„(5) With regard to claims within the meaning of section 38 of the German Insolvency Code, priority treatment will be given to those claims that do not involve debt instruments pursuant to subsection (6) sentence 1.

(6) Debt instruments within the meaning of this sentence are bearer bonds and order bonds and rights comparable to these debt instruments which, by their nature, are tradable in the capital markets, as well as loans against borrowers’ notes and registered bonds which do not constitute deposits pursuant to subsection (4) number 1 or 2. Debt instruments within the scope of section 91 (2) of the German Recovery and Resolution Act and debt instruments issued by public-law institutions that are not eligible for insolvency, as well as money market instruments, are not deemed to be debt instruments within the meaning of sentence 1.

(7) Subsection (6) sentence 1 does not cover debt instruments for which it is agreed that
1 repayment or the repayment amount is contingent upon the occurrence or non-occurrence of an event which is still uncertain at the time when the debt instrument is issued, or the claim is to be settled in a non-monetary form,
or
2 interest payments or the amount of interest paid is contingent upon the occurrence or non-occurrence of an event which is still uncertain at the time when the debt instrument is issued unless the interest payment or amount of interest paid is solely contingent upon a fixed or floating reference interest rate and is settled in a monetary form.“

1 Scope and objective

The new rule provides a ranking solely within the category of CRR institutions’ liabilities which constitute insolvency claims for the respective creditors pursuant to section 38 of the German Insolvency Code (Insolvenzordnung). Therefore, the new rule will be without prejudice to the current classification of liabilities that constitute subordinated insolvency claims for the respective creditors within the meaning of section 39 of the Insolvency Code. These subordinated insolvency claims within the meaning of section 39 of the Insolvency Code will retain their current insolvency ranking relative to the other insolvency claims within the meaning of section 38 of the Insolvency Code.

The subordinated liabilities of CRR institutions pursuant to section 39 of the Insolvency Code include, among other things, Additional Tier 1 and Tier 2 instruments as well as other liabilities which are subordinate in the insolvency of a CRR institution owing to a contractual provision. Pursuant to section 46f (5) of the Banking Act as amended, those claims of a CRR institution’s creditors within the meaning of section 38 of the Insolvency Code that do not involve debt instruments pursuant to section 46f (6) sentence 1 of the Banking Act as amended will be given priority treatment in insolvency proceedings.

Apart from defining the ranking for satisfying claims in insolvency proceedings, the new rule will also have an impact on the resolution of a CRR institution according to the provisions of the German Recovery and Resolution Act (Sanierungs- und Abwicklungsgesetz, SAG) or the Single Resolution Mechanism Regulation (SRMR) respectively. If the preconditions for the resolution of an institution pursuant to section 62 SAG or Article 18 of the SRMR have been fulfilled, the resolution authority may, among other things, apply the bail-in tool (section 90 SAG; Article 27 SRMR). Within the scope of this tool, eligible liabilities (section 91 (1) SAG) can be written down or, for recapitalisation purposes, be converted into the institution's own funds (bail-in). If the resolution authority applies the bail-in tool, it must comply with the liability cascade set out in section 97 (1) SAG (Article 17 SRMR), according to which eligible liabilities are included in a bail-in only after shares and other Common Equity Tier 1 instruments, Additional Tier 1 instruments and Tier 2 instruments have been drawn on. Within the group of eligible liabilities, liabilities must be drawn on in the order laid down under insolvency law (section 97 (1) sentence 3 SAG).

