Bondholder Challenges

Simon Carswell reports on legal challenges by subordinated bondholders of AIB and Bank of Ireland.   The main contention seems to be the up-ending of usual ranking of equity and junior debt. 

At the core of the case taken by Aurelius is whether a subordinated bondholder – the lowest-ranking creditor in the capital structure of a company – should be wiped out when the bank is only in existence because of €13.3 billion that must be injected by the State on top of a €7.2 billion bailout.

Aurelius claims the Government has subverted the rules of the capital markets where shareholders should be wiped out first and then junior bondholders.

It says that the stakes held by shareholders, including the Government’s preference and ordinary shares, should bear losses first.

. . .

Another subordinated bondholder challenge is also looming. On Wednesday the London law firm White and Case said it had been hired by bondholders in Bank of Ireland holding about €700 million of the €2.6 billion.

They claim that the bank’s proposal to inflict losses on lenders through a debt-for-cash-or-equity deal is “fatally flawed” because it fails to respect the fundamental principle that creditors must be repaid ahead of shareholders.

Although I am open to correction by the experts out there, my understanding is that for junior bondholders in place before the State’s capital injections, solvency is being judged based on pre-State capital injection capital levels.   On this basis, the reversal of the usual ranking should not affect the ability to raise bond financing in the future.  Moreover, Eoin Bond, our expert commenter on these issues, has argued on a few occasions that the subordinated bond is dead as a financing instrument for Irish banks, so we shouldn’t be overly concerned about its treatment. 

Even so, I worry that uncertainty about the future creditor regime – and not just for subordinated bondholders – is making the restoration of the creditworthiness of the new pillar banks more challenging.  There is not much point in pumping large amounts of supposedly loss-absorbing capital into a bank if there are fears that the capital will later be disregarded.    Regime uncertainty is being much debated in regards to sovereign debt, but it applies in the case of bank debt as well.   The temporary and rather draconian nature of the Credit Institutions (Stabilisation) Act has not helped in this regard; and the proposed permanent special resolution regime is not set to be enacted until the end of 2012.    

I would be delighted to hear from commenters that these concerns are misplaced, and that potential creditors draw a sharp line between the treatment of legacy junior debt and any new debt issued by the banks.   But I do think it would help for the government to provide as much clarity as possible as to the nature of the future creditor regime.

20 thoughts on “Bondholder Challenges”

  1. While it might be arguable that the state’s injections should be absolved for consideration, it does not follow that previous equity holders should be.

  2. @ John

    you’re right to have at least some concern on this, as, while subdebt is dead in the water for a long time to come, there is no doubt some element of contagion, or as you economists might suggest, a ‘signalling effect’, that if you’re willing to burn subdebt, you’re now at least in theory more willing to burn seniors or depositors than you were yesterday.

    As i’ve previously said, i think the treatment of subdebt has been “fair”, in that they would have been toast without the support of the govt anyway, and the issue of equity holders being maintained is, to my mind, somewhat trivial in terms of the sums involved (Anglo, EBS and INBS equity zeroed, market caps of AIB and ILP implying 99% wipeout of original pre-crisis equity). That we got to today’s situation via a very ugly and disjointed method is unfortunate, but it was chiefly for reasons designed to in fact protect most of the private sector investment in the banks, not the opposite.

  3. “I would be delighted to hear from commenters that these concerns are misplaced, and that potential creditors draw a sharp line between the treatment of legacy junior debt and any new debt issued by the banks.”

    Most investors don’t like the false contrivances. A lot of them assume that the effective switching of seniority away from gilts of any duration and toward senior (even unguaranteed) bank bonds of shorter duration, should be temporary.

    Whatever you think about bank bond investors, it is the traditional marginal investor in gilts that you should be looking out for.

    By messing about with seniority, issuing guarantees, differentiating between different types of “legacy” capital – or not, you are becoming an ever more non-mainstream investment opportunity. People want to be paid for the hassle of trying to keep up with it all, and the risk that they might misinterpret something.

