Bondholders’ burden

There is one good thing about a financial crisis: it has drawn attention to the need for robust laws and regulations dealing with struggling or failing institutions. The various corporate, bank and state collapses since 2008 have led many countries to set up or consider establishing special resolution schemes – frameworks specifically designed to handle collapsing financial institutions.

The UK has long operated without specific laws of this kind. Practitioners have worked as best they can within the broad bankruptcy and restructuring legislation. But support for specially-designed schemes has grown recently.

"Generally I am a reluctant supporter of special regimes for exceptional cases," says Norton Rose partner Hamish Anderson.

"In the UK we have had a proliferation of regimes which has produced incoherence in the legislation as a whole – they don't follow a consistent pattern. I accept that the events of 2008 pointed to the need to deal with financial institutions collapses in a rather different way."

When dealing with financial institutions, the risks are particularly big. Left unchecked, one bank's collapse can lead to a domino effect which could badly damage confidence in the integrity of a whole country's financial system. The size of the potential repercussions of such a systemic failure has led to the worldwide proliferation of bank resolution laws. They come in various shapes and forms, but their broad purpose is the same.

"Bank resolution procedures are by their nature bespoke and are there to rescue banks before formal insolvency proceedings," says Philip Hertz, a Clifford Chance partner in London. "They follow the model devised historically for troubled life insurance companies which is premised on the theory that it's better to transfer the business to another insurer than for the company to fall subject to formal liquidation proceedings."

Special regimes

One element found in many new regimes is the requirement for so-called living wills, or comprehensive recovery or contingency plans. In September 2011, the United States Federal Deposit Insurance Corporation (FDIC) approved Dodd-Frank, which requires large bank holding companies and other systemically important financial companies to develop comprehensive contingency plans for the orderly resolution of their affairs under the US Bankruptcy Code (or other applicable insolvency regime).

The UK is taking a more interventionist approach to recovery plans. While Dodd-Frank emphasises how the institution itself will resolve its financial distress, the UK provisions (found in the Financial Services Act 2010) focus more on what options are available to the regulators in the event of possible failure. The information in an institution's recovery plan is intended to help the regulator to implement the stabilisation powers of the Banking Act 2009. That Act gives UK regulators much wider powers to intervene and compel a transfer of part or all of a failing bank to a private sector purchaser, a bridge bank or even to temporary public ownership.

Similar provisions are found in the latest Irish legislation. As well as requiring resolution plans or living wills, the Central Bank and Credit Institutions (Resolution) Act 2011 provides for transfer orders (in which a minister or the central bank has the power to order the moving of assets and liabilities of a failing institution); the establishments of bridge banks (temporary special subsidiaries into which can be transferred certain assets and liabilities in order to protect depositors); the appointment of a special manager by the central bank, if the current management is felt to be inadequate; and the establishment of a resolution (bail-out) fund to which all banks will contribute.

So despite many similarities, resolution schemes tend to differ in the amount of intervention they allow or require from the regulator, or even a national government.

"Some approaches seem to blur the distinction between regulatory intervention and the insolvency process," Anderson says.

Bondholders' chequebook

Nowhere is intervention more apparent for investors than in provisions for bail-ins: compulsory conversion from debt to equity for bondholders if the bank gets in trouble. Although bail-ins have the advantage of providing certainty to the market, they generate considerable controversy.

Hamish Anderson, Norton Rose

Of course, bondholders will sometimes voluntarily buy in to similar arrangements. Contingency convertible (CoCo) bonds have grown in popularity since the first ones were issued by Lloyd's Bank in 2009. In Ireland, Irish Life and Permanent issued a CoCo instrument in July 2011 under which investors were allowed to hold a subordinated credit exposure to the bank; given certain predefined events occurring, it was also agreed that the relationship would change such that the bond converted to an equity investment.

So why the outcry over statutory bail-ins? The key is the discretion given to external parties – sometimes government ministers – to decide when debt is converted to equity. In the US, for example, regulators decided that the existing mechanism (in the Bankruptcy Code) by which debtors could be compelled to take equity in exchange for credit was not strong enough.

"If they're not under the protection of the Code, there is no way to compel them," says Mark McDermott, a partner of Skadden Arps Slate Meagher & Flom in New York.

In the case of large institutions, the Dodd-Frank rule now gives the US government authority to force debtors to bail in, despite their being outside the Bankruptcy Code.

"There is such great potential for public fallout from the failure of large institutions, that the legislative determination was made that these provisions should be put in," McDermott says.