Owing to the ranking laid down in section 46f (5) of the Banking Act as amended, the resolution authority, when applying the bail-in tool to eligible liabilities, will first have to draw on all liabilities arising from the unsecured debt instruments covered by the new rule before the CRR institution's remaining non-subordinated liabilities can be drawn on. As a result of the resolution principles laid down in section 68 (1) SAG, the resolution authority, when applying resolution tools, will have to ensure that shareholders and creditors bear losses to the same extent as they would have done in insolvency proceedings if such had been initiated at the time of the resolution order (section 68 (1) number 1 SAG). The provisions of section 46f (5) of the Banking Act as amended aim ‒ in the event of insolvency ‒ to improve the position of liabilities for which the application of the bail-in tool is likely to entail substantial practical, legal and technical difficulties considering the brief time available in the event of resolution, thus possibly leading to contagion risks or financial stability risks (Explanatory memorandum to the Federal Government’s draft bill regarding the Resolution Mechanism Act, Bundestag printed paper 18/5009 of 26 May 2015, page 91 [Gesetzesbegründung zum Regierungsentwurf des AbwMechG, BT-Drs. 18/5009 v. 26.05.2015, S. 91]). The application of the bail-in tool to these liabilities may run counter to the resolution objectives established in section 67 (1) SAG (in particular, section 67 (1) number 2 SAG). By contrast, the application of the bail-in tool in relation to the debt instruments covered by section 46f (6) sentence 1 of the Banking Act as amended is deemed to involve a particularly low risk (Explanatory memorandum to the Federal Government’s draft bill regarding the Resolution Mechanism Act, Bundestag printed paper 18/5009 of 26 May 2015, page 90).

2 Debt instruments

Debt instruments within the meaning of section 46f (6) sentence 1 of the Banking Act as amended are all bearer bonds (auf den Inhaber lautende Schuldverschreibungen) and order bonds (Orderschuldverschreibungen) and rights comparable to these debt instruments which, by their nature, are tradable in the capital markets, as well as loans against borrowers’ notes (Schuldscheindarlehen) and registered bonds (Namensschuldverschreibungen).

3 Exemptions

(a) Exemptions for deposits, debt instruments not subject to bail-in, and debt instruments of legal persons under public law that are not eligible for insolvency

Section 46f (6) sentence 1 of the Banking Act as amended does not cover all of an institution's debt instruments. To start with, all debt instruments that are deemed to be deposits pursuant to section 46f (4) number 1 or 2 of the Banking Act are exempted, as are debt instruments within the scope of section 91 (2) SAG. The latter include, for example, all secured liabilities, including liabilities resulting from covered bonds insofar as they are secured or covered at least by the value of the collateral posted for this purpose (section 92 (2) number 2 SAG). Debt instruments issued by public-law institutions that are not eligible for insolvency are likewise not deemed to be debt instruments within the meaning of section 46 (6) sentence 1 of the Banking Act as amended. The question of whether or not a legal person under public law is eligible for insolvency is determined by the pertinent federal legislation or, pursuant to section 12 (1) number 2 of the Insolvency Code, by the pertinent state legislation.

(b) Exemption for money market instruments

Another key exemption in practice concerns money market instruments. Pursuant to section 1 (11) sentence 2 of the Banking Act, money market instruments are all types of receivables that are normally traded on the money market, with the exception of payment instruments. Money market instruments are, therefore, all types of contractual claims with proprietary content that are transferable and are actually traded on the money market, and are not just tradable. The distinction between the money market and the capital market is determined by the length of time over which capital is made available. The distinction between the capital market and the money market generally is drawn at a period of 12 months or 365 days/366 days in the case of a leap year (subsection (2b) sub-item (gg) “Geldmarktinstrumente” of the notice issued by BaFin on 20 December 2011 entitled “Hinweise zu Finanzinstrumenten nach § 1 Abs. 11 Satz 1 Nr. 1 – 7 KWG”).

When determining this distinction, the original maturity is relevant for classifying debt instruments as money market instruments that are exempted from the provisions of section 46f (6) sentence 1 of the Banking Act as amended. This is because the point and purpose of this exemption is to avoid systemic risk by applying or threatening to apply the bail-in tool to instruments that both issuers and investors use for liquidity management. The threat of a priority bail-in could hamper both the issuability of money market instruments and also trigger contagion risks, especially for enterprises in the real sector that hold liquidity reserves in the form of money market instruments. An extension of the definition of money market instruments to include instruments with a residual maturity of up to 397 days as set out, for instance, in Article 3 (2) (b) of Directive 2007/16/EC or section 194 (1) of the German Capital Investment Code (Kapitalanlagegesetzbuch), would go too far for the purposes of the provision in hand. The definitions referenced each fulfil a different legal purpose.

