Novo Banco, S.A. (Novo) is the ‘good bank’ that emerged from troubled Banco Espírito Santo, S.A. (BES). It was set up under the Portuguese resolution measures by the Portuguese regulator, Banco de Portugal, to deal with BES’s assets and liabilities. The transfer to Novo did not include certain “excluded liabilities” and “excluded assets” which remained with BES.

What are the “excluded liabilities”?

What constitutes an “excluded liability” is crucial to anyone looking to invest in Novo bonds. Under the resolution measures and the resolution law, the main excluded liabilities are liabilities: (i) to shareholders with 2% or greater share in BES or to persons or entities who, in the two- year period prior to the transfer, were 2%+ shareholders; (ii) to members of management or audit boards, certified auditors in other companies within the BES group or to persons who contributed to the financial issues at BES according to Banco de Portugal’s understanding at the time (the so called “bad actors”); (iii) in relation to debt under instruments/securities forming the capital raising activities of BES; and (iv)in relationto debt oedto entites ofGrupo spíritoSanto (ecet for tose etiies hose hoings heen rnredo

What Novo Bonds are trading?

Notable Novo bonds trading in the market are covered bonds and senior unsecured bonds including zero-coupon bonds. The zero-coupon bonds are currently trading at a significant discount to par and are attracting the attention of distressed investors.

What are the risks when investing in Novo bonds?

There are several risks associated with the trading of Novo bonds. The main risks arise from two potential scenarios. The first is that the bonds fall within the “excluded liabilities” under the resolution measures. This could be the case where a previous holder of the bonds was a 2%+ shareholder of BES (some of Europe’s main financial institutions would fall into this category). A previous holder of the bonds may also have been a “bad actor”. Bad actors will likely include any members of the Espírito Santo group or associated persons who have, in the opinion of the Portuguese regulator, engaged in fraudulent activity and contributed to the financial issues at BES in some way. This will likely be the case for Eurofin Holding S.A., a Swiss financial company (and its associated entities), who is alleged to have handled questionable financial transactions on behalf of the Espírito Santo companies. If the previous holder of the bonds fell into any of the limbs of excluded liabilities there is a risk that the recovery on these bonds would be materially reduced.

The second risk scenario is the “re-transfer risk”. Under the resolution measures Novo may transfer, at any time, any assets or liabilities back  to BES. Any credit claims transferred back to BES would be included in the insolvent estate of BES, and would have their recoveries severely affected. However the risk of such re-transfer is, at this stage and with the information publicly available, low. Taking into account the principle of equitable treatment of creditors that governs the application of the resolution measures (as well as of the re-transfer power) and the serious complications and legal issues arising from any re-transfer, only extreme circumstances would dictate such a course of action by Banco de Portugal.

How to mitigate the main risks when investing in Novo bonds?

To mitigate these risks, investors in Novo bonds should consider the following:

  • perform thorough due diligence on the underlying asset, the seller and the previous holders of the bonds (where possible); and
  • include specific protections into their trade documentation, including (i) a disallowance provision allowing for a return of the purchase price if the bonds are found to be either “excluded liabilities” or the subject of a “re-transfer” under the resolution measures; and (ii) representations from the seller confirming that neither it nor any previous holders of the bonds were (a) 2%+ shareholders of BES, (b) “bad actors” or (c) fall within the ambit of “excluded liabilities” under the resolution measures.

What is the degree of risk?

It is very difficult, in practice, to segregate or identify all relevant parties who previously held the Novo bonds on the date the resolution measures were applied. This issue involved with tracing chain of title, together with the technical difficulty of enforcing the provisions of excluded liabilities or bad acts due to the fungible nature of bonds, means the risks associated with the Novo bonds are not so severe as to deter trading of these bonds, although these risks must be analyzed and understood by each investor prior to trading.