On 20 March, Australians awoke to learn that Credit Suisse and UBS were to merge. The merger followed the intervention of the Swiss authorities. Its purpose was to cure the crisis of confidence engulfing Credit Suisse. When the merger completes, Credit Suisse will cease to exist and its business will be run by UBS.
Two aspects of the planned merger have caught the eye of investors in additional-tier one (AT1) securities worldwide. The first is the complete write-down of AT1 instruments of Credit Suisse. The second is that, under the terms of the merger, holders of Credit Suisse ordinary shares will receive on completion one share in UBS for every 22.48 shares held in Credit Suisse. This is worth a lot less than the market value of their Credit Suisse shares before the merger was announced, based on the share prices of Credit Suisse and UBS at the date of the transaction, but it is something. Holders may even gain if the merger completes and the UBS share price appreciates. Holders of Credit Suisse AT1 instruments are to receive nothing.
Some will ask whether this is right and fair. Aren’t holders of AT1 preferred claimants to the holders of ordinary equity? Therefore, shouldn’t they receive value in priority to the holders of ordinary equity? Australian investors might ask whether their position, if similar circumstances affected an Australian bank, would be the same or different.
The answers to these questions are nuanced. Generally, AT1 holders have some preference over holders of ordinary equity as regards distributions and a return of capital in the event a bank is liquidated. But just because an instrument is classified as AT1 does not mean the holders are guaranteed an outcome ahead of ordinary equity in all cases, and in particular in the case where a regulator has to take action to keep the bank a going concern to avoid loss to depositors or to the financial system more broadly.
The precise rights of AT1 holders are a function of a number of factors including the terms they have agreed to, the powers of the issuer’s regulator under the laws of the issuer’s home jurisdiction and how the regulator determines those powers should best be exercised in the particular circumstances.
Among countries that have followed the Basel III model of regulation, there are similarities in these laws and in the terms of AT1. But there are also very important differences. In what follows we will discuss how the Credit Suisse case illustrates this and where the position for an Australian bank would be likely to differ.
“Generally, AT1 holders have some preference over holders of ordinary equity as regards distributions and a return of capital in the event a bank is liquidated. But just because an instrument is classified as AT1 does not mean the holders are guaranteed an outcome ahead of ordinary equity in all cases.”
WHAT HAPPENED IN THE CREDIT SUISSE CASE?
When the Swiss Financial Market Supervisory Authority (FINMA) announced it had approved of a merger between UBS and Credit Suisse on Sunday 19 March, it also announced: “The extraordinary government support will trigger a complete write-down of the nominal value of all AT1 shares of Credit Suisse in the amount of around CHF16 billion [US$17.4 billion], and thus an increase in core capital”.
The “extraordinary government support” was a reference to the granting of further liquidity to Credit Suisse by the Swiss National Bank that is backed by a default guarantee by Switzerland.
It seems that the terms of the Credit Suisse AT1 instruments provided for them to be automatically written down and cancelled if a “write-down event” occurred. The write-down event included if the bank’s common equity tier-one capital ratio were to fall below a predefined level or a “viability event” occurred. The offering documents for the AT1 instruments describe two limbs of the viability event. In summary, these appear to be:
- Where the regulator determines that a write down is an essential requirement to prevent Credit Suisse from becoming insolvent.
- Where Credit Suisse has received an irrevocable commitment of extraordinary support from the Swiss government or the Swiss central bank that has or imminently will have the effect of improving Credit Suisse’s capital adequacy and without which, in the determination of the regulator, Credit Suisse would have become insolvent.
In each case, it seems customary measures to improve Credit Suisse’s capital adequacy at the time must have been “inadequate or unfeasible”.
The FINMA announcement suggests an event within the second limb of the definition of viability event occurred, leading to an automatic write-down in accordance with the terms of the instrument. This outcome is not conditioned on ordinary equity first being extinguished or otherwise absorbing losses.
It should be borne in mind that Credit Suisse’s AT1 notes are governed by Swiss law. Their construction, the powers of Swiss regulators and how they should exercise them, and what redress investors might have if powers have been exceeded are all matters of Swiss law – on which we make no comment. But let’s assume the public sector support given to Credit Suisse answers to the description in the terms and that the regulatory determinations have been properly made.
