reflect their true cost of funding them. The Association of Corporate Treasurers (ACT) has said it expects these clauses only to be invoked if lenders generally are experiencing exceptional difficulty in raising funds in the interbank market or are paying materially more for interbank deposits than the displayed screen rates for LIBOR. To date, lenders have been reluctant to invoke market disruption clauses possibly out of fear it will indicate they are in worse financial health than other lenders or for borrower-relationship reasons. Notwithstanding this reluctance, there are examples of market disruption clauses being invoked outside the UK. For example, on 20 October 2008 Reuters reported that the market disruption clause in a US$350 million credit facility for Alrosa (a European company) had been invoked. The operation of a market disruption clause also gives rise to competition law concerns as it could result in the exchange of commercially sensitive information between lenders. All commercially sensitive communications within the syndicate should be carried out via the facility agent.
Parties may consider using shorter interest periods for new drawdowns and/or on the rollover of an existing loan. This is because the LIBOR rate for a shorter interest period may be significantly lower than for a longer period. For example, parties may agree interest periods of one week or less instead of the typical one, three or six-month interest periods.

Distressed borrowers

Some borrowers are finding it difficult to comply with the terms of their existing facilities as a result of the financial crisis. Terms that may be breached include the financial covenants and, if a company's financial position has deteriorated significantly, there is a risk that the company may go into a formal insolvency proceeding or not be able to pay its debts as they fall due. If a financial covenant breach is possible, the borrower should check if it has the right to exercise an equity cure and, if such a right exists, discuss with shareholders whether they are prepared to invest further equity for this purpose.

A material adverse change (MAC) event of default may be triggered by trading underperformance or poor prospects before the borrower breaches a financial covenant or an insolvency related event of default occurs. Historically, lenders have tended to wait for a financial covenant breach or an insolvency related event of default to occur before accelerating the facilities. This is due to the uncertainty of whether (under most formulations of the clause) a MAC event of default has actually occurred.

To avoid insolvency proceedings, some companies will have to consider debt restructuring with their lenders. For more detail on debt restructuring, see What are the restructuring options for companies in financial difficulty?

Pre-emptive drawing of revolving facilities

The financial crisis has led to fears that lenders will not make good on their commitments to lend money under existing facilities. This, combined with borrowers' anticipated need for liquidity, has led many borrowers to draw down their revolving facilities pre-emptively. Other borrowers have drawn on their revolving facilities as other sources of funds have dried up.

On 13 January 2009, the Financial Times reported on a survey of 137 large companies which revealed that banks have, on average, cancelled or refused to renew about a third of unused banking facilities for those companies. This is another reason why borrowers have pre-emptively drawn facilities.

Insolvent lenders

The solvency of certain financial institutions has been questioned, particularly following the collapse of Lehman Brothers. Accordingly, both lenders and borrowers need to be aware of the issues that arise if a lender becomes insolvent. For detail on these issues, see What issues arise if a bank becomes insolvent?

Debt buybacks

There has been a growing trend of borrowers (or parties related to them) buying back that borrower's syndicated debt in the secondary market (for more details, see Debt buybacks).

What impact has the financial crisis had on the terms of new credit facilities and commitment letters?

The financial crisis has had a severe impact on the terms of new credit facilities and commitment letters, namely:

Club deals

As liquidity has dried up, risk-sharing between lenders has become key on new facilities. Speakers at the Loan Market Association (LMA) conference, held in London on 16 October 2008, reported that those deals that are being done tend to involve an increased number of lead banks which arrange the deal on a club basis, rather than with a view to syndicating most of the debt. In many cases, this means that deals are taking longer to complete and are on more onerous terms.

Relationship banks have become more important to borrowers and these banks are perhaps focusing on getting firmer commitments from borrowers that ancillary business will be placed with them as a condition to making new loans available.

Commercial terms

Second lien finance is falling out of favour. In its place, mezzanine finance may be used. This is because, unlike second lien finance, mezzanine finance ranks behind senior debt in terms of payment even prior to acceleration.

Lenders are likely to require greater certainty on how facilities will be repaid at the end of their term. Currently, there is greater focus on borrowers showing that they are likely to be able to refinance those facilities by a bond issue.

It is also likely that:

Payment in kind mechanisms, such as PIK toggles (which were used in a number of 2006 and 2007 financing arrangements), will be less common.
Interest rates and facility fees will be higher than on comparable deals from 2006 and 2007. A February 2009 survey by the ACT reported margins having risen three to five times from their pre-credit crunch levels.
Financial covenants will be more stringent and facilities will no longer be made available on covenant-lite or covenant-loose terms.
The testing of financial covenants will be carried out more frequently.
Events of default which enable a lender to accelerate the facility will become more extensive and will include a MAC event of default.
The amount of debt offered as a multiple of the borrower's EBITDA will decrease compared to the preceding few years.

CDS pricing

In respect of some new facilities (particularly stand-by or back-stop facilities for commercial paper), lenders have been looking at alternative pricing mechanisms to the traditional method of charging interest at a fixed margin over LIBOR. One of the mechanisms is to use the price of the borrower's credit default swaps (CDS) at the time of drawdown as a reference for calculating the margin. The ACT has published a briefing note for borrowers, which highlights some issues of which borrowers should be aware if they agree to CDS-based loan pricing.

Market disruption

Various amendments to the usual form of market disruption clause have been discussed in the market. This is because during the financial crisis LIBOR (which is the traditional standard by which the interest rate for facilities is calculated) has not necessarily reflected the true cost of funds for many lenders (see Interest rates). Proposals have included:

Lowering the voting threshold level of lenders required to trigger the market disruption clause. (Historically, lenders together holding 30 to 50% of commitments have had the right to trigger the market disruption clause.) On the other hand, borrowers might seek additional protection by requiring lenders to warrant that each lender usually accesses funding at or below LIBOR.
Clarifying the facility agent's role in implementing the provisions, for example by obliging it to consult with the lenders at the request of one or more lenders.
Clarifying confidentiality issues when the agent passes on the cost of funds' calculation provided by a lender as a lender's funding rate is sensitive confidential information. Breaches of competition law could arise if this information is exchanged with competitor lenders.
Changing the LIBOR definition so a panel of reference banks is used, in the first instance, to determine LIBOR rather than using a screen rate. In this way, the funding costs of some of the smaller lenders in the syndicate can be taken into account as well as the larger lenders which will probably be contributing data for the purpose of calculating the LIBOR screen rates.
If the market disruption clause is invoked, charging the borrower a blended rate calculated from each lender's actual cost of funds. This would deal with lenders not wishing to disclose their actual cost of funds to the borrower. The agent would, however, pay each lender their actual costs of funds so this system would be administratively burdensome.

In June 2009, the LMA published amendments to its market disruption and cost of funds provisions, which have been commented on by the ACT.

Insolvent finance parties

Historically, facility agreements have been drafted on the assumption that lenders do not fail. However, the insolvency of Lehman Brothers has highlighted problems with previously little-negotiated provisions in facility agreements. For example, the following issues should be considered when drafting new facility documentation:

In many cases, the facility agent or security trustee can only be removed with its consent. Documentation may be amended so that an insolvent facility agent or security trustee can be removed without it having to take any positive action and without it being able to object to its removal. Often, the facility agent and security trustee can be removed by the majority lenders. Identifying who the majority lenders are so that the facility agent or security trustee can be removed is often an initial hurdle because in large syndicates the facility agent will be the only one who has details of the lenders and their commitments. The issue of ensuring security remains valid (particularly in civil law jurisdictions) upon a change of security trustee also needs to be considered.
Providing that the borrower does not have to pay a commitment fee to an insolvent lender.
Including express netting provisions for rollover loans so that a borrower is not at risk of a lender in financial difficulty failing to re-advance its portion of such a loan. Currently, many revolving facilities are documented so that a rollover loan is made by the borrower repaying the maturing loan to the lenders and redrawing a new loan in an amount equal to or less than the maturing loan, although in practice such loan is effected by a book entry only.
Catering for what should happen if it is known that one or more lenders will not advance their share of any drawdown.
Providing that an insolvent lender loses its voting rights in syndicate decision-making.
Giving the fronting bank which issues bonds/guarantees/letters of credit (Instruments) under a facility discretion to call for cash collateral from lenders in financial difficulty or to exclude such lenders from the group counter-indemnifying its obligations under the Instruments. Alternatively, structures where each lender issues an Instrument pro-rata to its commitment to the beneficiary may become more common, particularly if lenders are unprepared to take on the credit risk of acting as fronting bank.
If the insolvent lender is also the hedging counterparty for interest or currency swaps relating to the facilities, allowing set-off by the borrower between amounts owed under the facility agreement and the hedging agreement. Arrangements for ensuring that hedging arrangements are novated from the insolvent lender are also being considered in the market.
Providing a mechanism whereby a sub-participant under a sub-participation can become a lender of record if the creditworthiness of the lender which has sub-participated its interests in the facilities deteriorates or it becomes insolvent. Often, there will be tax or practical issues with a sub-participant becoming a lender of record, such as the borrower's consent being required or transfers only being permitted to qualifying lenders (for typical eligibility criteria, see PLC Finance, Facility agreement: drafting note: Qualifying Lender).
Borrowers may want much tighter restrictions on the lenders' ability to transfer their participation in facilities, particularly if there are undrawn commitments.

In June 2009, the LMA introduced finance party default provisions into its documents, which have been commented on by the ACT.

For more on issue arising in respect of insolvent finance parties, see What issues arise if a bank becomes insolvent?

Debt buyback provisions

As debt has increasingly traded at a discount during the financial crisis, borrowers (or parties related to them) have considered buying back their debt. This was often not explicitly addressed in documentation and issues have emerged. In response, the LMA published on 29 September 2008 an amended leveraged facilities agreement containing two debt buyback options (see Debt buybacks).

Forward-start facilities to refinance existing borrowings

Forward-start facilities are becoming more popular. As such facilities are signed well in advance of the maturity date for the facilities to be refinanced they offer borrowers the security of long-term funding at a known price. Such facilities also enable borrowers to be more confident about making going concern statements for the purposes of their accounts.

Commitment letters

In current conditions, arrangers and underwriters may seek to include a market MAC clause in the commitment letter. Such a clause means that their obligation to arrange or underwrite a syndicated loan is subject to no event occurring which constitutes a market MAC (that is a material adverse change to the international or domestic lending or capital markets) prior to the facility agreement being signed. Care needs to be taken over whether the market MAC applies just to events that occur after signing of the commitment letter or includes events that have already arisen but continue after signing.

It is also likely that a market flex provision (that is a provision that allows for pricing and structural changes to be made by the arranger of the loan if market conditions require) will be included more frequently in commitment letters and, indeed, exercised if the financial crisis continues.

What measures have the UK government, Bank of England and the regulatory authorities taken to support the banks and the interbank lending market?

