In approving the merger of UBS and Credit Suisse (CS), FINMA referred to the risk of CS becoming illiquid and stated that the transaction and measures taken would “ensure stability for [CS’s] customers and for the financial centre”.
Under the terms of the merger agreement, Additional Tier 1 (AT1) capital instruments (AT1 Bonds) will be written down to zero, reversing the usual order of priority of repayment of bank/corporate debt on insolvency. As a result, AT1 bondholders will receive no return, yet unusually, CS’s shareholders will receive a modest return.
Following negative commentary on the “wipeout” of the AT1 Bonds, on 23 March 2023, FINMA provided information about the basis for the write-down of the AT1 Bonds. The soundings about potential challenges to the legal basis for the write-down of the A1 Bonds may have prompted FINMA’s announcement. FINMA confirmed that the write-down was authorised:
- on a contractual basis, whereby the AT1 Bonds contractually state that they will be completely written down in (i) a “viability event” and (ii) if extraordinary government support is granted. FINMA confirmed that both contractual conditions were met, and
- through its enactment of a Federal Council Emergency Ordinance of 19 March 2023, authorising FINMA to order the write-down of the AT1 Bonds.
A bank’s capital
The capital of a bank comprises Tier 1 and Tier 2 capital. Tier 1 capital is the primary funding of a bank. It consists of Common Equity Tier 1 (CET1) and AT1 capital. CET1 includes equity share capital, retained earnings and other reserves. AT1 Bonds are a hybrid instrument known as “contingent convertible bonds”. They can be converted into CET 1 instruments (i.e. equity share capital) or written down.
Equity share capital holders, or shareholders, own shares in a company. Bonds are a form of debt that must be repaid. They are usually issued by a company or bank (Issuer) and bought by a bondholder. In the case of liquidation or insolvency of the Issuer, shareholders’ debt ranks below that of bondholders in the order of priority given to claims against the Issuer.
In the EU, regulations govern the capital requirements of a bank, the Capital Requirements Regulation (CRR), and the Capital Requirements Directive, which were transposed into Irish law. The CRR allows for trigger events in AT1 instruments that require their principal amount to be converted into CET 1 instruments or written down. So, in the EU, the write down of AT1 instruments can also occur. The point of contention however, is whether in such circumstances, the equity holders (i.e. shareholders) would still receive a return, thereby inverting the traditional hierarchy of priorities of claims?
Such an eventuality appears unlikely, having regard to:
- The Irish European Union (Bank Recovery and Resolution) Regulations 2015 (2015 Regulations) which transposed into Irish law Directive 2014/59/EU establishing a framework for the recovery and resolution of credit institutions and investment firms (BRRD). The BRRD and the 2015 Regulations introduced a process known as “bail-in”, a resolution tool, under which shareholders’ and bondholders’ investments are written down or converted. However, if for example the Central Bank of Ireland was applying the bail-in resolution tool in respect of a failing bank, it would be required to respect the hierarchy of claims principles, under which shareholders must bear the first losses, followed by creditors. [Regulation 64 of the 2015 Regulations].
- The joint statement issued on 20 March 2023 by the ECB Banking Supervision, the Single Resolution Board, and the European Banking Authority in response to the write-down of the AT1 Bonds.
The joint statement referred to the European recovery and resolution framework, that establishes “the order according to which shareholders and creditors of a troubled bank should bear losses. In particular, common equity instruments are the first ones to absorb losses”. The statement confirmed that AT1 continues to be an important component of the capital structure of European banks.
The reduction to zero of CS’s AT1 Bonds will continue to generate much interest in the coming months. Also, news emerged in recent days that Switzerland’s federal prosecutor had commenced an investigation into the merger for potential breaches of Swiss criminal law. It said it needed to investigate “numerous aspects of events around Credit Suisse” to identify any crimes within its remit.
It remains to be seen whether a legal challenge to FINMAs actions, and in particular the write down of the AT1 Bonds will be initiated. Although banking law in Switzerland is not subject to EU regulation, any future litigation will be of interest to bondholders and financial advisers based in the EU.