Another good example is Ireland's Credit Institutions (Stabilisation) Act 2010 (Cisa), which vested considerable powers in the minister for finance, including letting him apply for subordinated liability orders – bail-ins in a wider sense of the word.

"The subordinated liability order provisions of Cisa effectively provide for the burning of subordinated bondholders in the institutions covered by the Act," says Peter Murray, a partner of A&L Goodbody in Dublin.

"In the main they were used as a threat – a bank with subordinated debt would make a voluntary exchange offer, and at the same time a published statement from the minister of finance encouraged bondholders to take up the offer, or if not he would likely exercise his powers under Cisa."

In September 2010, the Irish government faced huge and risky exposure to the liabilities of Anglo Irish Bank (which had been nationalised the previous year). One way to reduce the amount of money needed to bail-out the bank was to force a bail-in from subordinated bondholders, who held about €1.6 billion ($2.12 billion) of debt at the time (figure from the Financial Times).

Questions over the constitutionality of the Cisa provisions relating to the use of subordinated liability orders, would have led the government to assess their use carefully. But they would have been influenced strongly by the exceptional nature of the crisis in Ireland and how low down in the capital structure of the relevant institutions the subordinated debt was.

"Without government intervention the debt in the bank would be worthless," says Murray.

It was with this background that the Irish finance minister said on October 1 2010: "I expect the subordinated debt holders to make a significant contribution towards meeting the costs of Anglo."

Pádraig Ó Ríordáin, Arthur Cox

In contributing, bondholders took considerable pain (they were offered 20¢ in the euro; those who refused got 1¢ for every €1,000 of bonds), but the Irish subordinated debt provisions served their purpose at the time. A large part of Ireland's 2011 capital raising requirement was met through this kind of liability management exercise, and virtually all the subordinated debt in the Irish market has now been exchanged or managed.

From a macro-economic viewpoint, then, bail-ins seemed to prove their worth in Ireland. In fact, the legislation replacing Cisa, the Central Bank and Credit Institutions (Resolution) Act 2011 (see BOX OUT 1), now omits subordinated liability orders, indicating a move away from statutory bail-ins.

No matter the benefits to the wider economy, given the experience in Ireland it is easy to see why bail-in provisions are so scary for bondholders, whose views on rescue are very different to those of governments.

"Bondholders are only used to converting debt to equity in circumstances where they can make the decision; bondholders are always very difficult to persuade to join a rescue," says a London-based restructuring partner. "They will want to choose on a case-by-case basis whether they convert to equity. Why should they be forced into joining a scheme?"

In some cases, they may decide they can get a better financial outcome from an institution's failure than from pitching in to help out by converting their debt to equity.

Statutory bail-ins have another feature which lawyers find offensive: the ability to retrospectively change existing contractual provisions. Bondholders who entered willingly into a commercial agreement can find the terms suddenly changed to their disadvantage. Legal certainty has entirely dissolved. Adding to the uncertainty is that this kind of bail-in is also, by nature, rather widely defined, making them rather a blunt instrument from a subordinated bond holders' perspective.

A time and a place for everything

What is important to remember is that Cisa was enacted as part of a line of emergency legislation (and has now been partly replaced). Despite their general reservations about compulsory conversion for bondholders, most practitioners see the need for exceptional measures in exceptional circumstances.

"Northern Rock, Icelandic Bank – they failed, there was no rescue. You could say bondholders could have contributed to a rescue, that they should take their share of the pain; why shouldn't bondholders do that?" comments the London-based restructuring partner.

Pádraig Ó Ríordáin is a partner of Irish law firm Arthur Cox, and a member of an insolvency law advisory group to the European Commission. He sees a strong case for bail-ins in emergency circumstances.

Davina Garrod, Bingham McCutchen

"If you have debt in a bank, you have taken that bank's risk. An appropriate degree of bail-in to rescue the bank where the bank would otherwise fail, is therefore not necessarily a bad thing," he says. "Subordinated bondholders earn elevated coupons to compensate them for the risk they are taking. A bail-in provides a mechanism where that risk can be crystallised without winding up the bank or seeking first recourse to the taxpayer who has not taken that risk."

"Unfortunately, with the sovereign debt situation in Europe as it is, there's no longer a meaningful choice – there has to be some form of burden-sharing with the private sector," agrees Davina Garrod, a partner in Bingham McCutchen's antitrust and investment management practice groups.