    Getting on with resolving the banks would have been more appropriate.

    What kind of investor do you think is going to be interested in purchasing bonds in Irish banks in the future?

  4. Of course, ad hoccery and legal legerdemain drive up the cost of capital in general; the future redundancy of this particular tranche of the capital structure is neither here nor there. In fact, if the motivation is construed as being this cynical (‘subs are dead going forward anyway, so to hell with them’), investors across the capital structure are going to be hunting for a bigger bargepole.

  5. @Hohn McHale

    There are two separate issues here.

    The first is the legal position of all existing creditors in banks. This includes not just bondholders but depositors as well.
    It is perfectly possible for any company, presumably including a bank, to come to a scheme of arrangement with its creditors while not being in receivership or liquidation.
    Such schemes happen all the time outside the of the courts sometimes using rather strong arm tactics. However the schemes can be court approved under Section 201 of the Companies Act. The schemes generally only require percentage majorities of creditors in order to be approved. [I assume but am not clear that similar legislation is in situation for apply to banks]
    The implicit and indeed explicit threat all the time is of course, ‘Agree to this or you may get nothing in a liquidation’.
    I hope the State is crystal clear in giving this ultimatum to all bondholders, ECB or no ECB.

    The tragedy or more accuartely the negligence of the governments in introducing protection for depositors, means that they would now be virtually last in queue under a liquidation process. I cannot understand why this has not been addressed. Why are depositors considered a lesser class of person in every sense of the word?

    As to any new State capital being introduced, this should clearly be ring fenced, to have a status above any, repeat any, existing bondholders. If this cannot be achieved easily through the bank articles of association, the then the State should not do it. It should instead insert the capital into a reconstituted bank, transferring all deposits etc, and leaving all bondholders holding their little paper claims. It is time to play rough on
    this. Very rough.

    The second issue refers to future bank funding:

    As to future bank institutional funding. This is now a lala land concept as far as periphery banks are concerned for many years to come. The whole structure of world bank funding has been utterly exposed as having the flimsiest of foundations. Any scare in any part of the world immediately leads to bondholders not to buy bank bonds and banks not to lend to each other. An immediate liquidity crisis.
    It is insanity to attempt to run a European or indeed global economic system that requires functioning banks on the floating sanddunes of such institutional lending.

    Better for all to put in proper legislation protecting depositors and fund banks from that secured base.
    Let the bank bondholders go, without payment. And let them stay gone.

  6. An issue of far greater consequence for the future of the State is the downranking of Irish sovereign debt, perpetrated in the first instance by the last Government, and compounded since by every Tom, Dick and Harry who has pretended to rescue us.

    On bank funding, one of our highest priorities for the future must be to prevent Irish banks borrowing significant amounts from overseas. That’s what got us into trouble in the first place. It funded the bubble, drove our banks into insolvency, and severely damaged competitiveness. The ideal outcome on Irish bank creditworthiness is that they are trusted to take deposits, but no one will touch them with a bargepole when it comes to giving them access to debt.

  7. @BeeCeeTee

    The ideal outcome on Irish bank creditworthiness is that they are trusted to take deposits

    Why would a depositor put money knowing that it immediately is ranked below all bank bondholders from the minute it is lodged, regardless of when those bonds were bought or what kind of bonds they are?
    And knowing that every piece of collateral protecting his deposit has been pledged to bondholders, ICB/ECB etc.

    Idiots would not allow themselves to be fooled in such a way.

    Until depositors are properly protected forget about deposits returning to Irish or other peripheral banks. It will not happen.

  8. No sub bondholder should expect sympathy from the Irish taxpayer. To most people, the bondholders have been rightfully made to suffer. Yet, there are many unsettling aspects to the process undertaken particularly in the case of AIB and bank of Ireland.
    The minister decided upon a figure of 5 billion to be contributed by sub bondholders to recapitalise the banks.
    The minister then imposed coercive measures to realise this somewhat arbitrary target.