Two observations may be made. First, the write down of the AT1s was not enough to save Credit Suisse. A second transaction – a merger with UBS – was necessary. Second, the write down means the AT1s have been cancelled. As soon as this occurs the holders have nothing. There is no basis for them to participate in the subsequent merger transaction.
Of course, this means the AT1 holders have potentially been treated worse than they might have been had Credit Suisse been left to go into insolvency and, in that insolvency, a surplus was realised that was available to them after paying off all the prior ranking creditors.
In some jurisdictions, certain regulatory actions are constrained by an overriding principle that no creditor should be worse off than it would be in insolvency. In the EU, for example, there exists the power to bail in creditors to recapitalise a failing bank. But, again, in the Credit Suisse case it is a matter for Swiss law whether this is a principle of any application to a Swiss bank and to AT1s, given their terms.
“The key takeaway for market participants should be that it is not prudent to extrapolate outcomes from the label ‘AT1’ or broad notions of ‘ranking’. AT1 and the outcome for its holders in any particular case depends on its exact terms and the national regulatory system of the relevant issuer. These should be studied country by country.”
HOW DOES THIS COMPARE WITH AUSTRALIAN AT1?
Investors familiar with AT1 securities issued by Australian banks and insurers will know that they contain provisions to the effect that:
- If a distribution is not paid on the AT1 instrument, the issuer is restricted for a limited period from paying a distribution on its ordinary shares (the “distribution restriction”).
- If the issuer is wound up, the holder of an AT1 instrument has a right to a return of capital only after all creditors – including secured, unsubordinated and term subordinated creditors – have been paid in full, ahead only of ordinary shares.
- The AT1s must absorb losses – that is, be converted to ordinary shares or written off – if the issuer’s common equity capital ratio falls below a prescribed level or the Australian Prudential Regulation Authority (APRA) determines it will become nonviable. The terms of AT1 instruments do not attempt to define what nonviability is and APRA has not specified particular grounds it would take into account in determining it, beyond noting that it may be financial distress short of insolvency.
- In the vast majority of cases, the instruments provide for conversion to ordinary shares if the trigger event occurs. The number of ordinary shares is determined on the basis of the market price of the issuer’s shares at the time of conversion subject to a maximum number set assuming a fall in the share price to 20 per cent of the level prevailing at the date of issue of the instrument (thus limiting the dilution of existing shareholders). Holders would therefore become shareholders and be able to participate in any corporate action following conversion, for example, a merger or transfer of business. Only if the conversion is not effected within a short period, typically five business days, would the instrument be written off. In other words, write-off is a backstop if conversion is not effected for any reason. Bank issuers of AT1 typically take steps at the time of issue of AT1s to facilitate conversion occurring if and when required, for instance by making sure no shareholder approval is required for the issue of shares on conversion.
- Most AT1s of Australian banks also contain acquisition event or change of control conversion events, meaning that in circumstances where the bank is to be acquired by another bank by a usual corporate process – for instance where APRA had not made a nonviability determination – the acquiring bank would acquire the ordinary shares issued as a result of the conversion of the AT1s as well as the existing ordinary shares.
- The holder’s rights are limited to what is expressly provided in the terms and it is not given any general right to participate in other transactions.
These features derive from the prudential standards set by APRA which regulate when an instrument will qualify as AT1 .
An Australian AT1 is preferred to ordinary equity to the extent of the distribution restriction and the rights in a winding up. All these rights, though, are qualified by the requirement of the instrument to absorb losses as described above. No qualification to the requirements to absorb losses and no holder rights to participate in other transactions would be implied into the terms.
“An Australian AT1 is preferred to ordinary equity to the extent of the distribution restriction and the rights in a winding up. All these rights, though, are qualified by the requirement of the instrument to absorb losses. No qualification to the requirements to absorb losses and no holder rights to participate in other transactions would be implied into the terms.”
The Banking Act does not give APRA a general power to bail in debt or to convert or write off debt to equity. While APRA has very broad powers under the Banking Act to take action if a bank is in distress, the primary power it has in relation to AT1 – and tier-two – is to make the determination of nonviability that requires the bank to convert or write off some or all the instruments in accordance with their terms.
The Banking Act does not impose on APRA a requirement to ensure that, in the exercise of its powers, AT1 holders, or other creditors, are no worse off than they would be in an insolvency.
