05 May 2023

ECGI's Eidenmüller/Valbuena: Bailout Blues: The Write-Down of the AT1 Bonds in the Credit Suisse Bailout

A key principle of Chapter 11 corporate reorganizations is the ‘absolute priority rule.’ It requires that the claims of a dissenting class of creditors be paid in full before any stakeholders in a class junior to such dissenting class may receive or retain any property in satisfaction of their claims. As a consequence, creditors cannot be forced to accept cuts if shareholders are not completely wiped out. This principle is also central to legal frameworks governing the restructuring of banks. For example, Article 34(1)(a) of the European Bank Recovery and Resolution Directive (BRRD, 2014) stipulates that ‘Member States shall ensure that, (…) resolution action is taken in accordance with the following principles: (a) the shareholders of the institution under resolution bear first losses (…).’

Against this background, one would have expected that the write-down of the Additional Tier 1, or AT1, bonds in the Credit Suisse (CS) bailout would not have happened without its shareholders also being wiped out.[i] But the unexpected did happen: The bonds were written down, and CS’ shareholders received UBS shares worth $3.25 billion under the bailout deal.

In this post, we analyse the motives and mechanics of the write-down and argue that the prospect for a legal challenge is slim. At the same time, we question the merits of the write-down. Bondholders should fare no worse than common equity, regardless of whether a financial institution is put in an insolvency proceeding or bailed out, and the applicable bond terms should reflect this. We also raise the issue of a more principled approach to bailouts generally.

CS’ demise can be summarized by the exchange between Bill and Mike in Hemingway’s The Sun Also Rises. ‘How did you go bankrupt?’ Bill asked. ‘Two ways,’ Mike said. ‘Gradually and then suddenly.’ The SEC probed various accounting errors at CS eight months before the bank’s collapse. The nail in CS’ coffin came on March 15, 2023, when the chairman of its main shareholder, the Saudi National Bank, uttered the now infamous ‘absolutely not’ when asked about an additional liquidity injection into the bank. Despite an immediate liquidity backstop by the Swiss National Bank (SNB) of up to CHF 50 billion, market pressure mounted, and during the weekend of March 17-19, SNB, the Swiss Financial Market Supervisory Authority (FINMA), and the Federal Council (the Swiss government), engineered a takeover of CS by rival bank UBS. CS’ shareholders received $3.25 billion in UBS shares, the AT1 bondholders were wiped out, UBS received an additional CHF 100billion liquidity line from SNB backed by a federal default guarantee, and the Swiss government also provided a conditional loss guarantee to UBS of up to CHF 9billion.

The bailout deal is noteworthy for many reasons. First, Switzerland has a bank resolution regime comparable to the BRRD. But the Swiss finance minister believed that the regime would not work in an emergency and that following the existing protocols ‘would have triggered an international financial crisis.’ If resolution according to a dedicated regime set up after the 2007-2008 financial crisis would not work in Switzerland, what can we expect in other jurisdictions with similar regimes?

Second, to carry out the rescue, the Swiss government passed an Emergency Ordinance on March 16, 2023 (amended on March 19). New provisions include the granting of powers to FINMA (i) to bypass the need for general meetings to approve transactions involving systemically relevant banks (Article 10a) and (ii) to require the write down of ‘additional core capital’ (Article 5a). As a consequence, the bailout was implemented by administrative fiat, bypassing both parliament and the shareholder assemblies of the affected banks.

Third, based on Article 5a and the applicable bond terms, the holders of CHF 16 billions of AT1 bonds in CS were completely wiped out while equity holders, despite being materially diluted, were not. The Swiss authorities apparently believed that it was more important to placate CS shareholders than the AT1 bondholders. Shareholders could have initiated blocking litigation, anchor investors are needed to meet future financing needs, and employee shareholders must be motivated to come to work. Further, the identity of the AT1 bondholders—primarily sophisticated institutional investors—might also have played a role. Converting the bonds into equity – and offering the bondholders shares in UBS—might have disrupted the current governance structure.

For sure, the bondholders are upset. But their chances of succeeding in litigation are slim because the contractual terms of the bonds are quite clear.[ii] They stipulate a write-down to zero following the occurrence of a ‘Write-down Event.’ This can be either of two types: a ‘Contingency Event’ or a ‘Viability Event.’ Under the former, the CET1 ratio (Common Equity Tier 1 Capital / Risk-Weighted Assets) of CS must fall below 7 percent at any reporting date. Under the latter, ‘the Regulator’ must determine that a write-down is essential to prevent CS from becoming insolvent or from ceasing to carry on its business (scenario 1); alternatively, CS must have received an ‘irrevocable commitment of extraordinary support from the public sector’ (scenario 2).

These triggers, especially the ‘Contingency Event,’ are designed to kick in before the bank faces insolvency and to restore the specified capital ratio. In other words, the function of the AT1 bonds is to absorb losses before an existential crisis wipes out the bank’s equity. FINMA claims that the write-down of the bonds was done on the basis of the extraordinary support received by CS (scenario 2), and this seems right. The complete write-down of the bonds is the automatic consequence of the irrevocable commitment of public support. An exercise by FINMA of its Article 5a powers is not even necessary for this...

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