The aim of the new rule in question is to ensure that the bail-in tool is applied as simple and legally sound as possible. Otherwise, an instrument's ranking in terms of insolvency and thus also in a potential resolution would change over the instrument’s lifetime. This additional degree of complexity would run counter not only to the legal purpose of the provision, but also to the market’s interests in having transparency and clarity.

c) Exemption with regard to structured financial products pursuant to section 46f (7) of the Banking Act as amended

Pursuant to section 46f (7) of the Banking Act as amended, claims for which repayment or interest payments or the repayment amount or amount of interest paid is contingent upon the occurrence or non-occurrence of an event which is still uncertain at the time when the debt instrument is issued, or which are to be settled in a non-monetary form (“structured financial products”), are also exempted from the special insolvency rule. However, this does not apply to interest payments if the interest payment or amount of interest paid is solely contingent upon a fixed or floating reference interest rate and is settled in a monetary form. The aim of this provision is to exempt, in particular, derivatives and structured debt instruments, as well as combinations of the two, from the special insolvency rule where it is likely that the complexity of these instruments could lead to practical difficulties in applying the bail-in tool to them. Difficulties may result, in particular, from the fact that product structuring gives rise to repayments or interest payments, the amount of which may still be uncertain at the time of an insolvency or a resolution. This can lead to problems or at least to severe time lags in the valuation of balance sheet items which is required for a resolution (Explanatory memorandum to the Federal Government’s draft bill regarding the Resolution Mechanism Act, Bundestag printed paper 18/5009 of 26 May 2015, page 92). However, the complexity of the valuation is considered to be acceptable if the structure of a debt instrument is linked merely to a conventional and simple reference interest rate. In practice, only EURIBOR, EONIA and LIBOR currently come into consideration in this regard.

Solely by granting and designing contractual termination rights,, debt instruments are not made subject to the provisions of section 46f (7) of the Banking Act as amended. On the contrary: termination rights on the part of both the creditor and the issuer are in principle irrelevant for classification as a structured financial product. This also applies to the issuer's right of early repayment. The reason for this is that the debt instrument’s maturity date alone does not give rise to a valuation difficulty in the event of a resolution procedure. Given that debt instruments governed by German law constitute ongoing payment obligations and can thus be terminated for good cause at any time, and that debt instruments frequently also contractually give a right to early termination or early repayment, a right of early termination or early repayment would not be a suitable criterion for determining the scope of the exeption clause under section 46f (7) number 1 of the Banking Act as amended. The uncertainty regarding repayment therefore refers to a situation in which, owing to contractual arrangements, the repayment itself, ie “whether” and not only when the claim will be repaid, is contingent upon the occurrence or non-occurrence of an uncertain event. Therefore, strictly speaking, a situation in which repayment is contingent upon the occurrence or non-occurrence of an uncertain event is merely a subset of the uncertainty regarding the repayment amount, as this amount may also be zero.

4 Classification of features pursuant to section 46f (7) of the Banking Act as amended

The examples given under item (a) describe features which do not place debt instruments within the scope of section 46f (7) of the Banking Act as amended. These are followed in item (b) by descriptions of debt instrument features which are within the scope of this provision.

(a) Features which do not lead to the classification of a debt instrument pursuant to section 46f (7) of the Banking Act as amended

The following features do not place a debt instrument within the scope of section 46f (7) of the Banking Act as amended:

(1) Fixed coupon

Example: “5%” or another fixed rate over the entire term or “issue price = repayment price” (issued at 0% or at a negative interest rate)
Repayment or the interest payment itself or the repayment amount or amount of interest paid is not contingent upon an event which is still uncertain at the time when the instrument is issued.