UK government

The following measures have been taken by the UK government:

Banking (Special Provisions) Act 2008. The enactment of the Banking (Special Provisions) Act 2008 (Special Provisions Act). Under the Special Provisions Act, HM Treasury (Treasury) had the power to make an order to transfer to the public sector:
- Securities issued by banks and building societies; and/or
- Property, rights and liabilities of banks and building societies.
These powers were only capable of exercise until 20 February 2009 and only if it appeared to the Treasury to be desirable for either of the following reasons:
- Maintaining the stability of the UK financial system in circumstances where the Treasury considered that there would be a serious threat to its stability if the order were not made.
- Protecting the public interest in circumstances where financial assistance had been provided by the Treasury to the relevant bank and/or building society for the purpose of maintaining the stability of the UK financial system.
The Treasury made orders under the Special Provisions Act to nationalise Northern Rock and Bradford & Bingley. It also used its powers under the Special Provisions Act to transfer to a third party part of the respective businesses of Kaupthing Singer & Friedlander (a UK-based subsidiary of Icelandic bank Kaupthing Bank) and Heritable (a UK-based subsidiary of Icelandic bank Landsbanki). (For information on the government's actions to protect UK retail depositors in Landsbanki, see below.)
Banking Act 2009. The enactment of the Banking Act 2009, which largely came into force on 21 February 2009. It strengthens depositor protection and provides mechanisms for dealing with banks in financial difficulty (so effectively replaces the Special Provisions Act). Concerns about this and related secondary legislation have been raised by the Financial Markets Law Committee and the Banking Liaison Panel. In July 2009, the Banking Act 2009 (Restriction of Partial Property Transfers) (Amendment) Order 2009 (SI 2009/322), which seeks to address certain of these concerns, came into force.
On 25 February 2009, the detailed rules about the new procedures for the administration and winding up the affairs of failing banks in England and Wales came into force. Broadly, these mirror the existing regimes for administration and compulsory liquidation respectively. The main difference is that, in the case of the new administration regime, the focus is on protecting the bridge bank or private sector purchaser, following the transfer of the failed bank's property (as opposed to the more general aim of achieving the best results for creditors) and the focus in the new liquidation rules is on protecting retail depositors.
On 29 March 2009, the Building Societies (Insolvency and Special Administration) Order 2009 came into force. It applies Parts 2 (new insolvency procedure) and 3 (new administration procedure) of the Banking Act 2009 to building societies by amending the Building Societies Act 1986 (and other legislation). The insolvency procedure for failed building societies will be known as building society liquidation and the administration procedure for failed building societies will be known as building society special administration. As this legislation was brought in on an emergency basis to deal with the Dunfermline Building Society (Dunfermline) the Treasury subsequently issued a consultation paper on whether any modifications should be made to the building society special administration and building society liquidation procedures.
On 30 March 2009, powers granted under the Banking Act 2009 were used in relation to Dunfermline. Part of its business was transferred to the Nationwide Building Society. The partial transfer was designed to protect depositors and safeguard financial stability. Dunfermline's social housing loans (and related deposits) were transferred temporarily (until a permanent solution is found) to a bridge bank wholly owned by the Bank of England (and a company incorporated in Scotland). The remainder of Dunfermline's business was placed, pursuant to a court order, into building society special administration.
Bank recapitalisation scheme. The establishment of a facility to make tier 1 capital available to:
- UK incorporated banks which have a substantial business in the UK.
- Building societies.
Other UK banks can also apply to be included in the facility. On 15 April 2009, state aid approval was given to extend the availability of this scheme to 13 October 2009.
Credit guarantee scheme. For an interim period only, the establishment of a government guarantee of new short and medium term debt issuance to assist those financial institutions that have raised tier 1 capital by an amount and in a form acceptable to the government to refinance their wholesale funding obligations. On 15 April 2009, state aid approval was given to extend the drawdown window for this scheme to 13 October 2009. (The government had previously indicated they would seek state aid approval to extend the drawdown window for the credit guarantee scheme to the end of 2009 but do not seem to have done this.)
Guarantee scheme for asset-backed securities. The government will issue a full or partial liquidity or credit guarantee of eligible triple-A rated residential mortgage-backed securities backed by residential mortgages over properties in the UK meeting certain criteria. Guarantees are available to support issues by vehicles connected with those financial institutions that have raised tier 1 capital by an amount and in a form acceptable to the government.
Asset protection scheme. This scheme offers protection to eligible institutions against exceptional future credit losses on assets where there is the greatest degree of uncertainty about future performance given the current economic conditions. Eligible institutions could apply to participate in the scheme until 31 March 2009. The Royal Bank of Scotland group and the Lloyds Banking group have reached agreement with the Treasury to participate in the scheme.
Enterprise Act 2002 (Specification of Additional Section 58 Consideration) Order 2008. The enactment of the Enterprise Act 2002 (Specification of Additional Section 58 Consideration) Order 2008 (SI 2008/2645) to add maintenance of the stability of the UK's financial system as a public interest consideration. This allows the Secretary of State to intervene in relevant UK mergers, if maintenance of the UK's financial system is at stake, so that they can take place without reference to the UK competition authorities notwithstanding that there may be competition issues. This consideration was used to bypass referral to the Competition Commission in the merger between Lloyds TSB Group and HBoS plc.
Developing effective resolution arrangements for failing investment banks. The government's consultation: Developing effective resolution arrangements for failing investment banks is looking at the insolvency procedures for investment banks (see below).
Development of profit participating deferred shares as tier 1 capital for building societies. The Financial Services Authority (FSA) has worked with the Treasury to develop profit participating deferred shares (PPDS) to offer building societies more flexibility in their core tier 1 capital. It has determined that, in principle PPDS are capable of being treated as core tier 1 capital. Previously, the only source of core tier 1 capital available to building societies under FSA rules was reserves grown from internally generated profits. The introduction of PPDS means that building societies, like banks, now have the option of raising core tier 1 capital from external sources. A feature of PPDS is that they are more loss-absorbing than some other capital instruments. This feature will improve the quality of building society capital and its going concern loss absorbency.

Additionally, the government is scheduled to publish a white paper before summer 2009 describing its approach to the future of financial markets and setting out how it intends to achieve it. The proposals will cover, among other things, reducing the impact of the failure of financial institutions. It will also outline a programme of consultations to implement other parts of the Banking Act 2009.

Bank of England

The following measures have been taken by the Bank of England:

Special liquidity scheme. It made available a special liquidity scheme to banks, which was available for drawdown until 30 January 2009.
Discount window facility. It has established a discount window facility under which banks are allowed to swap eligible collateral for UK government securities at any time. From 2 February 2009, eligible institutions have been able to make drawings for a term of 364 days, as well as the previously available 30 days. This amendment to the facility was made to ensure the availability of long-term liquidity for banks after closure of the special liquidity scheme.
Sterling and US dollar auctions. Until such time as the market stabilises, it will provide auctions to lend to banks sterling for three months, and US dollars for one week, against an extended range of collateral.
Asset purchase facility. The establishment of an asset purchase facility (the Facility) to be provided by Bank of England Asset Purchase Fund Limited (the Fund) was announced on 19 January 2009. Since 2 February 2009, the Fund (a wholly-owned subsidiary of the Bank of England) has been authorised by the government to purchase from banks, other financial institutions and financial markets "high quality private sector assets", including corporate bonds, commercial paper, syndicated loans, paper issued under the government's credit guarantee scheme (see above) and certain asset-backed securities created in "viable securitisation structures". From 5 March 2009, the type of assets eligible for purchase by the Fund were broadened, for monetary policy purposes, to include UK gilts purchased in the secondary market. The Facility was initially authorised to make purchases up to an amount of £50 billion (funded by the issue of Treasury bills by the Debt Management Office) but this limit was subsequently raised to £175 billion. On 22 April 2009, the Chancellor wrote to the Governor of the Bank of England confirming the Facility would continue in the 2009/2010 financial year.
On 30 July 2009, the Bank of England extended the application of the asset purchase facility with the launch of a secured commercial paper facility. Under this new facility, the Bank of England will purchase asset-backed commercial paper from companies and investors in order to improve liquidity in the credit markets and support the provision of working capital to a broad population of companies.

What issues arise if a bank becomes insolvent?

Since the onset of the financial crisis:

Certain banks in the UK have been nationalised by the government due to solvency concerns (see UK government).
Measures have been taken by the Treasury and the Bank of England to support UK financial institutions at risk of insolvency (see What measures have been taken by the UK government, Bank of England and the regulatory authorities to support the banks and the interbank lending market?).
Steps have been taken by the Treasury to protect UK depositors with deposits in UK branches of foreign insolvent banks. For example, the UK government used the Anti-terrorism, Crime and Security Act 2001 to make an order to ensure that the UK funds of Landsbanki, an insolvent Icelandic bank which has branches in the UK, were not transferred from the UK until the position of the UK creditors of the bank had been clarified.

Various issues arise if a bank becomes insolvent, including the following:

Depositors

An insolvent bank is unlikely to be able to return all deposits held with it. Deposits held with institutions authorised by the FSA are protected to a limited extent by the Financial Services Compensation Scheme (FSCS). If a bank is insolvent and unable, or likely to be unable, to pay claims made against it by a depositor the FSCS may compensate the depositor. Currently, only the first £50,000 of savings are protected by the FSCS. The FSCS was set up mainly to assist private individuals, although smaller businesses are also covered. For reform proposals in this area, see Depositor protection.

Borrowers

Private individuals. The FSCS rules provide that, if a person owes money to a bank where he also has savings, the debts will be set-off against the savings when calculating eligibility for compensation under the FSCS. For example, if a person has £20,000 in savings and £15,000 outstanding on a loan from that bank then, if that bank becomes insolvent, he will only be eligible for £5,000 compensation. However, in January 2009, the FSA published a consultation paper proposing changes to the FSCS, including paying compensation to depositors on a gross basis.
Corporate borrowers under a syndicated facility agreement. A borrower normally does not have the right to terminate a facility agreement if a lender becomes insolvent. If a lender fails to fund its portion of a loan under a syndicated facility agreement, this is a breach of contract by that lender that may give the borrower the right to claim damages. The other lenders are usually only liable for their own commitments so do not have to fund the insolvent lender's portion of the loan.
If one of the syndicate lenders is insolvent, the borrower should try to establish whether that lender will in fact fund its portion of a loan. If it will not be doing so, the borrower should factor this into its cash-flow forecasts and look at the facility documentation to see whether it is possible to request a larger loan in anticipation of the insolvent lender failing to fund.
If the borrower has revolving facilities, the documentation usually specifies that a maturing loan must be repaid and then a new rollover loan redrawn in the same amount (or less), although in practice this is usually effected by book entries only. If the borrower is concerned that the insolvent bank will not honour its obligation to fund the "new" loan, then it should consider with the agent whether: (i) the rollover loan can be dealt with by book entries on the basis of an established course of dealings (albeit that this is technically at odds with the procedure to be followed as documented); (ii) the agent can exercise rights of set-off against the borrower and the insolvent lender (although it is arguable that standard LMA set-off provision do not allow the agent to set-off against the insolvent lender in these circumstances as the provisions relate to amounts under certain indemnity and costs provisions); or (iii) the facility agreement can be amended.
In June 2009, the LMA introduced cashless rollover provisions into its documents.
See also Insolvent finance parties.

Co-lenders under a syndicated facility agreement where the insolvent bank is the facility agent

If the insolvent bank is to continue in its role as facility agent, funds held by it as facility agent need to be kept segregated from its other funds and held on trust for the other relevant lenders and parties. However, the other lenders are likely to want to replace an insolvent facility agent for practical reasons and to avoid any issue with payments channelled through it being considered part of the facility agent's assets. Syndicated facility agreements usually contain provisions that allow the facility agent to resign and for the majority lenders to appoint a successor but not for the facility agent to be removed without its consent. Although likely to be contrary to the terms of the facility agreement, the lenders and the borrower should consider making payments direct rather than via the facility agent until a new facility agent can be appointed. See also Insolvent finance parties.

Counterparty to a sub-participation

If the insolvent bank is the lender of record and has entered into a sub-participation, the sub-participant has no proprietary claim to any payments made on the underlying loan by the relevant borrower to the insolvent bank. If the insolvent bank receives a payment from the borrower and does not pass it on to the sub-participant, the sub-participant will have to claim in contract against the insolvent bank for the amount of such payment. The LMA has published a paper on mitigation of grantor credit risk, which sets out possible options for a sub-participant in a funded sub-participation to mitigate the risk of the lender of record becoming insolvent.

