The market had long been preparing for the implementation of the BRRD’s bail-in regulation on January 1. However, the Bank of Portugal’s decision to bail in a small number of senior bondholders in Novo Banco, the ‘good’ bank created after the collapse of Banco Espirito Santo (BES) in 2014, just before this implementation took place ensured that the ushering in of bail-in legislation when it finally came was overshadowed by confusion and controversy.
Many senior bond investors relaxing over their year-end break were rudely interrupted by the press release from the Bank of Portugal on December 29.
It stated that, based on the deteriorating situation at Novo Banco, “Banco de Portugal decided to confer again on BES the responsibility for certain issues of non-subordinated bonds issued by the latter and intended for institutional investors”. (The affected bonds had been transferred from BES to Novo Banco when the latter was set up in August 2014).
It then identified five tranches of fixed rate senior bonds maturing between July 2016 and June 2024 with a face value of €1.985 billion that would be retransferred to BES and, in effect, wiped out.
The fact the bail-in took place on December 29 is widely seen as an attempt to complete the process before the bail-in regulations under BRRD came into force on January 1 this year. However, as this was a transfer of bonds to a third party rather than a conversion to equity or write-off, the applicable regulation under BRRD was already in place when the retransfer took place.
When Euromoney asked the Bank of Portugal about the authority under which the bonds were transferred, it confirmed that it was the right granted under the BES rescue in 2014.
"The retransfer was made pursuant to a power provided for under the Portuguese Banking Act which was included in the original resolution decision for BES," Bruno Proenca, head of communication directorate at Bank of Portugal, tells Euromoney.
Proenca maintains that the BRRD conditions for the retransfer were, nevertheless, met. "A similar power is provided for under BRRD and the conditions for the exercise of that power are similar," he states. "The conditions for the exercise of the retransfer power in the manner it was exercised were satisfied." He does not, however, elaborate on the basis upon which this conclusion has been reached. On Wednesday January 13 the ECB issued a statement declaring that: "The decision by Banco de Portugal to bail in some senior bond holders in Novo Banco was taken exclusively by BdP under its national resolution powers. The ECB neither requested nor approved a bail-in of senior bond holders in this case." Not exactly an unequivocal endorsement.
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Sonya Van de Graaff, |
"One of the relevant provisions of the BRRD in this case is the transfer/retransfer of a liability to a third party (since this power was in effect on the date of the purported retransfer to BES)," explains Sonya Van de Graaff, partner in the business restructuring and insolvency group at law firm Morrison & Foerster.
"Whilst this precise factual scenario has not previously been adjudicated on and there have been admittedly few cases testing the BRRD in court, it would be surprising if a retransfer of a liability was not, in itself, properly to be characterized as an exercise of a resolution power."
She adds: "If this is correct, it means that the Portuguese authorities needed duly to consider whether the conditions imposed by the BRRD on the date of the retransfer were satisfied and duly invoked, and the authorities could not rely on the factual matrix or legal characterization as at the date of the original transfer in 2014."
In other words, it is not sufficient to simply grant yourself the power of retransfer - as the Bank of Portugal did in August 2014 - and issue a press release.
Certain provisos have to have been met for the transfer of liabilities under BRRD. The institution has to be about to fail, not just have breached its tier-one capital ratios. The prospect of a consensual deal with private investors has to have been explored and it has to have been considered whether the transfer is in the public interest.
“Although the BRRD is untested in this respect, it would be surprising if a failure to satisfy a tier 1 ratio of itself satisfied invoking the powers granted to authorities in the BRRD," says Van de Graaff.
"The backdrop to the extraordinary powers given to authorities in the BRRD is the existence of extraordinary circumstances, and so we find that the first condition to invoking the BRRD’s powers requires the institution in question to be at risk of failure."
She continues: "BRRD was written into law to create a level playing field and is arguably a sensible solution to these problems.
"However, if it is invoked in an arbitrary fashion and if institutions try to hang their hat on anything other than clearly enunciated authority for their actions, then investor confidence in Europe will be shaken."