(2) Floating coupon

Example: “3-month EURIBOR +/- 150 basis points”
In such a case, the coupon is determined by the reference interest rate plus/minus the premium (spread or margin). The amount of interest paid is solely contingent upon a fixed or floating reference interest rate.

(3) Zero coupon

Example: “Issue price of €50, repayment amount of €100, ten-year term, no coupons”
In the case of an instrument with a zero coupon, the interest accrued on the nominal value is predefined and non-variable as agreed contractually. Repayment or the interest payment or the repayment amount or amount of interest paid is not contingent upon an event which is still uncertain at the time when the instrument is issued.

(4) Multi-step increasing or decreasing fixed coupons

Examples: “2% in year 1, 3% in year 2; 5% in year 1, 4% in year 2”
In such arrangements, the interest payments and repayments are predefined. Therefore, repayment or the interest payment itself or the repayment amount or amount of interest paid is not contingent upon an event which is still uncertain at the time when the instrument is issued.

(5) Fixed agreed individual interest payment and repayment flows

Example: “An investor pays €100 to begin with, receives €5 interest in year 1, €3 interest and €20 repayment in year 2, €5 interest and €80 repayment in year 3”
Owing to the amortising structure, interest payments, the final repayment amount and claims during the term are predefined. Repayment or the interest payment itself or the repayment amount or amount of interest paid is not contingent upon an event which is still uncertain at the time when the instrument is issued.

(6) Obligations in a foreign currency, but with a “secure” measurable interest rate and repayment

Example: “An instrument in USD in nominal terms with a fixed or floating coupon, repayment in USD at 100”
Interest payments, the final repayment amount and claims during the maturity period are predefined. The fact that the instrument is denominated in a foreign currency is not a feature which leads to classification pursuant to section 46f (7) of the Banking Act as amended.

(7) Inverse floating rates

Example: “5% ‒ 3-month EURIBOR”
The interest payment amount is solely contingent upon a floating reference interest rate (performance of the 3-month EURIBOR).

(8) Factorisation

Example: The payment of interest is in an interest period of the type “3-month EURIBOR x factor”
The interest payment amount is solely contingent upon a reference interest rate. The fact that multiplication or addition is carried out here has no bearing on the assessment.

(9) Floating-rate notes with a 0% floor to avoid negative interest rates

Example: “The coupon’s 0% floor is stated explicitly in the bond terms or can be interpreted implicitly”
Negative interest rates pose legal problems which means that, under certain circumstances, even in the absence of a relevant explicit contractual provision, an implicit 0% floor may be interpreted as having been agreed. If, for clarification purposes, a 0% floor is included in the contractual documentation, this does not create a structured product within the scope of section 46f (7) of the Banking Act as amended.

(10) Fixed coupon which, however, changes according to predefined interest rate types/periods

Example: “2% fixed coupon in years 1 and 2; thereafter, 3-month EURIBOR + 150 basis points until maturity”
Interest payments, the final repayment amount and claims during the maturity period are predefined for all periods; the period sequence is also predefined. This means that there is not an event which is still uncertain at the time when the instrument is issued within the meaning of section 46f (7) of the Banking Act as amended.

(11) Unilateral ordinary right to give notice on the part of the debtor but no ordinary right to give notice on the part of the creditor

Example: “Maximum maturity of ten years, issuer has an annual ordinary right to give notice after five years; repayment amount (eg 100%) is predefined”

(12) Extraordinary right to give notice on the part of the debtor but no ordinary right to give notice on the part of the creditor

Example: “Extraordinary right to give notice for good cause, eg tax treatment”

(13) Statutory right to give notice

Example: “Borrower’s note with an ordinary right to give notice on the part of the debtor pursuant to section 489 of the German Civil Code (Bürgerliches Gesetzbuch)”

(14) Ordinary or extraordinary right to give notice on the part of the creditor

Example: “Ordinary right to give notice on the part of the creditor after five years or extraordinary right to give notice for good cause”
In the cases cited in subsections (11) to (14), the repayment amount is predefined and not contingent upon an uncertain event.

b) Features which lead to the classification of a debt instrument pursuant to section 46f (7) of the Banking Act as amended

The following features place a debt instrument within the scope of section 46f (7) of the Banking Act as amended:

(1) Calculation basis for interest payment contains derivatives

Example: “Coupon = number of days on which a reference index lies within a range”
The interest payment is uncertain as the coupon payment amount is contingent, among other things, upon a reference index.