If the insolvent bank is the sub-participant, the lender of record is unlikely to receive payments from the insolvent bank to fund future loans requested by the borrower. Nonetheless, the lender of record has a contractual obligation to the borrower to meet any drawdown requests irrespective of whether it receives funds from the sub-participant. If the lender of record has to pass on a payment received from the borrower to the insolvent sub-participant, it should consider whether set-off of that payment against other amounts owed to it by the insolvent sub-participant is possible. If not, it will have to pass on the payment.

Solicitors' liability for client funds if bank collapses

The Law Society has published a practice note (updated on 30 December 2008 and again on 8 January 2009) which gives advice to solicitors handling client funds on how to mitigate the risk of incurring any liability if such funds are lost as a result of a bank collapse.

Prime brokerage

Issues have arisen in connection with the UK subsidiary of Lehman Brothers, which is in administration. This subsidiary was carrying on prime brokerage activities and was therefore holding client assets. To date, the administrators have been unable to return these client assets due to the way the administration process works. In response, the government is consulting on whether it is appropriate to make changes to market or regulatory practice or to lay secondary legislation to address issues around prime brokerage that arise on insolvency of investment banks.

Why are people talking about credit default swaps?

Over recent years the size of the CDS market has grown rapidly so that by the end of June 2008 the notional amount of outstanding CDS contracts was approximately $54.6 trillion according to an International Swaps and Derivatives Association (ISDA) market survey. CDS contracts have come under the spotlight due to the size of the market and the failure or near failure of a number of financial institutions heavily involved in the CDS market. Key concerns raised include:

Lack of transparency and counterparty risk. Most CDS contracts are not traded through an exchange or other multilateral trading platform as they are individually negotiated. Information about CDS sellers' potential exposure to a particular reference entity and the value of CDS contracts sold by an institution in financial difficulty is not reliable. The problem is amplified as CDS contracts (which were originally mostly used to hedge risk on a bond or other financial instrument held by the protection buyer) are now widely traded on a speculative basis (that is the protection buyer has no interest in an underlying bond or financial instrument issued by the reference entity). If a significant participant in the CDS market or a reference entity on which significant CDS contracts have been written fails it is difficult to predict the knock-on effects. This adds to market instability.
Lack of a central clearing mechanism. A central clearing counterparty (CCP) reduces counterparty and operational backlogs (such as formal confirmation of trades) by establishing and monitoring strict financial and operational criteria. The use of a CCP also means that post-default there is a standardised and transparent procedure for close-out valuation methodology and terminating and settling contracts. Without a CCP there are likely to be a variety of close-out approaches, depending on the terms of the particular contract even if that contract is based on an industry standard form contract. ISDA has published a number of protocols for dealing with the settlement of CDSs referencing particular entities (for example, Freddie Mac, Fannie Mae and Lehman Brothers). Such protocols have converted physically settled CDS into cash settled CDS. On 12 March 2009, it published a supplement and protocol (also known as the "Big Bang Protocol") which, if adhered to, incorporate CDS settlement auctions into the 2003 ISDA Credit Derivatives Definitions. Restructuring credit events were excluded from the auction process. On 14 July 2009, ISDA published a further protocol and supplement (also known as the "Small Bang Protocol") which, if adhered to, extend the standard CDS auction hardwiring provisions to restructuring credit events.

As a result of the financial crisis, it is widely expected that there will be greater regulation of the CDS market in Europe. The European Commission established an industry working group to make concrete proposals before the end of 2008 on how to mitigate the risks from credit derivatives, including CDS. On 19 February 2009, ISDA announced that nine of the leading dealer firms had agreed to use EU-based central clearing for eligible EU CDS contracts by the end of July 2009. This move came after an earlier threat in a speech on 3 February 2009 by Charlie McCreevy, European Commissioner for Internal Market and Services, that a regulatory approach would be necessary in the absence of a voluntary commitment from industry to clear trades on at least one European CCP. Towards the end of July 2009 Eurex Clearing and ICE Europe launched European CCPs for certain CDS products.

The European System of Central Banks and the Committee of European Securities Regulators have made recommendations to public authorities about CCPs.

Clearly, any EU legislative proposals that affect the derivatives market will impact on the UK regulatory regime. Consideration is being given to a number of areas, including:

The standardisation of over-the-counter derivative instruments.
Setting up a CCP for derivatives trades.
Increasing transparency in the derivatives market.

CDS are also being talked about in the context of pricing loans (for more on this, see CDS pricing).

What litigation is going to come out of the financial crisis?

The global turmoil in the credit markets and the losses suffered by banks, financial institutions, companies and ordinary investors raises the question, is a substantial upturn in contentious work now on the cards?

Leading law firms are reporting an increase in pre-litigation advice. Documentation relating to complex debt instruments such as collateralised debt obligations (CDOs) and structured investment vehicles (SIVs) has not been "stress tested". These documents are likely to be scrutinised and potential for claims considered.

The financial crisis hit the US some months before the UK. Accordingly, events in the US may provide some assistance when considering what litigation may arise in the UK. However, the differences between the two legal systems should be borne in mind. Key differences in litigation practice and procedure include limited pre-action activity, jury trials and the prevalence of class actions. This may mean that the UK will not see the same volume of litigation as the US, although similar issues are likely to arise.

Summarised below are some of the key players and types of claims which may be arise in the current economic climate.

Possible litigation parties

Potential claimants

The potential claimants include:

Shareholders. In the past year, shareholders have seen the value of their investments fall by a significant amount as companies and the stock market continue to suffer substantial losses. In some cases their investments have been virtually wiped out.
Borrowers. Lenders, facing their own liquidity crises, may be unable or unwilling to meet their funding obligations to borrowers under their credit facilities or their commitment letters (see Borrowers). With alternative sources of finance likely to be in short supply, borrowers may sue lenders to enforce their obligations.
UK government. The government may seek to hold the persons they consider responsible for the market collapse financially or criminally liable for their actions. There may also be claims by public authorities who have invested their funds in banks which have collapsed such as the Icelandic bank, Landsbanki.
Investors. Investors who have suffered losses may bring claims relating to advice given in relation to the purchase, investment and sales of securities.
Pension claims. This may include claims by trustees and/or beneficiaries of defined benefit pension schemes against an employer company (or liquidators) for contributions to prop up an ailing scheme fund. Alternatively, a dispute might arise if the employer takes steps to deal with the credit crunch (for example a corporate reorganisation) which arguably "triggers" an employer debt under pensions legislation (see Pension liabilities).
Employees. Employees who have seen the value of their pension and other retirement plans plummet in value may seek to sue their employers.
Mortgage lenders. As borrowers default on mortgage payments lenders will be seeking to enforce their security and may also look to professionals who advised them on the transaction to recover any shortfall.

Potential defendants

Potential defendants include:

Ratings agencies. Many investors are wondering whether credit rating agencies who assigned high credit ratings to mortgage-backed securities properly managed their conflicting interests or even understood the securities they were rating (see Credit rating agencies).
Mortgage lenders. Mortgage lenders are being accused of lax lending practices resulting in mortgages being issued to risky borrowers.
Directors. Those who managed failed or troubled companies may be accused of not disclosing material information about their companies' financial condition including any exposure to subprime mortgages and mortgage-backed securities. These claims may be covered by directors and officers' liability insurance. Officers and directors may also be subject to criminal liability and allegations of wrongful and/or fraudulent trading in any insolvency situation (see What issues should directors of a company in financial difficulty bear in mind? ).
Investment banks. Investment banks are accused of creating risky securities with complicated structures that even they did not fully understand.
UK government. Claims may be brought against the government by shareholders and investors who have suffered losses in financial institutions following government intervention and nationalisation. The government's actions may also be subject to judicial review.
Brokers. Claims of misselling may arise.
Professional advisors. Solicitors, financial advisors, actuaries and accountants may face claims in professional negligence.
Companies. In pensions claims, the defendants would usually be those who have funds to contribute to the scheme, or may influence its funding position: that is, employer companies (or liquidators) or professional advisers (who are backed by insurers).
Trustees of pensions claims. It is possible that trustees might face breach of trust claims in relation to their duties to a pension scheme.

Types of claims

There are a number of claims that claimants may assert.

Breach of contract

Borrowers may seek to force lenders to comply with their lending obligations under various financing documents alleging breach of contract against lenders. Potential remedies may include applications for specific performance although consideration of whether damages are an adequate remedy will be relevant.

Inadequate disclosure

Claimants may argue that officers, directors and underwriters of financial institutions were guilty of failing to disclose material facts such as:

The extent of their mortgage-related losses.
The strength of their finances.
Conflict of interests.

In addition, many investors are accusing credit ratings agencies of being too close to the banks and issuers who paid for their ratings and not issuing independent and untainted ratings on which the market in practice relied.

Misrepresentation and misselling

Investors may run claims alleging misrepresentation and negligent misstatement made by financial institutions and brokers. Documentation will need to be analysed to assess the validity of any exclusion clauses as will the relationship of the parties and the extent of any duty of care.

It may be an uphill struggle for experienced and sophisticated investors to establish that banks owed them a duty of care. For example, see the cases of JP Morgan Chase Bank & Ors v Springwell Navigation Corporation & Ors [2008] EWHC 1793 (Comm) and JP Morgan Chase Bank and others v Springwell Navigation Corporation [2008] EWHC 1186 (Comm).

While the events surrounding the Springwell cases took place a decade ago it is useful to apply the court's reasoning to potential disputes arising out of the credit crunch where significant gains had been expected.

Professional negligence

Claims may be brought in negligence against solicitors, financial advisors, accountants, actuaries and other advisors. Allegations that the advice fell below the standard reasonably required and that this resulted in losses may well be run. There is a duty to mitigate loss for claimants and therefore it may be some time before such claims emerge.

In any such claims the relationship between the parties will need to be considered including an analysis of which duties were owed to which parties and by whom.

Breach of fiduciary duties

Investors may allege that banks owed them a fiduciary duty. In the absence of an express written record to establish such a relationship, it may be difficult (but not impossible) to establish such a relationship. Again the judgments in the Springwell cases may be instructive (see Misrepresentation and misselling).

Review of transactions following insolvency

On the onset of insolvency a director's duty is to the creditors of the company. Following the insolvency of a company there is likely to be a review of the directors' conduct for circumstances which may give rise to claims for fraudulent and wrongful trading. This may lead to proceedings against directors or those found to be shadow directors. See What issues should directors of a company in financial difficulty bear in mind?

To achieve a better and speedier recovery than would be available to unsecured creditors of an insolvent company, creditors may seek to assert proprietary rights over the company's assets following the onset of insolvency (for example, see RAB Capital Plc & RAB Capital Market (Master) Fund v Lehman Brothers International (Europe) [2008] EWHC 2335).

A company's insolvency may also trigger the winding up of any associated occupational defined benefit pension schemes, and the trustees will also become creditors (regulatory bodies such as the Pensions Regulator and Pension Protection Fund may also become involved).

Increase in arbitration?

It is not yet clear whether the credit crunch will lead to an increase in arbitration, and the confidentiality of arbitration means that reliable statistics are elusive. The flexibility, confidentiality and cost-effectiveness of arbitration as a dispute-resolution mechanism may make it an attractive choice for parties. Similarly, the ability to appoint an arbitrator with banking or market expertise may make arbitration a particularly appropriate method for determining difficult issues relating to usual or market practice. Certainly, established securities arbitration/mediation schemes (such as that operated by the Financial Industry Regulatory Authority, known as FINRA, in the US) suggest that litigation should not be regarded as the only option.

