Market-first subordinated perp: how it was done

Author: Gemma Varriale | Published: 2 Feb 2012
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The first Basel III-compliant tier one subordinated bonds to incorporate a write-off feature have launched in the Swiss market, marking a new milestone in post-crisis regulatory capital restructuring.

The bonds, issued by Zürcher Kantonalbank (ZKB) on January 18, look set to provide a template for institutions seeking an alternative to convertible equity instruments.

“There’s no provision in Swiss law stipulating I unilaterally renounce my right to claim the principal, if a trigger event happens,” said René Bösch of Homburger in Switzerland, the lead partner on the deal . “We had to embed a provision that was structured as a contract so that a trigger event would lead to a write-down and the claim will disappear.”

The Basel Committee’s rules state that qualifying capital securities must include a mechanism to force investors to absorb losses. This is achieved either by  converting into equity or permanently writing off the principal amount of the bond upon occurrence of a so-called non-viability trigger.

Credit Suisse’s 2011 contingent capital bonds included the equity conversion mechanism. The second write-down method was untested until ZKB’s issuance.

Questions over how the write-off functionality would work meant lawyers had to examine the structure closely to ensure the bonds would be Basel III-compliant while still appealing to investors.

“It was a design issue,” said Bösch. “We had to clarify on what basis to measure whether there is a trigger point and what the sequence of events leading to it would be.”

The main issue centred on establishing when government support would  constitute state aid, thereby triggering the write-down mechanism, and when it would be commercially feasible and therefore not lead to a triggering event. For example, if the government wants the banks to expand and injects capital, this will not give rise to a trigger. But, if the circumstances are so extraordinary that there is no commercial reason other than just keeping the bank afloat then this would lead to a trigger.

For the capital to risk weighted asset trigger, the annual and semi-annual financial statements were used to provide a reliable accounting basis.

A further challenge with the subordinated debt was accommodating all the dividend discretion features.

Working with no precedent focused attention on drafting techniques. “We spent a lot of time finding the exact language and making the terminology as precise as we could to produce a robust structure,” added Bösch.

To do this, lawyers started out with plain-vanilla bond documentation then weaved in the particularities of the transaction.

Homburger acted as sole transaction counsel to ZKB and UBS. The bonds were placed through UBS and ZKB as joint lead managers.

Moody’s credit opinion on ZKB was issued on January 19.