A statutory manager appointed by APRA has powers to cancel and rights to acquire shares, subject to certain conditions . This is a power not a duty. APRA may or may not wish to appoint a statutory manager and the statutory manager may or may not wish to exercise the power.
AUSTRALIAN AT1 AND THE CREDIT SUISSE CASE COMPARED
While there are points in common between the Australian and Swiss regimes, there also appear to be some key differences between typical Australian AT1s and the Credit Suisse notes.
What is nonviability? In Australia, nonviability events are less prescriptively defined.
Conversion to equity is required if a nonviability or capital trigger event occurs. Most, if not all, AT1 instruments issued by banks and insurers in Australia are required to be converted into equity at the point of nonviability or on the occurrence of a capital trigger. Conversion to equity is the primary method of loss absorption – so, if APRA made a determination of nonviability or a capital trigger event occurred, the relevant bank would have to convert its AT1s into equity – ie ordinary shares.
Only if the conversion did not occur for any reason within the period specified in the terms – typically five business days from the nonviability determination – would the AT1s have to be written off like Credit Suisse’s AT1s. Write-off is a backstop and bank issuers should generally be prepared to effect conversion if it is required.
The Banking Act reinforces conversion. The Banking Act gives statutory backing to the effectiveness of the loss absorption provisions contained in the AT1 terms. Rules of law that might otherwise impede the operation of the provisions are overridden – with limited exceptions, principally for shareholding laws. So far as the terms provide for conversion, conversion should occur so long as the bank can carry out the actions required to issue shares as an operational matter .
“There is no principle of ‘no creditor worse off’ that applies in Australia. There is no requirement in the terms or general law that the rights of ordinary equity have to be extinguished before AT1 holders are subject to loss absorption.”
On analogous facts in Australia to Credit Suisse, if APRA were to determine an Australian bank to be nonviable it is likely holders of AT1 would have been converted and subsequently treated in the same way as other ordinary shareholders. Conversion is required to be effected immediately after APRA makes a determination. As a result, converted AT1 holders should be able to participate, as ordinary shareholders, in any corporate action that occurs following the conversion.
It is also worth noting that, in Australia, the level of required loss-absorbing capacity has been set with a view to the conversion or write off of capital instruments being sufficient by itself to recapitalise the bank to allow it to continue to trade. There is no requirement in Australian law that the loss absorption be coupled with a merger.
Only in the most severe circumstances, where the conversion or write off of capital instruments is considered inadequate to resolve the situation, should a further transaction by way of merger come into consideration. There are provisions in the Banking Act and related legislation to facilitate such a transaction, should it be necessary .
This is not to say that if an Australian ADI is to be resolved AT1 holders can assume they will receive their investment back in full before ordinary shareholders will receive any value. There is no principle of “no creditor worse off” that applies in Australia . There is no requirement in the terms or general law that the rights of ordinary equity have to be extinguished before AT1 holders are subject to loss absorption.
Indeed, it is plain from the terms of AT1s that when those instruments are required to absorb losses their holders may suffer economic outcomes that are not the same as they might have enjoyed in a winding up.
For instance, holders of equal ranking AT1 notes may receive different numbers of shares, depending on the maximum conversion number applicable to their instruments – as this is linked to the issue date for each series of AT1 notes. The existence of this maximum number may mean the shares they receive are worth less than the principal amount of the converted AT1 notes. The value of their resulting stake in the bank may vary according to what, if anything, has happened to the existing ordinary shares in the bank.
While ordinary shares are defined as equity that takes the first and greatest shares of losses as they occur, there is no requirement to have cancelled or reduced the claims of these shares before AT1 notes are converted . Where AT1 notes are converted, the measure of the loss they suffer is the dilution in their stake in the bank’s equity following the conversion.
There may be more lessons from the Credit Suisse case in the coming months. For now, the key takeaway for market participants should be that it is not prudent to extrapolate outcomes from the label ‘AT1’ or broad notions of ‘ranking’. AT1 and the outcome for its holders in any particular case depends on its exact terms and the national regulatory system of the relevant issuer. These should be studied country by country.
In Australia, AT1 is a contractual product with critical terms derived from prudential standards and then reinforced by statute. An instrument that provides for conversion should ordinarily result in conversion, so long as the issuer has the operational capacity to carry out the conversion. The terms, disclosure and those standards and statutes require careful attention.