On the other hand, the lack of any reliable mechanism for joining third parties and the fact that certain issues relating to corporate insolvency may not be arbitrable in all jurisdictions are factors pointing towards litigation rather than arbitration.

One topic which has provoked discussion in recent months is the possibility of investors invoking investment treaty protections via arbitration. Under investment treaties, governments undertake certain obligations to parties who invest in their country. Typically these include promises not to expropriate the investment, and to treat the investor fairly. Investors can enforce their rights under the treaty via arbitration.

It has been suggested that where, for example, the value of an overseas investor's holding has been diluted by government intervention (for example where a bank is nationalised), there may be potential for claiming against that government under a relevant investment treaty.

Pension claims

A dispute might arise if an employer takes steps to deal with the credit crunch (for example a corporate reorganisation) which arguably also "triggers" an employer debt under pensions legislation.

Difficult times might also prompt professional negligence claims by employers and trustees against the plethora of advisers to pension schemes (including lawyers, actuaries and accountants). In addition, trustees might also participate in investor claims to safeguard their scheme funding investments.

What are the long-term regulatory implications for banks and markets?

More financial services regulation

The financial crisis has exposed serious weaknesses in the regulation of the financial services sector. As a result, the legislative and regulatory requirements imposed on financial institutions in the UK are likely to be strengthened, and there will be further moves away from industry self-regulation.

Some sectors of the financial market, such as CRAs, will become regulated (see Credit rating agencies). In other areas which are already regulated, there will be more onerous or prescriptive regulation, such as enhanced capital, liquidity and transparency requirements (see Capital and liquidity requirements and Accountancy and valuation requirements).

Many of the proposed legislative and regulatory changes that have been initiated in response to the financial crisis are being driven by the European Community institutions, which aim to implement a harmonised package of regulatory reforms across the EU. The FSA is actively involved in discussions at EU level.

Changes to the FSA's regulatory regime

Despite calls for more prescriptive regulation, the FSA has indicated that it plans to retain its principles-based approach to regulation of the financial services industry in the UK. With this approach, the FSA focuses on the outcomes it expects from regulated firms, and not the means by which these outcomes are achieved. However, it does acknowledge that more prescriptive regulation will be necessary in certain areas, such as capital, liquidity and transparency requirements, to ensure financial stability and consumer protection. Whether the FSA is able to retain its principles-based approach in the long term will depend upon the detail of the EU legislation that is produced responding to the crisis, as the UK authorities will have to implement this. The key areas where UK regulatory reform is expected, or likely, are set out below (see What are the key areas for regulatory reform?).

The financial crisis has highlighted weaknesses in the FSA's supervision of regulated firms. The FSA has recognised this and has been working to enhance and strengthen its supervisory arrangements. These improved arrangements are designed to help minimise the risk of future crises, by focusing the FSA's supervisory resources on the high-impact, systemically important, firms. For such firms, it is likely that the FSA's supervision has already become more intensive and invasive, particularly in relation to their risk management arrangements.

The FSA is also actively involved in European and international initiatives to improve the oversight of major cross-border financial services institutions and groups (by establishing supervisory colleges), and to strengthen the co-operation and co-ordination of national regulators in ensuring financial stability oversight and crisis management, both among jurisdictions within the EU and between the EU and other major jurisdictions (see Global solutions are needed for global problems).

There may be an increased risk of FSA enforcement action against regulated firms who do not maintain adequate capital and liquidity or who do not have sound risk management systems and controls in place. The FSA's enforcement strategy (known as its "credible deterrence" strategy) is designed to create a genuine expectation that wrongdoing in the financial services industry will be identified and punished, thereby protecting consumers and guarding against abuse in the financial markets.

Global solutions are needed for global problems

The financial crisis has shown just how great an impact the failure of a financial institution in one jurisdiction can have on consumers, businesses, financial institutions and economies around the world. It is generally recognised that global solutions are needed to minimise the risk of another crisis occurring.

As indicated above, many of the changes that will be made to the UK regulatory regime will be shaped by European legislation. International initiatives relating to the global regulatory framework (known as the international financial architecture) will also play an important part in shaping EU and UK regulatory regimes. In addition to regulatory reform, international initiatives are also underway to improve the oversight of cross-border financial services institutions and groups by establishing supervisory colleges for all major cross-border financial institutions and to strengthen cross-border co-operation and crisis management arrangements among regulators and supervisory authorities.

The first international summit on the financial crisis, attended by representatives of both the developed and the developing world, was held by the G20 in Washington DC on 15 November 2008. World leaders present at the summit agreed to continue to work together to support the global economy and stabilise financial markets. They also agreed on a number of common principles for reform of the financial markets, and launched an action plan to implement these principles (with priority actions to be completed by 31 March 2009). The key principles tie in with, and are likely to influence, the EU and UK initiatives summarised below (see What are the key areas for regulatory reform?). Progress on implementing the agreed principles will be reviewed at the next G20 summit, chaired by the UK, which will take place in London on 2 April 2009.

Although regulators around the world recognise that action to improve the current financial services regulatory regime is urgent, there are concerns that reform should not take place before the financial markets have stabilised. Reaching global consensus on the regulatory reforms is likely to take some time, and may well result in a dilution of the proposals for reform. It is, therefore, difficult to give an accurate indication of when these international initiatives will be implemented, how the UK regulatory regime may change as a result of these initiatives and how these initiatives will interact with similar initiatives at European and UK level. However, it is now clearer, following the November 2008 G20 summit, that significant reform of certain key areas is likely to be progressed by the end of March 2009.

In October 2008, the Chancellor of the Exchequer asked Lord Turner, FSA Chairman, to make recommendations for reforming both the UK and the international approach to banking regulation, to ensure the future stability of the UK banking system (known as the "Turner Review"). The Turner Review will address "fundamental questions raised by the unprecedented events in financial markets over the past year", including the FSA's supervisory approach, and policy relating to capital, liquidity and remuneration.

The FSA is expected to publish the findings from the Turner Review on 18 March 2009. They will be accompanied by a detailed discussion paper which will set out the FSA's proposals for changes in regulation and supervisory approach which it considers need to be made. The Tuner Review will undoubtedly be influenced by the decisions reached at the November 2008 G20 summit.

In February 2009, an independent high level group chaired by Jacques de Larosière published a report on the future of European supervision and regulation. In broad terms, the group recommends the taking of "a number of critical policy changes", at European and international level, to prevent a recurrence of the type of systemic issues and vulnerabilities to which the financial crisis has given rise. In his foreword to the report, M. de Larosière urges "enhanced, pragmatic, sensible European cooperation for the benefit of all to preserve an open world economy".

The European Commission President, José Manuel Durão Barroso, has described the report as "a balanced and rich report which provides a good basis for further Commission work". On 4 March 2009, the European Commission will publish a communication giving an initial assessment and preliminary response to the group's main proposals as outlined in the report. This communication will set out how the European Commission intends to take the group's proposals forward and will form the basis for its contribution to the spring meeting of the Council of the European Union. President Barroso has made clear that the report confirms his "firm belief that a European system of financial supervision is indispensable".

What are the key areas for regulatory reform?

The financial crisis has exposed a number of actual or potential regulatory gaps which need to be reviewed and, if necessary, addressed. Although international initiatives to reform the global regulatory regime are at an early stage, there is clearly a large degree of overlap with international, EU and UK initiatives that are either already underway, or planned.

The main areas where regulatory reform is expected in the UK are summarised in the sections below.

Capital and liquidity requirements

A failure by banks to properly manage the capital and liquidity risks to which they have been exposed has been a major factor contributing to the financial crisis (see What caused the financial crisis?).

The FSA has already increased its supervisory focus on banks' compliance with existing capital and liquidity requirements, and on how they manage risk. This has resulted in many firms having to hold increased levels of capital so as to ensure compliance with the FSA's regulatory requirements. Also, the FSA now expects regulated firms to take into account market volatility in their risk models and stress testing arrangements to ensure that they maintain capital at levels that will enable them to withstand extreme events in the future. For many firms, this means more robust and rigorous stress and scenario testing.

In the long term, prudential regulations are likely to be amended to impose tougher capital and liquidity requirements on regulated firms. Consideration is also being given to "counter cyclical" provisioning, which would effectively require banks to build up a general loss reserve during good times which would be drawn down when the economy deteriorates and actual losses are incurred, as well as more effective measures to ensure that highly leveraged "shadow banking entities" do not escape prudential regimes.

The FSA launched a consultation, in December 2008, setting out its proposals for "a far-reaching overhaul" of the liquidity requirements for banks, building societies and investment firms (CP08/22). The amended rules are designed to significantly enhance firms' liquidity risk management practices (thereby increasing the stability of the UK financial markets), and to improve the FSA's ability to monitor and supervise firms' liquidity risk exposures. The new liquidity regime will require firms to undertake individual assessments of their liquidity risks. Firms will be required to manage their liquidity risks either by managing their assets and liabilities to reduce possible liquidity demands, or by holding truly liquid assets to offset possible demands. The new regime is intended to minimise the possibility that institutions will require emergency liquidity assistance from the central bank, and to lead to a reduction in reliance on overnight funding.

The FSA has indicated that the proposals in CP08/22 are based on agreed international liquidity standards, particularly the Basel Committee on Banking Supervision's (BCBS) revised principles for sound liquidity risk management and supervision, and the liquidity work of the Committee of European Banking Supervisors (CEBS).

The FSA has advised that implementation of the tougher liquidity standards proposed in CP08/22 will result in firms having to review their current agreements and practices. It expects that many firms will have to significantly reshape their business models over the next few years. However, the FSA believes that the new regime will also bring substantial long-term benefits to the competitiveness of the UK financial service sector through increased strength, resilience and market confidence. Comments can be made on CP08/22 until 4 March 2009. Thereafter, the FSA intends to publish feedback and policy statements to CP08/22 by April 2009, and is proposing to implement the amended liquidity regime by October 2009. The FSA also plans to publish a separate consultation paper on liquidity reporting in the first quarter of 2009.

In December 2008, the FSA also published a consultation paper setting out proposed changes to the rules and guidance on stress and scenario testing in various parts of the FSA's handbook of rules and guidance (CP08/24). These changes are intended to better reflect the importance the FSA attaches to robust stress and scenario testing and to clarify its expectations of firms. Comments can be made on CP08/24 until 31 March 2009.

In the longer-term:

The European Commission has published its legislative proposal to strengthen and improve the regime under the Capital Requirements Directive (2006/48/EC and 2006/49/EC) (CRD), in order to minimise the likelihood of a recurrence of the financial crisis. The European Commission is pushing for the swift adoption of these measures. In December 2008, the Council of the European Union agreed a general approach to amendments to the CRD and the European Parliament is expected to vote on these amendments in April 2009. However, a revised CRD is unlikely to come into effect quickly as, once amendments are adopted at EU level, EU member states are likely to have two years to implement them.
The BCBS has published for consultation its proposals to strengthen the Basel II capital framework, implemented across the EU under the CRD. The proposals follow a review of Basel II by the BCBS as part of its longer-term strategy to strengthen in a fundamental way banks' capital adequacy, risk management and supervision in view of weaknesses revealed by the crisis in the global financial markets. The strategy is designed to support the April 2008 recommendations of the Financial Stability Forum (FSF) to enhance the resilience of markets and financial institutions and the November 2008 G20 action plan (see above). The consultation closes to responses in spring 2009. The BCBS proposes that its trading book proposals be implemented no later than December 2010 and that its other proposed measures to strengthen Basel II be introduced in either July 2009 (that is, the proposed Pillar 2 risk management enhancements) or December 2009 (that is, the proposed Pillars 1 and 3 enhancements).