"But it must be done in a transparent manner which maximises legal certainty for creditors and other investors," she adds. "The EC and national regulators need to be straight about which types of debt are eligible for write-down. Derivatives are a particularly tricky area which requires a lot more institutional thought."

For Ó Ríordáin a vital detail is the trigger point for any bail-in provision.

"Can a regulator trigger bail-in unilaterally just because it comes to believe the level of regulatory capital in the bank has become insufficient and there is a danger of instability?" he asks. "Markets may adjust to bail-ins on the basis of an objective trigger point and a clear pricing mechanism, but the risks associated with a system which theoretically could be triggered by a single unsettled regulator would be far harder to calculate. It would make the market very nervous where there is a system which is subjective or which is hard to predict, one in which debt could be converted to equity at the flick of pen."

To provide better certainty, lawyers say they prefer to see bail-ins allowed for on a contractual basis, rather than dictated in statute.

"The provisions in Cisa are, of course, not the kind you'd negotiate in a detailed way on a commercial basis," says Murray. "[The contractual] model is a much more efficient model in that the parties know in advance the specific circumstances in which the bond will convert or be written down and that can be negotiated and priced accordingly, as distinct from a retrospective amendment by statute which is more difficult and uncomfortable for investors for to assess and price."

So contractual bail-ins can help financial institutions to raise capital at a sustainable commercial level, and it is possible to allow for them in such a way that a regulatory authority can still set key parameters, such as what will be treated as core tier 1 capital.

"The regulatory authorities still have a big stick in the sense that it will still be they who set the capital requirements (in terms of level of overall capital, level of bail-in debt and the required general characteristics of each element of the capital structure) – they can still drive the process," says Murray.

European cohesion

In Europe, a cohesive regime for bank resolution is long overdue. Plans for a new Directive were first announced by the EC in October 2010. Consultation followed, as did a working paper in early 2011. But the Directive has not yet officially appeared. One source says it could be published in March 2012, but even then would not be enacted for another two years.

A working draft proposal obtained by IFLR opens by admitting that the 2008 financial crisis showed "a significant lack of adequate tools at European Union level to effectively deal with unsound or failing credit institutions". While it makes frequent use of safe terms such as "recovery", "resolution" and "crisis management", a large proportion of the Directive will deal with what are, in practice, write-downs.

It appears it will include resolution measures of the kind already seen in legislation in the UK, Ireland and the US: requirements for banks to draw up resolution plans and living wills; provisions on bridge banks; and rules on the establishment of credit resolution authorities which would be given a remit to oversee a resolution regime as implemented in the member state, including the power to put in special managers.

"Current drafts we have seen indicate that the resolution authorities will have a lot of discretion," says Garrod. "While it is positive that the authorities will have some flexibility to decide when and how to intervene on a case-by-case basis, this assumes a minimum depth of relevant experience in all of the 27 Member States. Some may say that the expertise within regulators [across Europe] varies tremendously."

It is almost certain that the Directive will include fairly detailed bail-in provisions, although these will not go down to the level of precision of specifying dates on which bonds would become bail-inable. The Commission appears to be taking a mixed approach, requiring banks to issue bail-in-able debt which could be written-down or converted on a statutory trigger, but ensuring that statutory powers would be included as contractual terms between the private parties (see BOX OUT 2). In this way, at least bondholders will know what they are getting into.

Lessons learnt?

In the UK, new legislation such as the Banking Act 2009 remains largely untested. But practitioners appear confident that it will stand up well to a further crisis.

"Although certain aspects of the Act appear quite revolutionary, many of the features derive from the existing provisions of the Insolvency Act 1986," says Paul Durban of Bingham McCutchen. "Only time will tell, but it is broadly felt that the flexibility of the Act means that it should hold up well to the various challenges which could confront it in the future."

Lawyers say that one of the keys to making it easier to deal with the collapse of global institutions lies in greater cooperation between regulators in different countries, and more convergent laws.

"There needs to be greater alignment of resolution processes from country to country – then we won't have problems like those that arose in Lehman where the processes in the US and UK were very incompatible," suggests Donald Bernstein, a New York partner of Davis Polk & Wardwell. "We need globally coordinated processes, and the regulators need to have a common view as to how to approach them. The more convergence there is in available procedures, the less systemic risk there will be if these financial institutions become distressed."

While a truly global resolution procedure may be a very long time coming, initiatives such as the EU Directive, as well as the work of global organisations including Insol International (see Gordon Stewart interview), should make the pain a little more bearable next time. And if there's one thing specialists agree on, it's that there will almost certainly be a next time.