UPDATED JANUARY 14: Bank of Portugal comments
Counsel disagree over whether Bank of Portugal’s (BoP) write-down of five Novo Banco senior bond tranches breaches Europe’s new bail-in regime, laying the groundwork for a legal wrangle just days after the new EU rules took effect.
On December 29, three days before responsibility for large eurozone bank resolutions was transferred from member states to European Central Bank-level, BoP instructed the notes be moved into the lender’s bad bank predecessor, Espirito Santo (BES), before it is wound-up.
Affected bondholders are preparing lawsuits against BoP and Europe’s bank investor community has hit back, claiming such regulatory inconsistency will make it significantly more expensive for lenders across the continent to raise debt.
But BoP’s most immediate problem could be that its reason for bailing-in bonds placed only with institutional investors – namely, to protect small bondholders – seems to have backfired.
“That may have been the Bank of Portugal’s rationale, but it appears to be the case that in the secondary market a lot of these bonds were acquired by retail investors,” PLMJ partner Hugo Rosa Ferreira told IFLR.
The December bail-in comes nearly 18 months after BES was restructured, from which Novo Banco was created as the bridge bank with a balance sheet comprised of BES’s surviving assets and liabilities.
It applies to five tranches of senior bonds issued under Novo’s medium-term note programme. They have a face value of €1.94 billion ($2.12 billion), are governed by Portuguese law and were sold in minimum denominations of €100,000 – the typical threshold that distinguishes qualified investors.
TwentyFour Asset Management, Blackrock and Pimco are among the affected bondholders. But Portuguese media reports suggest that tens or even hundreds of private and retail investors also hold the bailed-in notes.
- On December 29 Portugal’s central bank transferred five series of senior bonds from Novo Banco to its predecessor bad bank Espirito Santo, before it is wound-up;
- Affected bondholders are planning on suing the central bank. Their claims potentially include breach of pari passu (as not all senior bonds were bailed-in);
- Of the bank’s 52 senior bonds, it seems these five were chosen because they were placed with institutional investors meaning that retail investors would not be affected and that Novo’s franchise remains intact before its sale later this year;
- But retail investors have acquired the transferred bonds in the secondary markets, and the damages claims from any successful lawsuit could thwart Novo’s sale;
- Bond investors and ICMA said this type of regulatory discretion drives up senior bank bond prices, and in extreme circumstances could make certain classes uninvestable.
Mounting legal actions
In a January 5 note, TwentyFour Asset Management said ‘litigation is almost certain’ and many other bondholders have spent the new year seeking legal advice on their right of recourse.
The bond transfers qualify as an administrative action and are challengeable in Portugal’s administrative courts.
“The Bank of Portugal in my opinion didn’t have the power to make this transfer,” said Ferreira, who has been meeting with affected bondholders in London.
“Not only in general terms but also because it violates the pari passu rule by being discriminatory by targeting institutional rather than retail – which isn’t permitted under BRRD [Bank Recovery and Resolution Directive] – and those notes governed by Portuguese law and subject to Portuguese jurisdiction, which may limit the ability of bondholders challenging the decision,” he added.
But some Lisbon-based lawyers disagree, on both counts. They claim that BoP is entitled to make transfers following the original restructure and that, within the confines of the BRRD write-down waterfall, it has some discretion to choose among stakeholders with an equal ranking.
In an emailed statement on January 14, BoP said the transferred bonds were carefully selected in accordance with Portuguese law and the principles of BRRD. They stress that where creditors in the same class are treated differently in a resolution action, distinctions must be equitable, justified in the public interest, proportionate and not discriminate on the grounds of nationality.
Bondholders’ first claim: no right to transfer
Novo Banco is a bridge bank, meaning it must be sold within two years of its creation.
The Bank of Portugal in my opinion didn’t have the power to make this transfer
“During that period, as a matter of law the central bank – acting as resolution authority – can make adjustments to the assets or liabilities that remain in either the new or bad bank,” said one Lisbon-based partner who spoke on the condition of anonymity. “What they have done is consistent with BRRD.”
Indeed, in its statement the BoP noted that the original BES resolution decision expressly provides that, as the resolution authority, it can ‘at any time re-transfer assets and liabilities between’ the two entities. The Lisbon partner noted that the central bank has made other, albeit smaller transfers between Novo Banco and BES to clarify some matters following the restructure.
Yet according to Tim Skeet, chair of the International Capital Market Association’s (ICMA) working group on bail-in, this subsequent moving of the goalposts is a problem – more so than the picking and choosing of creditors.