As indicated above, the FSA plans to publish a discussion paper (alongside the findings from the Turner Review), that will form part of a wider review of the global regulatory environment, in March 2009. In this paper, it will set out its views on required standards on liquidity, capital and risk management. In a speech in January 2009 on the financial crisis and the future of financial regulation, Lord Turner, FSA Chairman, said that it is essential to put in place new approaches to capital adequacy that would entail banks holding more capital against risky trading strategies and counter-cyclical capital requirements to build up adequate buffers during good economic times, which can be drawn on in bad. He confirmed that the FSA was working closely with the BCBS and the FSF to design the details of such a regime.

In the first or second quarter of 2009, the FSA plans to publish a consultation paper on the enhanced CRD package, and the Tripartite Authorities plan to publish a discussion paper on counter-cyclical measures.

Derivatives markets

For more on the reform proposals in this area, see Why are people talking about credit default swaps?

Depositor protection

Effective compensation arrangements for depositors are an essential component of protecting customers and enhancing confidence in the banking system. Due to concerns that current compensation arrangements are inadequate, consideration is being given at both UK and EU level to improve and, in particular, to increase, the levels of depositor protection under national deposit guarantee schemes. The European Commission is also keen for the level of cover to be harmonised across the EU.

In the UK, the FSA is consulting on changes to the depositor compensation arrangements available under the FSCS (for more information about the FSCS, see Depositors). Some of these changes would impact not only eligible depositors, but also eligible customers of other financial products and services. There has been particular controversy over proposals that the industry should pre-fund the FSCS, although this suggestion appears to be on hold for now.

On 7 January 2009, the FSA published a consultation paper (CP09/3) setting out proposals to speed up the payment of compensation by the FSCS to depositors in the event a deposit-taking firm (that is, a bank, building society or credit union) fails, in order to minimise hardship to depositors in these circumstances. In CP09/3, the FSA also outlines steps it proposes to take to increase public confidence in the FSCS by increasing their awareness and understanding of these arrangements. The FSA has indicated that the proposals set out in CP09/3 will predominantly require changes to FSA rules. In addition, operational changes to the FSCS have been made by the Banking Act 2009, which received Royal Assent on 12 February 2009.

Comments can be made on the proposals in CP09/3 until 6 April 2009. Subject to FSA Board approval, the FSA proposes that the rules on fast FSCS payouts will be implemented from 31 December 2010, and the new enhanced disclosure rules on consumer awareness will be implemented from 1 January 2010. The FSA has advised that it will consider how temporary high balances and client accounts should be treated under the FSCS in a further consultation paper in early 2009. It also plans in the future to look at the application of the proposals in CP09/3 to other types of claim covered by the FSCS.

The European Commission is pushing for the swift adoption of measures to improve national deposit guarantee schemes in the EU (by amending the Deposit Guarantee Schemes Directive (1994/19/EC)), and these measures will impact on the UK regulatory regime. In early December 2008, the Council of the European Union agreed a general approach to amendments to this Directive. Following which, the European Parliament adopted a report to amend the Directive (making amendments to the European Commission's original proposal) at a plenary session in Strasbourg on 18 December 2008. The Council of the European Union formally endorsed the proposed amendments on 26 February 2009. The European Parliament has indicated that member states will have to implement the amended regime by 30 June 2009 at the latest.

The FSA has indicated that its proposals in CP09/3 are compatible with the European Commission's proposals, although further changes to the UK regime may be required in due course to fully comply with these EU requirements.

Corporate governance

The financial crisis has put the corporate governance of financial institutions under the spotlight, as it is generally recognised that poor corporate governance has been a major contributing factor to the turbulent financial conditions.

In the long term, there may be increased regulation, possibly initiated at European level. Areas of particular concern that are currently being reviewed are:

Risk management arrangements, particularly in relation to capital and liquidity risk (see Capital and liquidity requirements above).
The composition of the board of firms: criticism of the failure of boards to curb risky practices appears to be centred on non-executive directors.
Remuneration structures (see Remuneration structures below).

The FSA has increased its supervisory focus on these three areas, and will take action if it is not satisfied that a firm has appropriate arrangements in place that are aligned with sound risk management. It has indicated that it considers action against individuals who carry on senior management functions as the most effective means of achieving credible deterrence (see Changes to the FSA's regulatory regime).

In February 2009, HM Treasury published a press release announcing that the government has commissioned an independent review of corporate governance in the UK banking industry. Sir David Walker will chair the review, which will report jointly to Alistair Darling, the Chancellor of the Exchequer, Peter Mandelson, the Business Secretary, and Paul Myners, the Financial Services Secretary. The review will present preliminary conclusions to these ministers in autumn 2009 and will make final recommendations by the end of 2009.

Announcing the review, the Chancellor said it was "clear that corporate governance should have been far more effective in holding bank executives to account" while Lord Mandelson promised that the review would ensure that UK banks had "competent, well-run and transparent boards which are engaged with their shareholders and capable of understanding and managing risk effectively".

Remuneration structures

There are widespread concerns that inappropriate bank remuneration schemes may have contributed to the financial crisis by encouraging bank staff and senior management to take excessive risks for short-term personal profit.

In the UK, the FSA has already increased its focus on banks' remuneration structures and bonus schemes. It will not get involved in setting remuneration policies or imposing restrictions on the level of bonuses paid by banks. However, the FSA does expect banks to be able to show that their remuneration structures are treated as part of, and are aligned with, their risk management strategies.

In October 2008, the FSA sent a "Dear CEO" letter to banks outlining its continued work on remuneration structures, together with its initial thinking on remuneration policies. The Annex to the letter sets out some high-level criteria for good and bad remuneration policies, and banks are urged to review their remuneration policies against the benchmark of the criteria. Regulated firms should have done this, and should have taken immediate action if their remuneration policies were not aligned with sound risk management systems and controls.

The FSA indicated that it would be visiting recipients of the letter before the end of 2008 to check whether any bad remuneration policies were still in place, and to have discussions on what constitutes good practice in this area. In early 2009, it will give feedback on the good practices it has identified from these visits, and hopes to be able to report on the progress of international work in this area (the FSA is keen to develop a global framework on bank remuneration schemes, in order to stop executives from holding banks to ransom). At the same time, the FSA also plans to publish its findings from a general review of remuneration structures in the London market (on a no-names basis), with a revised statement on what it considers to be good practice.

On 26 February 2009, the FSA published a draft code of practice on remuneration policies (Code) which applies to all FSA regulated firms. The Code consists of one general, and ten specific, principles relating to firms' remuneration policies and arrangements. None of the principles are concerned with the levels or quantum of remuneration, as the FSA still considers that these are matters for firms' boards. The aim of the Code is to ensure that all firms have remuneration policies which are consistent with sound risk management, and which do not expose them to "excessive risk".

The FSA plans to use the Code to "assess the quality of a firm's remuneration policies and linkage, if any, between such policies and excessive risk-taking by staff". The FSA has explained in the Code that it may ask a firm's remuneration committee to provide it with evidence of how well the firm's remuneration policy complies with the principles. Where the principles are not being met, it will ask for the firm's plans for improvement. The FSA will also ask firms to use the principles as part of the Internal Capital Adequacy Assessment Process (ICAAP), in order to assess their exposure to risks arising from their remuneration policies.

Commenting on publication of the Code, Hector Sants, FSA Chief Executive said:

"We have already outlined the work we have been doing on remuneration during the last 12 months. The [Code] we have published today is the next stage in that work and clearly lays out the framework we expect firms to adopt."

The press release announcing publication of the Code states that the FSA will consult on the draft Code, and further proposals for remuneration policy, in March 2009. The FSA's further remuneration policy proposals are likely to be set out in the detailed discussion paper that is expected to be published alongside the Turner Review in March 2009. The FSA has advised that the Code will not be added to its Handbook until the consultation process has ended.

Separately, HM Treasury has published details of the government's asset protection scheme, one of the terms of which is that participating banks will need to develop "a sustainable long-term remuneration policy". The FSA has explained that it has published the draft Code to provide clarity to the participating banks on what suitable remuneration policies involve. It has also advised that the Code will only become effective for banks who are not participating in the asset protection scheme, and for other firms, following the consultation process. However, the FSA has reminded banks that it still expects them to be operating remuneration policies that meet the good practices identified in its October 2008 "Dear CEO" letter. Other non-bank firms would also be advised to ensure that their remuneration policies are meeting the good practices too.

In February 2009, HM Treasury announced the independent review of corporate governance in the UK banking industry, which will be chaired by Sir David Walker. The review will present preliminary conclusions to these ministers in autumn 2009 and will make final recommendations by the end of 2009. For more information on this review, see Corporate governance above.

At European level, at its October 2008 meeting, the Council of the European Union set out some high-level principles in relation to executive pay and called on member states to put those principles in practice. It asked the European Economic and Financial Affairs Council (ECOFIN) to report back on decisions taken by member states in this respect by the end of 2008. On 30 November 2008, the Council of the European Union published a review prepared by two of its committees (the Economic Policy Committee (EPC) and the Economic and Financial Committee (EFC)) (for the ECOFIN) on recent measures taken by member states in relation to executive pay. The review outlines the policy actions which have been taken in relation to executive pay by member states since the October 2008 Council meeting.

The European Commission has launched a wide ranging review to analyse the adequacy of regulation, oversight and transparency in the financial markets. Amongst other things, this review will cover executive remuneration (in particular, the need for reward structures to be more closely aligned to the real medium term benefits accruing to companies). The European Commission will report on its findings to the European Parliament and the Council of the European Union prior to the spring 2009 Council meeting.

The form of any European regulatory initiative on remuneration and the impact it may have on the UK regulatory regime is currently unclear.

Accountancy and valuation requirements

Under International Accounting Standards (IAS), banks and other financial institutions must value certain financial instruments which appear in their accounts as assets and liabilities at fair value (mark-to-market valuation).

Opinions on fair value accounting are divided: some suggest that fair value accounting has caused, or at least exacerbated, the financial crisis (see What caused the financial crisis?); others (such as David Tweedie (see Further reading)) disagree, suggesting that bad lending practices are primarily responsible and asserting that fair value accounting is necessary for transparency and has only served to reveal the true extent of the damage sooner than most banks would have liked.

However, following pressure from Europe, in October 2008, the International Accounting Standards Board (IASB) allowed an amendment to allow the reclassification of certain financial instruments in the accounts of entities using IAS. Reclassification is already permitted under US generally accepted accounting principles (GAAP). Some European banks have now adjusted their financial statements on the amended basis, this revaluation has reduced losses by billions. Critics of the amendment suggest that it is "window dressing".

In line with interpretive guidance issued in the US by its Securities and Exchange Commission (SEC), the IASB has published a paper (see Further reading) on measuring and disclosing the fair value of financial instruments in markets that are no longer active and where forced sales distort prices. The "mark-to-model" valuation method is based on judgement and allows substantial adjustments to be made to market prices to consider amongst other things, discount rates, cash flows, and risk.

Although there are still widely differing views on the continued use of fair value accounting methods, it is generally agreed that to improve investor confidence in the markets there is a need for:

Greater levels of transparency through enhanced disclosures, particularly in relation to complex financial instruments.
Global convergence in accounting standards.

