European lawyers have declared pre-insolvency structured debt-for-equity swaps for banks as legally possible, opening up a new way to increase much-needed core Tier 1 capital.
Outlined in the April edition of IFLR, the structure involves a true sale of a refinancing line’s repayment obligation from a local holding bank to a special purpose vehicle (SPV) followed by the SPV’s merger with a Luxembourg or Netherlands-based SPV, and then the merger of the foreign SPV with the local financial institution.
The process eventually provides risk weighted asset relief to the local financial institution, and increases its core capital.
According to Boris Chonkov, in-house lawyer at Hypo Alpe-Aldria-Bank in Vienna, who invented the structure, lawyers in Italy, Germany, England, Sweden, Austria, Luxembourg, the Netherlands, Croatia and Slovenia have checked the structure and declared it to be legally feasible. He is yet to check with Spain, Portugal and Greece, but doesn’t forsee any specific issues.
Ultimately Chonkov wants to open discussions with European Banking Authority (EBA) and for it to examine the structure and provide guidance on its implementation, along the lines of contingent convertible bonds (CoCos).
In the meantime, Chonkov is waiting for feedback from European prudential regulators on the feasibility of the structure from a prudential regulatory standpoint.
“I believe there will be only questions, and no objections,” he said.
“It’s nothing dealing with collateral, nothing that deals with hard sale and nothing which isn’t allowed,” he said. “It’s dealing with something using the current existing law to encompass a result which European lawmakers could ideally incorporate in banking and finance regulatory framework as well as securities and corporate law to address the risks associated with the cram-down and bail-in doctrines.”
Concerns overcome
Debt-for-equity swaps have been used in restructurings before - Germany used them for failing banks under its Bank Restructuring Act 2010, while Bulgaria used a similar structure for one of its own failing banks. But Chonkov’s structure is designed to be used for going-concern banks.
Debt for equity swaps have also been mentioned as a potential restructuring tool by the Bank for International Settlements, European Commission, European Union and EBA. However, a concrete structure for going-concern banks has not been put forward until now.
Chonkov said lawyers’ biggest concerns related to its highly structured nature; in particular, why the bank doesn’t just swap the refinancing lines between the holding bank and the local financial institution instead of using the SPVs.
However this type of local swap would only be possible in a distressed scenario, he said. The foreign SPV is necessary for the structure to work with a non-distressed bank.
Chonkov also had discussions with auditors in Austria about balance sheet management and the treatment of deferred and discounted purchase price issues, which were ultimately overcome.
Italian difficulties
While Chonkov said the structure should work legally anywhere in Europe, the regulators’ interpretations can still cause problems.
Italy is particularly susceptible. Emiliano Conio of Freshfields Bruckhaus Deringer in Milan said any mergers involving banks need to be approved in advance by the Bank of Italy, and it already has concerns that a merger of a bank and a debt-absorbing SPV could lead to a weaker overall merged entity.
However Chonkov believed this weakness was unlikely to arise in this structure as the structure is converting debt into equity and not absorbing debt.
According to Conio, the Bank of Italy also wants to ensure that the management and shareholding of the merged company would meet the requirements of a bank.
“But that said ... I think there is no single step or item in the structure which itself would be prevented as a matter of Italian law,” he said.
The regulations do not specify whether a non-bank financial institution needs prior authorisation from the Bank of Italy before implementing such a merger structure, he said.
However draft regulations on the regulatory treatment of non-bank financial institutions are at the consultation stage, and Conio expects the new rules to extend the regulatory regime for banks to non-bank financial institutions.
“If we want to think of a structure similar to what Boris has drafted, we need to think ahead in terms of what will happen in weeks or months,” he said. “When you merge banks or conduct a merger between an Italian bank and non-bank financial institution, the criteria and the issues will probably be broadly the same.”
Conio said at the moment the Bank of Italy is unlikely to approve the structure, however that doesn’t mean it won’t change its mind. Only four years ago non-banking financial institutions were banned from acquiring control or a significant participation in an Italian bank, but now this is possible with prior authorisation.
Discussions will likely be required with the Bank of Italy if it is to allow the country’s banks to use the structure.
Because of the potential for trouble in Italy, Chonkov said he is trying out the structure in Slovenia first. Some legal issues regarding set-off in insolvency need to be altered first, however once this is fixed the structure may be able to be put into use.
Will it happen?
But while the structure may be legally possible, will it actually be used? Oliver Kronat of Clifford Chance in Frankfurt said German law may provide for Chonkov’s structure, but in Germany banks have preferred to either sit on their assets until the right valuations arise, or synthetically securitise assets to achieve regulatory relief.
In Italy, Conio said banks are trying to get rid of the problematic assets on their balance sheet which are creating the need for capital increases.
Nevertheless, Chonkov is optimistic that once the EBA provides guidance, the structure could pay an important part in mending the battered balance sheets of Europe’s banks.
“We are now between inception and confirmation, I’m very confident it will happen,” he said.