“We fully understand the need for authorities to intervene and make changes, and that there will be costs broadly spread across the community,” he said. “But here is a case where the rules have been changed after the event and that inconsistency gives rise to concerns.”
In a January 11 statement, rating agency Fitch said Novo ‘shows bridge bank investors can face legacy retransfer risks until resolution is concluded’.
‘In our opinion, the handling of Novo's resolution process raises questions about how future bank resolutions might be dealt with in the EU, particularly because the timeframes could prove quite lengthy.’
Bondholders’ second claim: breach of pari passu
The transferred bonds rank pari passu with Novo’s 48 other senior bonds, which have an outstanding value of around €10 million.
BoP said the bonds were selected ‘based on public interest and aimed to safeguard financial stability and ensure compliance with the purposes of the resolution measure’ applied to BES.
Bondholders will claim that this breaches their pari passu protection, which promises that all bondholders in the same class will be treated equally. ‘The equal ranking language that sits in every prospectus is a core value that we never thought would be broken,’ TwentyFour Asset Management wrote in a December 30 note.
However the Lisbon partner said that the BRRD does allow certain distinctions to be made within the same class of creditors, provided it is in the public interest and interest in financial stability.
“I wasn’t directly involved but I’m sure the BoP’s rationale and various grounds for deciding to do this have all been considered,” the source told IFLR. “I think they are very aware that there may be litigation, but I trust that there is sufficient comfort with the grounds on which the measure was taken.”
One of its reasons for distinguishing small (possibly individuals) from large investors is, it’s presumed, to facilitate the mandated sale of Novo Banco, following the cancellation of its auction in September.
The Lisbon partner said protecting the brand was clearly a concern. “The moment you hit retail investors or depositors, there is a greater concern about the franchise and the ability to subsequently sell the bank, as that may trigger a reaction from the public at large, the day to day clients,” the said.
But Ferreira believes that, just like the desire to shield retail, this motive will also hit a wall.
“I believe the litigation around this may constitute an obstacle to the sales process,” he said. The BoP has said that Portugal’s resolution fund will absorb any contingencies and liabilities resulting from BES’s liquation, but Ferreira believes it doesn’t have enough cash to cover damages if the lawsuits are successful.
Bondholders may have a third claim: proportionality. It’s widely understood that BoP transferred the bonds to plug Novo’s €1.4 billion capital shortfall, as required by the ECB. Bailing-in nearly €2 billion could be deemed excessive.
European bank investors have slammed BoP’s move, claiming it is opportunistic and an example of the regulatory risk that hinders lenders’ ability to reach their capital requirements under Basel III.
The bonds were transferred two days before the Single Resolution Mechanism (SRM), the second pillar of the Banking Union, took effect. The SRM implements BRRD and has, by and large, transferred BoP’s resolution powers over to the SRM board.
According to Ferreira, BoP wanted to make a decision while they had full control of the situation.
The handling of Novo's resolution process raises questions about how future bank resolutions might be dealt with in the EU
Under the Banking Union, national authorities can still exercise discretionary powers which, as the BoP has shown, can create significant regulatory risks for investors.
Regulators’ ability to behave in different ways is a long-held concern of the buyside community, and the Novo Banco developments have caused even comparatively placid investors to come out the woodworks.
“That view has been expressed to me by a variety of investors who usually keep their heads down, and some have been very forthright in their comments,” said the ICMA’s Skeet.
It’s also manifested itself through Europe’s bond markets. Senior bond prices have fallen and there were no new issuances by financial issuers during the first week of January – which historically sees significant activity.
Investors can’t adequately predict and price this type of regulatory risk. The Europe-wide impact of the Novo transfers gives further weight to ICMA’s claim for more predictability, and better dialogue between rule-setters and investors. Otherwise in extreme circumstances, certain type of bank debt could become uninvestible.
“We hope that doesn’t happen, and don’t necessarily expect it to, but with this kind of backdrop and action there will be investors that say that for the foreseeable future we aren’t prepared to invest in this category of debt in certain jurisdictions as they will be concerned about their ability to price risk,” said Skeet.
ICMA’s bail-in working group raised these issues in an August 2015 letter to the ECB. Following the Novo developments, it plans on tabling this and related topics with the Bank.
BoP said protection of Portuguese banks paid no part in the process of selecting these bond issues
Italy’s BRRD transposition assessed
Contractual recognition of bail-in under fire
EC’s deposit guarantee scheme revealed