To pursue these aims, the IASB and the Financial Accounting Standards Board (FASB) (the US accounting standard setter) announced in a press release at the end of December 2008, the membership of the newly established Financial Crisis Advisory Group (FCAG). This is a high-level international advisory group (comprising regulators, preparers, auditors, investors and other users of financial statements) that has been set up to consider financial reporting issues arising from the global financial crisis. The FCAG's first meeting will be held in London on 20 January 2009.

The European Commission is also pushing for the swift adoption of measures to reform the accounting rules, and these measures will impact on the UK regulatory regime.

Short selling

There have been widespread concerns about investors around the world short selling.

In June and September 2008, the FSA introduced restrictive measures to curb short selling practices in the UK, to protect the integrity and quality of the financial markets and guard against further instability in the financial sector. The measures banned the active creation or increase of net short positions in the stocks of UK financial sector companies (financial stocks) and required disclosure to the market of significant short positions in financial stocks. The measures were intended to increase market transparency and act as a deterrent against what the FSA perceives to be market abuse.

With effect from 00:00:01 on 16 January 2009, the FSA allowed the ban it had imposed in relation to short selling to lapse, permitting short selling of financial stocks thereafter. The FSA took this decision as it considered that the "special circumstances" which led it to introduce the ban had changed.

The FSA has, however, maintained the disclosure obligation in relation to the short selling of financial stocks until 30 June 2009 on the grounds that "maintaining the enhanced transparency regime will help continue to minimise the potential for market abuse and disorderly markets in UK financial sector stocks".

On 6 February 2009, the FSA published a discussion paper on short selling. It has concluded that, at the present time, no direct restrictions should be imposed on short selling, although it has reserved the right to reintroduce a ban at a future date, without consultation, should it consider this necessary.

However, the FSA considers that there are clear advantages to enhanced transparency and proposes to introduce an amended and extended version of its current disclosure obligation under which firms would have to disclose to the market significant short positions in all UK listed stocks. It does not set out in its discussion paper definitive detailed proposals in this respect since it believes that reaching international consensus on the key issues arising in relation to short selling is critical. The FSA is currently contributing to the work being undertaken by the working groups established by the International Organisation of Securities Commissions (IOSCO) and the Committee of European Securities Regulators and will use the feedback from its discussion paper to inform the international debate. The FSA's discussion paper closes to responses on 8 May 2009 and the FSA will subsequently issue a feedback statement setting out its conclusions on a longer-term short selling policy.

Other regulators and stock exchanges outside the UK have adopted measures to combat short selling similar to those implemented by the FSA.

Hedge funds

During the financial crisis, hedge funds have come in for criticism for their practice of taking short positions in certain financial institutions, arguably fuelling market and consumer panic about the viability of those institutions (for more information, see Short selling above).

The FSA considers that hedge funds were not a catalyst or driver of the financial crisis and takes the view that direct regulation of hedge funds is not appropriate at present, despite the current pressure for more regulation. Instead, the FSA welcomes the steps which the industry has taken to raise standards, by virtue of the Hedge Fund Standards Board's best practice standards on risk management, valuation and disclosure, published in January 2008.

At European level, there have been calls for the hedge fund industry to be directly regulated (notably in reports adopted by the European Parliament in September 2008). The position of hedge funds is being considered as part of the ongoing EU review of the regulation and supervision of the financial markets. On 18 December 2008, the European Commission launched a wide-ranging public consultation on hedge funds, focusing on four key areas: systemic risks; market integrity and efficiency; risk management; and transparency towards investors and investor protection.

The consultation closed to responses on 31 January 2009. The European Commission will take into account the recommendations of the de Larosière group on the future of European supervision and regulation (see More financial services regulation above) and will use responses to its hedge fund consultation, as a basis for:

Developing a European regulatory initiative for the hedge fund industry. In February 2009, the European Commission President, José Manuel Durão Barroso, said that the Commission intends to present "detailed concrete proposals" on hedge funds in April 2009.
Providing European input into the discussions on hedge funds at international level which are being taken forward by the G20 and IOSCO. At a meeting of the European members of the G20, together with representatives of the European Commission and the European Central Bank, in Berlin on 22 February 2009, the need for fundamental changes to global economic systems was acknowledged and agreed. The EU leaders present at the meeting agreed that the global solution to the crisis will include regulating and supervising all financial markets, products, and participants, including hedge funds.

Clearly, any EU and international legislative proposals in relation to hedge funds would impact on the FSA's work in relation to the UK hedge fund industry.

Private equity

There are concerns that the build up of leverage in the financial system, including in private equity funds, may have distorted the functioning of the real economy.

Although the FSA has identified market abuse and conflicts of interest as the main areas for a continued regulatory focus on the private equity sector, it is broadly satisfied with the current UK regulatory approach to this sector. This approach involves an element of industry self-regulation under voluntary guidelines (known as the Walker Guidelines) which set out recommendations on transparency and enhanced disclosure for the private equity industry.

The position of the private equity sector is currently being considered as part of the ongoing EU review of the regulation and supervision of the financial markets. The European Commission believes that self-regulation represents the most promising means of promoting good practice (in particular, in relation to corporate governance, transparency and reporting) in the European private equity industry. It is currently undertaking a review of the scope, content and performance of the codes of practice which have been introduced by the European private equity industry at European and national level and will report to the European Parliament on its findings. In February 2009, the Commission President, José Manuel Durão Barroso, said that the Commission intends to present "detailed concrete proposals" on private equity in April 2009.

Any EU legislative proposals in relation to private equity would impact on private equity firms operating in the UK.

Retail banking

The impact of the financial crisis on bank customers, particularly retail customers, has resulted in calls for an overhaul of the current retail banking regime in order to ensure better protections for retail customers.

To date, the FSA has not made comprehensive rules governing the conduct of retail banking business. It has introduced rules for this sector only where required under EU law, or where it has considered it necessary to deliver specific consumer outcomes (primarily in the area of prudential regulation). Alongside the FSA's limited regime, the conduct of retail banking business has been self-regulated under the voluntary Banking Codes (Codes) monitored and enforced by the Banking Code Standards Board (BCSB).

However, the FSA has identified gaps in the Codes (including the lack of a standard equivalent to the FSA's requirement on regulated firms to treat their customers fairly), as well as weaknesses in the BCSB's disciplinary powers and in its regulatory approach. Accordingly, the FSA believes that it would be more effective to move away from the voluntary regulation of retail banking activities, and instead extend its regulation across all aspects of a bank's relationships with its retail customers, excluding credit regulated by the Office of Fair Trading, such as unsecured loans and credit cards.

The FSA launched a consultation, in November 2008, on its proposed new regulatory framework for this sector, and has suggested bringing the new regime into force in November 2009.

Although a formal announcement has yet to be made, it was widely reported following the Queen's speech on 3 December 2008 that the government intends to put the Codes on a statutory footing in order to ensure that banks treat their customers fairly. The British Bankers' Association (BBA) has welcomed this proposal, commenting that such a move would be appropriate. The means by which the government would implement this proposals is not yet clear.

Credit rating agencies

CRAs have been widely criticised for contributing to the market turmoil by underestimating the credit risk of structured finance products and failing to reassess the high ratings they had ascribed to such products linked to subprime mortgages as market conditions worsened. Additionally, many investors were over reliant on these ratings and did not understand them (see What caused the financial crisis?).

Currently, CRAs active in the EU are principally governed by the voluntary International Organisation of Securities Commissions' code of conduct for CRAs (IOSCO Code). In November 2008, following a public consultation, the European Commission proposed a regulation on CRAs active in the EU, aimed at improving the process of issuing credit ratings and restoring investor confidence and consumer protection. The proposed regulation builds on, but is more extensive than, the IOSCO Code. It has four key objectives:

Ensuring that CRAs avoid (or adequately manage) conflicts of interest in the rating process.
Improving the quality of both the methodologies used by CRAs and the credit ratings which they issue. In particular, under the proposed regulation, CRAs must either differentiate rating categories for structured finance instruments or produce a comprehensive report attached to each structured finance rating issued.
Increasing transparency by imposing new disclosure obligations on CRAs, including publication of an annual transparency report.
Establishing a registration and surveillance framework for CRAs, based on the same principles as, and comparable to, the US framework for CRAs, to level the playing field between the EU and the US.

The European Commission is pushing for the swift adoption of these measures which, in due course, will have an impact in the UK. The Council of the European Union considers CRA regulation a "priority issue" and, at its December 2008 meeting, called for a decision to be quickly taken in this respect. In addition, the European Parliament is expected to adopt its report on the Commission's proposed regulation for CRAs in April 2009.

At an international level, the leaders attending the G20 meeting in London on 2 April 2009 (see Global solutions are needed for global problems above), will discuss international regulatory reforms, in order to restore global financial stability and aid economic growth. At a meeting of the European members of the G20, together with representatives of the European Commission and the European Central Bank, in Berlin on 22 February 2009, the need for fundamental changes to global economic systems was acknowledged and agreed. The EU leaders present at the meeting agreed that the global solution to the crisis will include regulating and supervising all financial markets, products, and participants, including CRAs.

Companies

What practical steps should companies take generally to protect themselves in the financial crisis?

There are a number of steps that any business should consider taking during economically difficult times, including the following:

Review existing facility agreements

If a company is in danger of breaching the terms of its facility documentation, it may seek to renegotiate those terms (in particular the financial covenants) to avoid that breach. At the moment, renegotiation will often be the preferred route, as the current lack of liquidity and the likelihood of more stringent terms of any replacement facility will make a refinancing impossible or undesirable. Given the fall in the LIBOR rate following the announcement of the government's bank bailout plan, if a facility's interest rate is not tied to LIBOR, the company should consider whether negotiating a LIBOR-linked rate may be in the company's interests.

The financial status of a company, or a deterioration in the general economic outlook may trigger the terms of any MAC clause (see above). While lenders seldom need to rely on a MAC clause in taking action under a facility, a review of the penalties available under that clause and the lenders' intentions with regard to it should form part of any general discussion on the terms of the facility.

In dire circumstances, it may be possible or appropriate to agree a workout with lenders, with the aim of relieving pressure on the company's obligations to meet short to medium-term interest, capital or other repayment schedules (see What are the restructuring options for companies in financial difficulty?).

Re-evaluate the budget and business plan

As a pre-cursor to discussions with lenders and investors, a company should re-evaluate the continued viability of the budget and business plan in the light of economic conditions. Testing company strategy and targets against management reports and interim accounts will pinpoint areas of weakness and assist the board in deciding the correct course of action. It may enhance the credibility of that process if the company has input from specialist advisers when carrying out such a review, rather than relying solely on internal resources.

Monitor the financial position

A company should check the safety of its cash deposits, if it suspects that the institutions where they are held are likely to suffer financial difficulties. For more detail on the issues arising from the failure of a lender, see What issues arise if a bank becomes insolvent?

A company should also assess whether it has sufficient liquidity for the short and long-term. If cash reserves and projected cash flow may not be sufficient to meet its present and anticipated obligations, it may be appropriate for it to consider some or all of the following:

Factoring or invoice discounting facilities to meet working capital requirements.
Seeking to reduce the length of credit and generally improve the terms it extends to its customers.
Seeking further equity investment. Do existing investors remain supportive of the ongoing business?
Restructuring existing debt, including converting debt to equity (see What are the restructuring options for companies in financial difficulty?).
Reducing spending to ease pressure on cash-flow requirements. In particular, is it able to renegotiate terms with existing suppliers who, likely to be keen to see the survival of businesses to which they supply, may be open to a temporary or permanent relaxation of payment and other conditions? In addition, will the company's landlord consider granting a rent holiday or a renegotiation of the terms of any leases, in preference to the risk of premises falling empty?