(2) Calculation basis for repayment contains derivatives (eg equity derivatives or credit-linked notes)

Example: “Repayment at 100 or DAX performance over time if higher (capital guarantee)”
With this kind of arrangement, the repayment amount is contingent upon an uncertain event. It contains an equity derivative which is to be exempted pursuant to the explanatory memorandum on section 46f (6) of the Banking Act as amended. Therefore, there is an event which is still uncertain at the time when the instrument is issued within the meaning of section 46f (7) number 1 of the Banking Act as amended.

(3) Index-linked bonds

Example: “Repayment amount or amount of interest paid is linked to the performance of an index”
In the case of index-linked bonds, eg inflation-linked bonds, the repayment amount or interest paid is contingent upon an uncertain event, depending on the structure chosen.

(4) Obligations in a non-deliverable foreign currency, for which interest payments and/or repayment are to be settled in another deliverable currency

Example: “Liabilities in Brazilian real (BRL) in nominal terms with a fixed or floating coupon, repayment in USD at a future exchange rate”
The repayment amount and/or amount of interest paid are contingent upon a future event (exchange rate path).

(5) Floating coupon plus one or more of the following features: interest rate floor (fixed or ascending/locked-in), interest rate ceiling, interest rate spread

Examples: “3-month EURIBOR, minimum 2%, maximum 4%”; “3-month EURIBOR, each fixed coupon becomes the interest rate floor for the subsequent periods”
The interest payment amount is uncertain at the time when the instrument is issued within the meaning of section 46f (7) number 2 of the Banking Act as amended. The corresponding exemption granted for exclusive linking to a reference interest rate does not apply as, besides being linked to a reference interest rate, the interest rate is structured as for a derivative (the limitation of individual interest payments contains an additional derivative in the form of a cap, floor or collar).

(6) Interest rate changes between pre-defined interest rate types/periods subject to the debtor or creditor exercising a right to choose

Example: “2% fixed in years 1 and 2. At the end of the two years, the debtor or creditor can choose between an interest payment equivalent to 2.5% or the 3-month EURIBOR + 200 basis points”
Owing to the debtor’s or creditor’s right or option to choose, the amount of interest to be paid is not clearly defined at the time when the instrument is issued. The interest payment amount is therefore contingent upon an event which is uncertain at the time when the instrument is issued (exercising an option right).

(7) Interest rate changes between interest rate types/periods subject to index performance

Example: “Fixed coupon for 2 years, interest to be paid is contingent upon DAX performance in subsequent years”
The fact that the instrument contains at least one interest period in which uncertainty regarding the interest rate amount is contingent not only upon a reference interest rate places the instrument within the scope of section 46f (7) number 2 of the Banking Act as amended for the entire maturity period. This applies regardless of whether the “structured” interest period is at the beginning, the middle or the end of the term..

(8) Floating coupon is contingent upon an alternative reference interest rate (ie none of the money market reference interest rates such as EURIBOR, LIBOR etc) which is quoted regularly and transparently on the market

Example: “10-year CMS + 50 bps” (swap rate compared with eg 6-month EURIBOR with the corresponding swap term)
Constant maturity swaps (CMS), in which a fixed or floating coupon is exchanged for another floating payment flow that is regularly brought into line with a longer-term reference rate, are quoted on the market; however, due to the structuring component, it is not a reference interest rate within the meaning of section 46f (7) number 2 of the Banking Act as amended.