    I have a number of problems with the process;
    (1) There is more than a whiff of “burn the bondholders” and political grandstanding to the unilateral action undertaken
    (2) The banks, NTMA and the department of Finance refused to engage in negotiations with bondholders who were in agreement on the principal of burden sharing
    (3) Yesterday’s Irish Times reported (relating to the Aurelius case) that documents indicate JP Morgan advised the Government to pursue a consensual transaction but this advice was rejected
    (4) The actions undertaken (SLO, coercive LME) are without precedent in the “developed world”. Kazakhstan restructured its banking system debt with significant haircuts on a consensual basis…..
    (5) There is a view that “hedgies” are the only aggrieved party and who cares about them anyway? That is simply not true. If Ireland hopes to return to the voluntary markets, many high yield funds will pass on investing in a jurisdiction where expediency, political posturing and legal uncertainty have increased.

    The fact remains that burden sharing could have been achieved in a consensual and less confrontational manner but the minister chose a macho approach which has short term political benefits but potentially long term damaging consequences. Perhaps the markets will have a short memory but I suspect that the appetite for credit exposure to Bank of Ireland, AIB and Ireland has been reduced as a result.

  9. @Creditor investor

    You say that burden sharing could have been achieved by agreement. But is it not the case that the only reason that a voluntary sharing would be agreed to is because of a credible threat of unilateral action? The invoking of the failure to negotiate strikes me as an odd aspect of the Aurelius case. Surely the issue is whether the State’s action is legal or not?

  10. @John McHale
    “The invoking of the failure to negotiate strikes me as an odd aspect of the Aurelius case.”
    Whether the State’s action is legal or not may turn on the constitutional right to fair procedures and it could well be that the Act is unconstitutional for failure to provide for a basis for negotiation. From memory, the NAMa legislation was challenged on this basis by a developer who succeeded in his challenge.

  11. An interesting part of the new Greek austerity package is the repatriation of money which escaped the country…
    “The new austerity measures slash spending and hike taxes between now and the end of 2015 – two years beyond the current government’s mandate. They also include a €50 billion privatisation drive for the same period. Measures include a one-off luxury tax on swimming pools and yachts and repatriating money taken out of the country.”

    Now how are they going to legally repatriate given free movement of capital etc?

  12. @ John McHale:
    To date, AIB conducted three Liability Management Exercises which contributed approximately 3 billion to AIB’s Tier 1 capital. These LME’s were entirely voluntary. The average average discount to par was roughly 45% and the average amount tendered 67% of the bonds targeted.
    Obviously there is no assurance a subsequent voluntary LME would achieve similar results given the remaining holders already passed on the opportunity to participate (assuming they were not excluded from the exercise as Aurelius was by virtue of its domicile). Some form of carrot and stick approach would almost certainly have been necessary.
    The path the minister chose was in my opinion the most harmful in that it was unlawful (likely to be determined by some court in the next couple of years even if the immediate Aurelius action in the High Court is unsucessful) and unilateral. It was good politics however; I fear Noonan is a political operator who does not know or understand markets.

  13. @John McHale / @Credit Investor.

    The discussion has prompted me to look up the Credit Institutions (Stabilisation) Act. On a simple reading of Section 28 of that Act, I cannot understand how @Credit Investor can claim:

    The path the minister chose was in my opinion the most harmful in that it was unlawful (likely to be determined by some court in the next couple of years even if the immediate Aurelius action in the High Court is unsucessful) and unilateral.

    The pity is that the Act would appear to confine itself to subordinate liabilities which it defines in the Act as follows:

    “subordinated liability” means, in respect of a relevant institution, an obligation or a liability in the form of a debt security or loan
    instrument (or any other document howsoever described or
    constituted) which is expressed to be, or otherwise ranks, subordinate
    in right of payment to the claims of depositors and unsubordinated
    creditors of the relevant institution, whether on a winding up
    or otherwise, and includes a guarantee;

    @Credit Investor:
    I regret the fact you lost.