As companies approach their financial year end, particular concern may arise over the ability of the board to state that the company remains a going concern. Auditors are likely to ask more probing questions particularly as to a debt provider's commitment to continue extending facilities and the status of the company's credit insurance. Early and open discussion with auditors will be essential. The role of the audit committee will become a prominent source of debate and so companies should ensure that such committee is given adequate time and resource to undertake its task.

Review existing commercial arrangements

A company should monitor the extent to which it is, or could be, affected by the financial health of its customers and suppliers. Having up-to-date information on customers and suppliers will enable companies to protect themselves in the most efficient way possible. Talking to those closest to the customers (sales force) and suppliers (buyers) and watching out for signs of trouble, such as abrupt management departures, will assist in anticipating any potential obstacles to the continuance of a company's own business cycle.

If a company is concerned about the continuance of a business upon which it relies it should consider a plan B as early as possible. It should monitor inventory and consider how long it could continue if a critical supplier fails and whether it could find alternative sources of supply for key products and services.

The board should also review the company's insurance policies (including the D&O policy) and the status of its insurance providers. If concerns exist over the ability of customers to meet current and likely future payment obligations, the company should consider whether it has adequate credit insurance. The last quarter of 2008 saw a number of providers refusing to extend credit insurance on renewal dates. Companies may want to investigate options elsewhere, if initial discussions with existing brokers do not appear favourable. If credit insurance cover has been reduced, the company should consider whether top-up credit insurance should be obtained under the government's top-up trade credit insurance scheme launched in May 2009.

Review corporate governance procedures

Directors should hold regular board meetings, attended by all directors, and ensure that detailed minutes of decisions are taken and circulated. Decisions ordinarily delegated to committees might more properly be taken by the full board.

The board should seek specialist legal advice as to the duties and responsibilities of directors in relation to a company facing financial difficulty. (For more on these, see What issues should directors of a company in financial difficulty bear in mind?) A court is unlikely to question the commercial merits of any particular decision, provided it is satisfied that directors acted in line with relevant duties. The statutory duty of directors to promote the success of the company for the benefit of its members as a whole is, in situations of threatened insolvency, replaced by a duty to act in the best interests of creditors (section 172(3), Companies Act 2006). Open dialogue with creditors on the company's survival planning may avoid the risk of any payment acceleration or other event of default options being exercised by creditors.

Public companies listed on the Official List of the London Stock Exchange should ensure sufficient familiarity and absolute compliance with the requirements of the Listing, Prospectus, Disclosure and Transparency Rules. Companies admitted to AIM which are incorporated under UK company legislation, or whose principal place of business is in Great Britain, will be subject to certain provisions of the Disclosure and Transparency Rules, as well as the AIM rules applicable to all companies admitted to AIM.

For information on potential areas of reform in corporate governance, see Corporate governance.

Consider incentivising management

At a time when the value of equity or options held by management may well be under water, incentive to deliver returns may be difficult to identify. While arguably counter-intuitive to rebase the strike price of options (it may seem odd to effectively reward management by lowering the price during a period of difficult trading) shareholders must balance this against the motivating effect that such an action may have. The intention is not to reward failure, but to rebase what constitutes success in the light of external forces.

What are the restructuring options for companies in financial difficulty?

The following restructuring options are commonly used by companies in financial difficulty:

Equity raising. The success of raising equity from existing shareholders and/or new investors will depend upon the perceived soundness of the company going forward. On 11 March 2009, the Financial Times reported that, in some cases, banks are demanding that new equity is injected as a prerequisite for agreeing to restructuring facilities for companies (for example, Wolsley and Premier Foods).
Renegotiation of banking covenants. If a company is at risk of breaching covenants in its facility documentation, it can attempt to avoid the breach by trying to renegotiate those covenants with its lenders so as to avoid the breach. Given the current lack of liquidity in the market, renegotiation of the facility will often be a better course of action than attempting to refinance the facility. Usually, the earlier a company approaches its lenders the better.
Initiating a workout arrangement with its creditors. If the company has inherent value and a sound medium to long-term business plan it may be possible for it to agree a restructuring arrangement with its lenders (commonly referred to as a workout). Such an arrangement may involve:
- deferring or rescheduling capital payments, for example by changing the repayment dates or changing the amortisation profile;
- capitalising interest;
- a debt to equity conversion, which allows lenders to covert their debt into equity.

Lawyers and bankers have expressed concern that the successful implementation of out-of-court restructurings of financially distressed companies may be frustrated by creditors which hold CDS which reference such companies.

What issues should directors of a company in financial difficulty bear in mind?

In addition to the practical steps that a board of directors may take to protect its company during a financial crisis (see What practical steps should companies take generally to protect themselves in the financial crisis?), the directors must also consider their personal position. Directors are generally not liable for the debts of a company. However, personal liability may be incurred in certain situations, in particular during periods of financial difficulty for the company. As soon as the directors are aware that the company may face financial difficulty, they should seek external, legal advice (in addition to ongoing dialogue with appropriate accountants).

Non-executive directors (and, in a number of cases, shadow directors) have the same duties and liabilities as executive directors, including those set out below, except that they are not subject to considerations arising from an employment relationship.

Company law: statutory duties

Directors are subject to duties contained within sections 172 to 177 of the Companies Act 2006 (2006 Act). In times of financial difficulty, their compliance with those duties comes under additional scrutiny. In particular:

Where a company is insolvent or on the verge of insolvency, the directors owe a duty to the company to act in the best interests of the creditors, not the shareholders, of the company (section 172(3), 2006 Act).
Directors must exercise independent judgement and must avoid any situation which conflicts or possibly may conflict with the interests of the company (sections 173 and 175, 2006 Act). Nominee directors of parent companies, as well as lender and investor board representatives, will face particular problems under these duties. The 2006 Act does provide for shareholders and boards of directors to authorise conflicts.
The duty to exercise reasonable care, skill and diligence imposes a subjective, as well as an objective, test. Directors with experience of trading through near insolvency may be held to a higher standard as a result.

Company law: public companies

Directors of public companies whose shares are listed on the Official List of the London Stock Exchange must consider the impact of the Listing and Disclosure and Transparency Rules and the Financial Services and Markets Act 2000 (FSMA). In particular:

Directors who might otherwise want to restrict the disclosure of information to protect the legitimate interests of their company must comply with the obligation under the Disclosure Rules to notify a Regulatory Information Service of any inside information which directly concerns the company.
Section 397 of FSMA imposes criminal penalties for misleading statements and practices, including where:
- a director dishonestly conceals any material facts (including a dire financial situation) or recklessly makes misleading or false statements for the purposes of inducing others to deal or refrain from dealing; or
- a director engages in any act or course of conduct (including keeping silent) which creates a false or misleading impression as to the market in, or price or value of, shares.
Behaviour which involves misusing information relevant to dealing in investments, creating a false impression as to supply, demand, price or value of an investment or taking action to, or spreading information which may, distort the market may constitute market abuse, a civil offence giving rise to an unlimited fine. The market abuse regime runs alongside the criminal insider dealing regime.

Companies admitted to AIM which are incorporated under UK company legislation, or whose principal place of business is in Great Britain, will be subject to certain provisions of the Disclosure and Transparency Rules, as well as the AIM rules applicable to all companies admitted to AIM.

Directors of public companies must also continue to comply with the 2006 Act. In times of difficulty, directors should be particularly aware of the criminal sanctions for failing to call a meeting following a serious loss of capital. If net assets fall to half or less of the company's called-up share capital the directors must, within 28 days of becoming aware, convene an extraordinary general meeting to discuss the position and what steps, if any, should be taken to deal with the situation (section 656, 2006 Act).

Insolvency law

Directors may be required to contribute to the assets of an insolvent company on the application of the liquidator where it appears that:

A director has misapplied, retained, become accountable for any money or other property of the company, or been guilty of misfeasance or breach of any fiduciary duty (section 212, Insolvency Act 1986 (IA86)). A court may also order the director to repay, restore or account for money or property with interest.
A director was knowingly party to the carrying on of business with the intention to defraud creditors (section 213, IA86). Fraudulent trading is also a criminal offence under section 993 of the 2006 Act.
Prior to the commencement of winding up, a director knew or ought to have known that there was no reasonable prospect that the company would avoid insolvent liquidation and did not, after that point, take every step with a view to minimising the loss to creditors from the company's insolvency (section 214, IA86). As with the duty to exercise reasonable care, skill and diligence under the Companies Act 2006 (see above), the courts will impose both an objective and subjective test to each relevant person. The potential for personal liability for wrongful trading is often a key concern of directors of companies facing financial distress, not least because it is difficult to be certain when the liability arises. Not only is it hard to say precisely when the directors incur the obligation to take every step to minimise the losses to creditors, it is at least as demanding to then determine what course of action will have the "least worst" impact on the company's creditors. As a broad rule of thumb, the more that directors base their decision-making upon the recorded advice of specialist advisers, the less chance there is of a liquidator successfully imposing personal liability upon them in due course.

Contractual liability

The general principle that directors are not liable for the debts of a company does not apply to liabilities agreed to in a director's personal capacity. It is common for directors of private companies (particularly family businesses) to guarantee the liabilities of the company. In difficult times, any such director should be fully aware of his rights and obligations under the terms of the relevant guarantee(s).

Disqualification

In addition to the personal sanctions described above, the court may disqualify any director (or shadow director) of a company which becomes insolvent from being a director of a company if his conduct as a director makes him unfit to be concerned in the management of a company (section 6, Company Directors Disqualification Act 1986). In making its determination, the court may take into account a number of matters, including those statutory constraints referred to in this note.

Are any companies buying back their own debt or shares?

The crisis in the financial markets has led to significant reductions in the price of loan assets being traded in the secondary market. This has created opportunities for borrowers (and their related parties) to buyback debt.

With share prices on average being far cheaper than they have been for a number of years, share buybacks are on the face of it a good way for a company to support its share price and demonstrate the board's belief that the market is undervaluing the company. However the dilemma for companies is that although shares appear cheaper, the freezing up of the credit markets, and the resultant difficulties in accessing debt finance, has meant that "cash is king" and companies are looking to preserve cash.

Debt buybacks

Normally, a financially healthy borrower's syndicated debt is traded in the secondary market at or very near to its face value to reflect the market's belief that the debt should be repaid on time and in full. However, the financial crisis has created a new environment in which lenders are finding themselves forced to sell loan assets to shore up their balance sheets. This activity has pushed down the price of the debt with much of it now being traded at a sizeable discount to par.

For a borrower, another member of its group or a related party (for example a private equity sponsor), purchasing debt at a discount to par provides an obvious financial benefit (provided, of course, the purchaser is in a solid financial position itself). Other benefits may be acquired such as voting rights and with that the ability to influence or perhaps block any future refinancing, restructuring or enforcement of a default (an obvious concern for lenders with any debt buyback). In certain situations, debt buybacks may be of interest to lenders as they may provide new financing opportunities.

Although there have been some publicly announced debt buyback transactions in the European leveraged finance market (for example TDC, a Danish telecoms company owned by a private equity sponsor, bought back senior debt in March 2008 and on 30 September 2008, the Financial Times reported that Phones 4U, a UK mobile phone retailer owned by private equity investors, had bought back some of its debt at about 75% of face value), it is very difficult to get a precise feel for how prevalent debt buybacks are becoming as there are various ways of disguising the economic substance of the transaction.

Following differences of opinion as to the legality of debt buybacks under LMA-style documentation, the LMA addressed the issue in its form of leveraged facilities agreement by providing for two alternative and mutually exclusive clauses. One clause prohibits debt buybacks and the other permits them but subject to restrictions. While not preventing purchases by sponsors, both clauses disenfranchise them from voting.

