Head of Dispute Resolution Robin Henry comments on the sale of Credit Suisse and its legal repercussions for bondholders.

Credit Suiss A1 Tier bondholders are said to be outraged at being wiped out in the sale of CS to UBS last week. Claims are threatened against the Swiss regulators and CS for failing to protect the bondholders and for favouring shareholders ahead of them. The bondholders received nothing from the $17bn due to them while the shareholders received $3.3bn from the sale to UBS.

Surely nobody could have seen this coming. Oh but wait a minute … way back as far as 2014, I wrote an article which did warn of the risks of these types of bonds.

The A1 Tier bonds were introduced after the Financial Crisis of 2008 as a way of absorbing losses in case of a default. They are also known as Contingent Convertible (“CoCo”) bonds.

Regulators were demanding that banks be better prepared to absorb losses during a crisis (rather than expect the taxpayer to bail them out). CoCo bonds provided a cheap means of improving the banks’ tier one capital ratios. Banks are required to hold a proportion of their risk-weighted assets in the form of tier one capital (comprising common equity and retained earnings) so that losses will fall on shareholders rather than creditors.

Banks are required to pay coupons on these CoCo bonds up until the occurrence of a particular event called a “conversion trigger”. A conversion trigger may be the bank crossing a nominal capital to assets ratio, or a decision by the regulator that the bank is “in trouble”. At this point the bonds will either convert into shares or will simply be written down to zero.

As I wrote in 2014 “There are, however, serious risks for the investors. In good times, the bonds act in the same way as normal high yield bonds. However, the higher coupons payable may not be sufficient recompense if the trigger event occurs, particularly as a result of a regulator taking a unilateral decision to warn of problems for the issuing bank. Following a trigger event, investors may find themselves either ranking equally with shareholders or even subordinated to them.”

The CS bondholders now claim that the actions of the Swiss regulator FINMA upends the usual order of priority in an insolvency by favouring shareholders over bondholders – and there is no argument about that. Other US and European regulators have since said that the actions of the Swiss regulator would not have been taken in their jurisdictions, not least because it is not easy to see why the shareholders as a class should have been preferred to the bondholders.

Nevertheless, whether the bondholders will succeed in legal claims seeking to recover the value of their bonds remains to be seen. This will require a detailed examination of the meaning of the risk warnings included in the bond documentation which stated that “FINMA may not be required to follow any order of priority and the bonds could be cancelled prior to equity”. However, it will also require the courts to interpret Swiss financial regulations to understand whether FINMA did actually have the power to require the bondholders to be subordinated in this way.

What is of perhaps wider concern is that the actions of the Swiss regulators in allowing CoCo bonds to be subordinated to shareholders have depressed the market value of these bonds (currently worth $260bn) so that, for example, the price of Deutsche Bank AT1 bonds dropped to 63c on the dollar. Equally worrying is that (again foreshadowed in my 2014 article) CoCo bonds might actually exacerbate a future banking crisis because the effect of a conversion trigger being sprung may add downward pressure to a falling stock price. It is for this reason that CoCo bonds have been called “death spiral bonds”.