Stress test
The bail-in provoked uproar in the market, with investors in the market claiming that their rights to be treated pari passu with all senior bondholders in Novo Banco had been violated.
“Five out of 52 bonds were chosen to be transferred to the bad bank; it should have been all, or a part of all, or none,” says Mark Holman, CEO at Twenty Four Asset Management in London, which has a small position in the affected bonds. ‘The Central Bank says it chose those five because they were firstly in Portuguese law (which they could rewrite) and secondly, these bonds were not intended to be sold to retail. The latter may seem very noble, but it is still not legal."
Litigation by investors caught up in the furore is now widely expected.
This controversial bail-in was triggered by a €1.4 billion capital shortfall at Novo Banco that was identified in November’s European Central Bank (ECB) stress tests. It needs to be understood in the light of two preceding events. Firstly, the rescue of regional Portuguese bank Banco Internacional do Funchal (Banif) and its subsequent sale to Banco Santander. In a deal finalized in December, Spanish lender Santander will buy the majority of Banif’s assets for €150 million while the Portuguese state will commit €2.26 billion to cover future contingencies. This follows a €1.1 billion injection of funds into Banif by the state in January 2013 and its €400 million participation in a contingent convertible bond issue by the failed bank.
Secondly, the ability for legal claims against the Bank of Portugal by lenders to a Goldman Sachs-arranged loan to BES in 2014 to be heard in the UK Commercial Court seems to have reinforced the determination of the Bank of Portugal to limit the bail-in to domestic bonds only. The US bank had arranged the $835 million English law loan to BES – which was to fund a Venezuelan refined oil project – via special purpose vehicle Oak Finance just weeks before the Portuguese lender collapsed in mid-2014.
The $835 million loan was initially transferred to Novo Banco in August, but in December 2014 the Bank of Portugal resolved that the transfer had not been authorized and the liability for the loan remained with BES. This would mean that lenders would inevitably be wiped out and, unsurprisingly, they made the decision to sue.
However, because this loan had been written under English law, the lenders won the right to sue the Bank of Portugal in the UK Commercial Court. The English court ruled that regardless of the status that the Bank of Portugal’s decision with regard to the transfer of the loan might have in Portuguese law, it had no status under the BRRD and therefore no effect under English law. It is a situation the Bank of Portugal will not want to find itself in this time, although it has remained defiant in the face of the UK court decision. According to Bloomberg, on January 14 the Bank of Portugal announced that regardless of any court decision BES’s debt to Oak Finance will remain at the bad bank, partly because Goldman has a 2% stake in BES.
Bad timing
When Novo Banco failed the ECB stress tests in November, the timing could not have been worse for the Bank of Portugal. After the fall of the country’s Conservative minority government in the same month after just 11 days, a new alliance between the Socialist, Communist, Green and Left Bloc parties took power with a rigorously anti-austerity agenda.
The extent of state involvement in Banif’s resolution meant any suggestion that further state funds could be used to plug Novo Banco’s new capital shortfall was now out of the question.
Newly appointed prime minister António Costa had been highly critical of the previous administration’s handling of the situation at Banif and the new government was under severe pressure from critical public opinion to avoid any more taxpayer money going towards bank restructurings.
“The decision to transfer the bonds on December 29 is completely connected with the change in government and the rescue of Banif,” says one source in Lisbon. “The current Socialist leadership almost lost support in parliament because of the quick decision to provide taxpayer funds to Banif, so there was no way that they could do it again with Novo Banco.”
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Carlos da Silva Costa, |
This meant that Carlos da Silva Costa, governor of the Bank of Portugal, was left with two choices: tap the resolution fund – which owns 100% of Novo Banco – for the amount needed or to bail-in Novo Banco bondholders.
The resolution fund was established in August 2014 on the collapse of BES and it injected €4.9 billion into the new good bank. All banks operating in Portugal contribute to the fund and for it to be hit again would raise questions of systemic risk for Portugal’s shaky banking sector.