Share buybacks

Public listed companies tend to use share buybacks as a means of returning surplus cash to shareholders, increasing earnings or assets per share or adjusting the overall gearing ratio of their balance sheet. Share buybacks are sometimes used by listed companies, especially investment trust and venture capital trust companies, to provide enhanced liquidity in their shares, particularly where the market in their shares is otherwise very limited. Additionally, in a falling stock market share buybacks are often an attractive way for a company to support its share price.

In the early part of 2008 it seems that companies were opting to spend their spare cash on their own shares rather than hoard it in anticipation of tougher times ahead. For example:

Vodafone Group plc announced a £1 billion share buyback programme on 23 July 2008 following the issue of its interim management statement on 22 July 2008. The company said this action "reflects the board's belief that the share price significantly undervalues Vodafone".
Northern Recruitment Group PLC announced a tender offer on 30 October 2008. The company's shares had been falling in value due to lack of demand. The company and its advisors felt that the situation was unlikely to improve and gave shareholders the opportunity to realise their investment in the company for cash as part of a plan to de-list the shares.
Spirent Communications Plc announced a tender offer on 15 September 2008. The company had experienced an increase in profit which had led to a sizeable free cash flow. The tender offer was designed to allow the company to achieve a faster rate of earnings per share growth and decrease the size of the excess cash balance on the company's balance sheet.

A number of companies have also used B share schemes as a method of returning excess cash to shareholders, for example De La Rue plc and Rolls Royce Group plc. Indeed the Financial Times reported on 13 November 2008 that the trend in the third quarter of 2008 in the UK and the rest of Europe was for more buybacks not fewer.

However, the sharp deterioration in the markets in early October will probably mean that buyback programmes will slow down as companies look to keep their cash whether for internal purposes, dividends, possible acquisitions or other investment opportunities. In November 2008, the London Stock Exchange announced it was halting a share buyback programme and warned of "difficult and uncertain" market conditions.

M&A

What impact has the financial crisis had on private equity and leveraged M&A deals?

In the first nine months of 2008, UK private equity buyouts numbered 503, compared to 672 for the whole of 2007, according to data compiled by the Centre for Management Buy-out Research. The aggregate value of those 2008 deals totalled just £17.1 billion, compared to £45.9 billion during 2007, at least in part due to the absence of the mega buyout, which played such a prominent part in the 2007 market.

The market before the financial crisis

The easy availability of "covenant-lite" debt financing during the M&A boom, together with the mid-market trend for auction sales of potential buyout targets, raised the average deal size beyond historic levels.

With access to easy and often relatively cheap credit, buyout funds used increasing amounts of leverage to make acquisitions, with a debt to equity ratio of 3:1 commonplace. Such leveraging required a lesser commitment from the private equity provider and created scope for a much greater uplift in the value of its equity stake. This possibility took on significant importance given that competition for deals often led to private equity houses taking smaller equity stakes.

Competition between private equity houses, combined with significant private equity funds that needed to be spent, meant that the secondary buyout market became a significant exit route, with institutions often prepared to pay more than trade purchasers.

Effects of the financial crisis

The onset of the current financial crisis has, over the past year, had a significant impact on both the private equity industry and private-equity backed companies. The effects have included the following:

Less financing is available for new deals. Less financing is now available from traditional lenders. Where finance is available, any necessary syndication is being sought before, rather than after, deal completion. Such "club" deals have proved lengthy and difficult to put together, to the point where banks are now generally not prepared to lend at all to the top end of the buyout market. So far in 2008, the number of deals above £250 million has fallen to 2006 levels (10 in the period to 30 September 2008, compared to 32 during the whole of 2007, according to the Centre for Management Buy-out research).
Deal flow has slowed considerably. Mid-market deal flow remained robust in 2007 and early 2008 but has since subsided, at least in part due to banks' existing commitments to leveraged loans agreed in the recent boom years. The write-down of the value of the assets of potential buyout targets available for security, as well as the fragility of the banks' own assets and the magnitude of their potential exposure to liabilities, has also contributed to a marked withdrawal of available funding. With lenders not prepared to commit to such favourable terms as previously, if at all, and equity providers unwilling to offer valuations seen during the past year, many potential buyout management teams have decided to "wait and see" what 2009 will hold before actively seeking investment partners. It has, however, been reported in a recent survey that 34% of those respondent UK companies with turnover in excess of £10 million which expect to make an acquisition within the next 12 to 24 months, expect to turn to private equity funding.
Companies are seeking to renegotiate or refinance existing debt. Despite banks having agreed to generous financing terms in recent years, the increase in the LIBOR rate from 2007 rates as a result of banks' reluctance to lend to each other, as well as general cash-flow issues, has led many private-equity backed businesses to seek to renegotiate or refinance existing debt. Where replacing existing debt is possible, the likelihood of more stringent covenants attached to new debt is unattractive. Deleveraging existing mid-market deals through further equity injection has become a feature of private equity investment during 2008, as a bridge to a time of more favourable banking markets. Where existing facilities provide for a PIK toggle, portfolio companies may be tempted to capitalise interest by issuing payment in kind notes, effectively deferring payment of that interest (and relieving pressure on cash flows) until repayment of the principal debt.
Companies are considering repurchasing their own debt. The possibility of buying back traded debt has come into focus, with the advantages of easing financial covenant compliance and interest payments being weighed against the impact on short-term cash reserves. (For more on this trend, see Debt buybacks.)
Private equity fund investors are struggling to meet capital commitments. Permira's recent offer to cap commitments to its Permira IV fund at 60% of each limited partner's commitment seems unlikely to be the only example of its type.

The future

With large portions of the buyout market in slowdown, investors with funds to spend have a number of options, including the following:

Reducing the investor's usual target deal size and/or widening its sector focus and so generating greater deal competition.
Where fund rules permit, committing a greater proportion of funds to overseas/emerging markets investments. Whilst the "de-coupling" of the western and emerging markets no longer appears sustainable in the current climate, opportunities for high earnings growth will likely still draw private equity investment.
Purchasing the assets of distressed or insolvent companies. Asset, rather than share, deals allow many liabilities to be left with the distressed company. A strong management team may provide investors with a viable buy and build strategy, whether part-bank funded or equity only. See also There must be some good opportunities to buy the assets of distressed or insolvent companies. Do any special considerations apply?
Purchasing traded debt instruments at a steep discount from banks needing to deleverage (see also Debt buyback provisions).

The current lack of faith of the public markets in smaller quoted companies suggests that, whilst flotations are unlikely to be the dominant exit route for existing private equity investments, public to private transactions may once again come to the fore for new investments, as companies see the advantage not only of private funding and the lack of public company regulation, but also the accompanying commercial expertise.

In anticipation of rising borrower defaults and the expected trend for converting leveraged debt to equity, a number of banks are recruiting private equity specialists to manage a growing portfolio of equity interests. This convergence of interests between traditional lenders and the private equity houses will see banks taking a greater interest in short-term turnaround and, potentially, longer-term value growth, rather than ability to service debt. Whether the banks will want to maintain such equity interests on their balance sheets for long enough to generate material returns remains to be seen.

For so long as the banks are reluctant to lend, the abolition of the financial assistance regime for private companies may not have the desired effect of simplifying and accelerating the deal process. Those banks that do lend will insist on tighter covenants and higher returns. Equity providers, with investors to satisfy and new funds to raise, are likely to require greater due diligence comfort, more restrictive management terms and clear exit strategies.

Whilst new deal opportunities are hard to find, secondary buyouts are likely to remain a fixture in the private equity market. The option for incumbent investors to hold on to portfolio companies for longer than is usually anticipated (often three to five years) will, in a number of cases, be limited by the life of any invested fund and the need to return capital to fund investors. Quick exit, fairly priced secondary deals will be attractive to investors of new funds. However, private equity, struggling to raise deal finance, may find greater competition from trade buyers in the form of recently reported "club" deals, historically the preserve of private equity itself. Under such clubbed deals, trade buyers pool resources for an acquisition, spread the risk and de-couple acquired businesses following closing. The practice does rely on buyers having different, but complementary, interests in the assets to be acquired. For that reason alone, it seems unlikely that the practice will make frequent appearance.

In Europe, socialist MEPs are calling for greater regulation of the private equity industry. Whilst the current European Commissioner for Internal Market and Services, Charlie McCreevy, appears more in favour of advocating "enlightened self interest" through self-regulation in each member state, Mr McCreevy's term of office will expire in mid-2009. To date, the focus of Europe tends more towards hedge funds (with a consultation on potential regulation launched in December 2008), although a report on the state of private equity in member states is expected in March 2009. The EVCA Brussels Task Force intends to supplement its November 2008 submission to Mr McCreevy with a more detailed submission in the first quarter of 2009. In the UK, with the Walker Guidelines Monitoring Group imminently due to give its annual report on the penetration and implementation of the Walker Guidelines (the UK's self-regulation), a lowering of the thresholds above which the guidelines apply, thereby extending the number of private equity firms and portfolio companies falling subject to them, seems likely.

There must be some good opportunities to buy the assets of distressed or insolvent companies. Do any special considerations apply?

Special considerations which apply to acquisitions of distressed or insolvent companies include:

Timing

Usually, it is in the best interests of both seller and purchaser to negotiate and finalise the acquisition of the distressed company as quickly as possible. This is because of the need to preserve value in the business before it is tainted by the stigma of failure or key employees, customers or suppliers lose confidence and leave the business.

Asset or share acquisition?

Buying the assets rather than the shares of the company means that it should be possible to leave most liabilities behind in the old corporate entity. An asset acquisition is also advantageous for the purchaser in terms of avoiding liability for any pension scheme deficit (see below).

A share sale would be preferable if the purchaser is interested in tax losses but this requires more extensive due diligence for which there is not usually time (see below).

Consideration

Sellers of distressed companies (usually, either an administrator or an administrative receiver) are not usually interested in negotiating deals for any complex consideration, such as deferred consideration or shares. Generally, they prefer to do an up-front cash deal, even if it means the overall consideration paid is lower.

Limited due diligence

Given the need for speed, the opportunity for the purchaser to undertake due diligence is usually limited. If the seller is an administrator or an administrative receiver he will, in any case, have limited information about the assets. The onus will be on the purchaser to take such steps as it can to undertake due diligence from the information provided by the seller.

No representations or warranties

A seller which is an administrator or an administrative receiver will not give any representations or warranties to the purchaser. Often, such a seller will expressly disclaim all responsibility for what they are selling. It may be possible to obtain representations and warranties from the distressed company but if it is insolvent these will be of little or no value.

Title of the distressed company to its assets

It will be important for the purchaser to check that the distressed company has title to the assets being sold. If the seller of the distressed company is an administrator or an administrative receiver he will only sell "such right, title and interest as the company may have" in the assets. This may mean that third parties have ownership or other rights over the assets.

Employee liabilities

Some of the most difficult problems associated with the acquisition of a distressed company arise from the application to the purchase of the Transfer of Undertakings (Protection of Employment) Regulations 2006 (SI 2006/246) (TUPE). Employee rights usually transfer automatically under TUPE on an asset sale.

Pension liabilities

A key concern for the purchaser will be to avoid becoming liable for any pension scheme deficit. As a general rule, this is easier to achieve if the purchase is structured as an acquisition of assets rather than an acquisition of shares.

United States of America

For an overview of the causes and impact of the financial crisis in the US, see PLC US Article, Financial Crisis: Series Overview prepared by PLC Corporate & Securities and PLC Finance in New York. The overview links through to more detailed notes on:

Financial crisis: Q&A (UK) | Practical Law