    I also lost as a very small shareholder of AIB.

    With a much larger loss as a member of an Irish pension fund that was heavily into all the banks.

    With an even larger loss in terms of having to absorb the bank losses onto my taxes via the State.

    With an even larger loss again, through partial loss of employment for myself and the full loss of employment of 60% of my work colleagues.

    And finally with an even larger loss again in the loss of opportunity of my now adult children all three of whom will now have to emigrate to make lives for themselves.

    Of all these losses, loss of money is by far the easiest to bear.
    And I have to say with conviction, that were I somewhat younger I would not have confined my protests to economic blog pages.

  14. @joseph Ryan
    I am not a lawyer but as Ceteris has pointed out, the constitutional rights of the affected parties may not have been respected and the coercive call option may be opressive action by the majority upon the minority (this avenue is being pursued by Anglo bondholders in UK courts).
    With respect to Irish financial assets and banks in particular, there are few if any winners, only losers. However, a shrinking pie should be allocated according to the rule of law and that specifies equity takes the first loss, sub debt next and so on. If you want to change the rules, it’s certainly more fair to get the consent of those affected.
    With respect to the larger costs of the financial and construction fiasco, I will digress. The human and economic costs will be devastating. However, the International community will not give Ireland an easy pass to default. Until the country has undergone wrenching adjustments it is tough to see a restructuring supported by Ireland’s trading partners. With income and pay levels well above most countries in the world it is unrealistic to think of “debt forgiveness”. How many low income countries struggle to service debt with a fraction of Ireland’s resources?
    Just as Europe fears the knock on effect of a default on senior bank debt, a sovereign default by Ireland (unless conditions deteriorate deplorably) is just not feasible. Extension of maturity dates, yes; haircuts, no.

  15. @certeris

    “The new austerity measures slash spending and hike taxes between now and the end of 2015 – two years beyond the current government’s mandate. They also include a €50 billion privatisation drive for the same period. Measures include a one-off luxury tax on swimming pools and yachts and repatriating money taken out of the country”

    My guess is they are going to go after black market money that has escaped all Greek taxes and been sent to Switzerland (predominantly). An exceptional deal on this would get Switzerland brownie points withe the whole EZ and fit in with the idea of levying taxes on “presumed income”.

    What do you reckon?

  16. @Grumpy
    You may be right as the Swiss have demonstrated a propensity to cave under pressure from super powers. However, the more wily Greeks will have learnt the lessons of UBS and probably investing in sunnier places like Bermuda or the Caymens. The once off tax on yachts is unlikely to yield much as they too will park in more hospitable waters. The cement pond owners will obviously have problems. The whole thing looks like window dressing.

  17. @Credit Investor

    However, the International community will not give Ireland an easy pass to default.

    I, for one, am not looking for an easy pass to default.
    Just remove the private banking debts from the Irish Balance sheet. That will do me.
    As for where they are put, the ECB should be asked to figure that one. They seem to have a very good communications channel to the same bondholders.

  18. @Credit investor

    I agree with you regarding the legalities of the loss structure but your post displays a ignorance of the source of demand withen economies.
    The western economic farce has been kept in the air by cheap fuel which the banks used to externalise production and use wage arbitrage to extract a surplus from this productivity.
    They feed western subjects credit to keep this demand engine going.
    Their profits was savings from non payment of wages – cost of fuel to transport goods to customer.
    Now that the cost of fuel is rising this equation is becoming more tenuous again so they are striving to reduce wages and capital inputs again , however this compromises redundencey to a dangerous extent and is no longer practicable- hence the breakdown in the credit cycle.

    We need to pay western workers more not less to break this unsustainable trade infrastructure built on artificially overvalued valued debt.
    This will destroy the value of equities just as their value increased in the 80s and 90s on the back of this trade.
    Resistance to higher wages may work for another period for holders of capital but in the end will lead to a greater breakdown crisis.

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