“There will have been significant pressure from the banks for the resolution fund not to be tapped further,” reckons one Portuguese banker. “This would have hit the profitability of all other Portuguese banks and would translate into lower tax revenue for the new administration. Indeed, the fact that only fixed rate bonds were selected for retransfer seems to have been made in order to further limit the impact of the bail-in on Portugal's banks."
Holman asks: "Why did [the Bank of Portugal] overlook the Portuguese law institutional targeted floating rate bonds? The answer is that these were sold to the Portuguese banks, who themselves would then incur losses and who coincidentally are co-owners of the resolution fund. The new bail-in directive would not allow for such selectivity.”
It seems clear that the bail-in was the best of a limited number of options for the Bank of Portugal. However, the decision to target such a narrow section of bondholders for the process shocked the market.
“[The bail-in of senior debt] is something we had contemplated but felt was unlikely given the state’s decision to sell the bank; however, in any event, given the senior debt stack of around €12 billion versus a capital shortfall of €1.4 billion, it should only be a small haircut of around 12c in the euro,” observed John Magrath, partner at TwentyFour Asset Management on December 30.
Pressure to sell
The rapidly deteriorating situation at Novo Banco is behind the desire for a speedy sale of it to a third party – a process that was halted in September after bids by three bidders (Anbang Insurance, Fosun International and Apollo Global) were all deemed too low. If the situation continues to deteriorate and the bank is not sold further bail-ins of senior bondholders cannot be completely ruled out.
The bail-in has now plugged the capital hole, and the auction process is due to restart on January 15 but the treatment of bondholders in plugging that hole will have done nothing to improve investor confidence in the story. The Bank of Portugal has now hired Sérgio Monteiro, the former secretary of state for public works, transport and communications in the previous administration of Pedro Passos Coelho, to manage the sale. The first auction was advised by BNP Paribas.
The key issue is that the Bank of Portugal targeted these five tranches of bonds rather than apply a small haircut across the board to all senior bondholders. While the Bank of Portugal has responded to Euromoney's questions about retransfer authority, it did not address questions put to it over the basis upon which the bonds were selected for retransfer. The press release issued on December 29 states that: "The selection of the bonds was based on public interest and aimed to safeguard financial stability and ensure compliance with the purposes of the resolution measure applied to BES".
Under BRRD there is discretion to differentiate between different types of creditor in bail-in, but certain conditions need to be met. They can be invoked if it is not possible to bail-in certain instruments within the required time frame (for example, derivatives); if certain classes need to be excluded from bail-in to ensure continuity of the business; to avoid widespread financial contagion, for example to eligible deposits not covered by deposit insurance, or certain classes of bonds can be excluded if it can be proved that the loss to creditors overall will be greater if they are included.
If the Bank of Portugal has undertaken the bail-in on the basis that one or more of these criteria have been met then that has not been made clear to the market.
The fact all five tranches of bond that were bailed in on December 29 were written under Portuguese law must be seen as significant. The belief is that the central bank would want to keep any litigation arising from the retransfer within its own domestic courts.
Biggest hits
In selecting these bonds for what is effectively a complete write-off, the Bank of Portugal is facing the world’s largest bond investors head-on. To quantify the potential damage at home, Portuguese buyers of the bailed-in bonds have now been asked by the authorities to identify domestic private clients and individuals to whom they might have sold them. The numbers are, however, likely to be small.
Of the €1.9 billion bonds transferred, €1.5 billion were held by just 30 investors. The biggest hits were taken by BlackRock and Allianz (Pimco), which had €250 million and €230 million exposure respectively on December 30 according to Bloomberg. BlueBay Asset Management had a €40 million position and UBS is understood to have had exposure of €38 million.
Upsetting these investors could have serious ramifications for Portugal – both BlackRock and Allianz have investments totalling more than €2 billion in the country. The former is understood to hold roughly €770 million Portuguese sovereign debt.
If investors in the retransferred bonds do decide to sue, the question will be whether the transfer by the Portuguese authorities of the bonds on December 29 was properly exercised under BRRD or whether they were relying on the right they granted themselves on the restructuring of BES in August 2014.
It will also focus on whether the pari-passu treatment of bondholders enshrined in the documentation has been violated.
