The Egg Drop Container: Hong Kong’s Financial Institutions (Resolution) Ordinance

The Egg Drop Experiment

Remember that experiment where students would build a container for eggs, then drop the container from a height, to see if it would protect the eggs from breaking?

September 2008 – mortgage giants Fannie Mae and Freddie Mac were taken over by the US government. Bank of America purchased Merrill Lynch for US$50 billion. Lehman Brothers filed for bankruptcy. AIG, the world’s largest insurer, accepted a US$85 billion federal bailout. Regulators closed Washington Mutual Bank. And on and on the global financial crisis went. Splat, splat, splat – eggs break when dropped.

But catching them as they fall is difficult. Banks that had invested in the rapidly devaluing mortgage-backed financial instruments experienced liquidity crises, bringing the global financial system to the brink of collapse. Lehman Brothers would be the last systemically important financial institution (“SIFI”) allowed to fail – other SIFIs would receive support by way of capital injections, asset or liability guarantees, and further forms of public funding.

The enormous public cost and threat to stability of the global financial system underlined how unsuitable insolvency proceedings are for resolving SIFIs whilst maintaining their provision of critical financial services, and the lack of regulatory power over SIFI failure.

In September 2009, the G20 Leaders engaged the Financial Stability Board (“FSB”) to devise more effective arrangements for resolving SIFIs – “Design a container for eggs to protect them when dropped, or to minimise the mess if broken.”

In October 2011, the FSB adopted the Key Attributes of Effective Resolution Regimes for Financial Institutions (“Key Attributes”), a framework for effective resolution regimes. The Key Attributes were endorsed by the G20 in November 2011 as the “new international standards for resolution regimes”, which would require legislative reforms in most jurisdictions to implement.

Some jurisdictions had already implemented reforms – the Dodd-Frank Act in the US (July 2010) or the Bank Recovery and Resolution Directive in the EU (May 2014). However, significant gaps were identified by the FSB’s Thematic Review on Resolution Regimes: Peer Review Report (April 2013) as to regulator powers of resolution in Hong Kong. The Financial Institutions (Resolution) Ordinance (“FI(R)O”) was thus conceived to implement the Key Attributes locally.

Nine years after the Financial Crisis, the question is whether the FI(R)O, which came into force on 7 July 2017, is just another layer of regulation wrapped over existing layers or will prove an effective egg-drop container.

One Size Fits All

At first glance, the FI(R)O appears to be another layer of regulation – a cross-sectoral statute providing new regulatory powers for the Hong Kong Monetary Authority (“HKMA”), the (new) Insurance Authority, and the Security and Futures Commission (“SFC”) as “resolution authorities” for banking, insurance and securities and futures sector entities, respectively. The FI(R)O applies to all banks, global systemically important insurers and licensed corporations, and financial market infrastructure entities (referred to as “within scope financial institutions”). The jurisdiction of the FI(R)O may be extended to holding companies and affiliated operational entities of financial institutions within the FI(R)O’s scope.

The application of the FI(R)O to corporations licensed under the Securities and Futures Ordinance (“SFO”) is unascertained, as the FSB’s assessment methodology for non-bank non-insurer global systemically important financial institutions has yet to be finalised.

The rationale behind creating a single, cross-sectoral regime was to better support the orderly resolution of financial institutions in a wider financial services group operating across multiple sectors. In resolving such a group, the FI(R)O empowers the Financial Secretary to designate a lead resolution authority. The lead resolution authority may exercise powers in respect of financial institutions as though it were the resolution authority of the sector that financial institution belongs to. In practice, it seems more likely that the lead resolution authority will give written directions to the other regulators, who must comply with such directions.

Whilst certain features of the FI(R)O – including compensation in Part 6 and the review tribunals under Part 7 – are common to all three sectors, it remains to be seen how the divers needs of different types of within scope financial institution will be addressed in resolution. Some provisions, such as the power of the HKMA to make capital reduction instruments under s. 31, or sub-s. 90(5) on suspension of termination rights in contracts of insurance, are sector-specific. Others, such as stabilisation options, may not be equally applicable.

Pre-Resolution Compliance

All three sectors are subject to preparation for resolution. However, compliance with these provisions is likely to differ in practice from sector to sector.

To ensure the efficacy of resolution, resolution authorities may carry out resolvability assessments of within scope financial institutions and carry out planning for their resolution. For these purposes, the HKMA has already published a Code of Practice on Resolution Planning Core Information Requirements (May 2017). Powers of assessment and planning are supplemented by powers of information gathering (s. 158) and entry and inspection (s. 160).

During assessment, the structure, operation, or business practices of a within scope financial institution may be considered “impediments” to the planned resolution. Resolution authorities may direct removal or mitigation of such impediments – though there is currently no guidance as to what an “impediment” is.

Further to capital requirements under the Banking Ordinance (“BO”), Insurance Companies Ordinance (“ICO”), or SFO, the FI(R)O empowers resolution authorities to make rules for loss-absorbing capacity of within scope financial institutions. Reference is made in s. 19 to international standard-setting bodies – the Legislative Council brief for the Financial Institutions (Resolution) Bill (2015) referred to the FSB’s Principles on Loss-absorbing and Recapitalisation Capacity of G-SIBs in Resolution as one example.

Resolution authorities may also make rules to require provisions in contracts that create liabilities for within scope financial institutions to acknowledge they may be subject to bail-in under stabilisation. A further rule-making power provides for acknowledgement of eligibility of termination rights in contracts with qualifying entities to be suspended in resolution.

To protect the resolution process, petitions for winding up by the Courts may not be presented in respect of within scope financial institutions unless notice is given to the relevant resolution authority (s. 192). This section will not come into force until rules have been made as to court practice and procedure.

Ceasing to be Viable and Initiating Resolution

Key to the FI(R)O is the concept of “resolution”, which differs from winding up. Where insolvency proceedings maximise and distribute remaining assets to creditors, resolution should be a rapid response for protecting critical functions (such as deposit taking, provision of loans, managing payment systems, etc) of failing financial institutions.

Section 5 provides that a financial institution is considered non-viable if it has failed to meet conditions required to maintain its authorisation to carry on business (such as licensing, approval, recognition or designation under the BO, ICO or SFO), and that authorisation may be removed, or it is unable to discharge its obligations for carrying on business. “Unable to discharge obligations” under this section may be confusingly similar to the inability to pay debts for the purposes of winding up. Key Attribute 3.1 states “[t]he resolution regime should provide for timely and early entry into resolution before a firm is balance-sheet insolvent and before all equity has been fully wiped out” (emphasis added), illustrating the pre-emptive nature of resolution.

Section 25 sets out conditions for initiating resolution – (1) that the financial institution has ceased to be viable; (2) there is no reasonable prospect the financial institution could become viable again through private sector action; and (3) the non-viability of the financial institution poses risks to the stability of the financial system.

These conditions are also relevant as prerequisites to exercise certain powers, such as the resolution authority’s power to give directions (s. 22), remove directors (s. 24), or make capital reduction instruments (s. 31).

Fulfilling the three conditions is likely to differ from sector to sector, raising the issue of how resolution powers will be exercised where a group includes within scope financial institutions in more than one sector.

Resolution and Stabilisation

Once s. 25 conditions have been fulfilled, a resolution authority must consult with the Financial Secretary before initiating resolution (s. 27). Resolution is initiated by issuing a letter under s. 30 indicating the resolution authority’s mindedness to resolve the financial institution. The financial institution may make representations in respect of the potential resolution.

FI(R)O Part 5 sets out powers of resolution authorities in resolution. Resolution authorities may manage or exercise the powers of a financial institution in respect of its affairs, business or property, as well as powers to transfer or issue securities to the resolution authority (s. 93). This may in some ways be compared to the powers of a liquidator, though the purpose and outcome of resolution is much different than distributing assets in liquidation.

Resolution authorities may suspend contractual obligations of a financial institution in resolution (s. 83), though certain types of obligation are excluded from suspension (s. 84). Similarly, the resolution authority may suspend termination rights of counterparties otherwise exercisable under contract with the financial institution in resolution (s. 90). Measures taken for the purposes of resolution are to be disregarded and shall not trigger contracts containing default provisions (s. 89).

To stabilise the parts of financial institutions that perform critical functions, a resolution authority may apply statutory stabilisation options to a financial institution in resolution. Under s. 33, the five options are:

  • to transfer the securities, assets, rights or liabilities of the financial institution to a privately owned purchaser;
  • a bridge institution;
  • an asset management vehicle;
  • a temporary public ownership company; or
  • to bail-in the financial institution.

Under s. 34, the resolution authority may apply one or a combination of the options, together or sequentially, or apply stabilisation to certain parts of the financial institution only. The resolution authority may also choose not to apply stabilisation – the general powers under s. 93 may apply, or the financial institution may be allowed to fail in the normal way, presumably by exercise of the resolution authority’s regulatory powers to wind up financial institutions, or by way of insolvency proceedings.

An Effective Egg Drop Container?

Due to the size and scope of the FI(R)O, matters such as: removal of officers; clawback of their remuneration; offences; compensation; and non-Hong Kong resolution actions have not been discussed.

It remains difficult to assess the effectiveness of the FI(R)O. The cross-sectoral approach leaves much open, presumably for flexibility. Further regulatory guidance needs to be developed under the rule-making powers – as illustrated by the exclusion from commencement of Part 8 and s. 192 of the rules for the court procedure of clawback of remuneration and on how notice of winding up petitions can be made.

Guidance as to when an institution is considered “non-viable”, and how more draconian powers such as removal of “impediments” are to be exercised, will be critical for compliance of within scope financial institutions. The issue of consistency between the three sectors where groups include within scope financial institutions in more than one sector also remains.

What is clear, however, is the ambitiousness of what the FI(R)O tries to accomplish, and the potential complexity in exercising resolution powers in Hong Kong.


Liberty Chambers, Barrister

Antonio Da Roza is a barrister-at-law at Liberty Chambers. He is a contributor to Hong Kong Civil Procedure; Hong Kong Archbold; Securities and Futures Ordinance Commentary and Annotations; and the author of the Amendments and Transitions to Cap. 32: A Visual Guide; The New Companies Ordinance: A Visual Guide; Companies (Winding Up and Miscellaneous Provisions) Ordinance Commentary and Annotations (2d Ed.); and the new Financial Institutions (Resolution) Ordinance Commentary and Annotations.