How Will Courts Decide in Bond Holders versus Central Banks?

[Bhargavi Zaveri Shah a doctoral researcher at the Faculty of Law, National University of Singapore and an editor of IndiaCorpLaw Blog and Harsh Vardhan is a management consultant]

The Supreme Court is currently hearing an appeal against a Bombay High Court judgement on Yes Bank’s restructuring plan. The question at hand in this appeal is this: whether, as part of Yes Bank’s restructuring exercise, the Reserve Bank of India (RBI)-appointed administrator could have written off Yes Bank’s additional tier  bonds without first writing down its equity shares. In other words, could the RBI-appointed administrator have preferred Yes Bank’s equity shareholders over its bond holders.

In the meanwhile, half way across the world, a similar write-off has been done by the Swiss National Bank (SNB) in Credit Suisse’s rescue plan. Under the UBS-Credit Suisse merger deal facilitated by the Swiss central bank, holders of Credit Suisse’s additional tier bonds will get nothing, while shareholders will receive $3.23 billion. As in India, Credit Suisse’s bond holders are reportedly considering legally challenging this decision of the SNB. Financial supervisory authorities in the United Kingdom (UK) and the European Union (EU) have issued statements reassuring the public that they would not resort to such prioritization in their own jurisdictions (here and here). The developments in the Credit Suisse case, therefore, have implications for the manner in which the Supreme Court and the litigants themselves might look at the Yes Bank challenge.

A key principle of corporate finance is that in the event of liquidation, equity shareholders will be paid out after all other claims against the company have been paid out. While no such prioritization rules apply in rescue or restructuring events, it is widely understood that equity shareholders are the first bearers of losses. This is as true of a small-sized manufacturing company as it is of global banks such as Credit Suisse and the Silicon Valley Bank. In the case of banks, the capital structure, largely dictated by the Basel Norms, is as follows: common equity tier (CET1), additional tier 1 (AT1) and tier 2 capital (T2).  Both AT1 and T2 capital is issued in the form of bonds that earn interest for the investor.  In the event of large losses, it is generally understood that the pecking order of bearing the losses would be – equity first, followed by AT1, and then T2 bonds. 

Banking regulations in most jurisdictions demand that banks maintain a minimum level of total capital based on the size of their loans and investments (generally called risk weighted assets). Additionally, they prescribe the maximum capital that can be held in the form of bonds, that is, AT1 and T2 bonds and the minimum that must be brought in as CET1.  While investing in these bonds, investors bear this pecking order of loss absorption in mind and appropriately price these bonds. Thus, AT1 bonds generally carry higher interest than T2 bonds.  Capital, composed of these three tiers, acts like a buffer protecting the depositors from losses that the bank may make say, due to non-repayment of the money that they lend out. It acts exactly like air bags in a car protecting the passengers from getting harmed in the event of an accident.

The SNB’s write off of Credit Suisse’s AT1 bonds without completely writing off the equity shares upended this well understood loss absorption hierarchy. When the Swiss central bank decided to write off AT1 bondholders, while making a pay-out to its equity shareholders, the Bank of England issued a statement titled “UK creditor hierarchy” re-emphasizing this order of priority, as follows:

“[A]T1 instruments rank ahead of CET1 and behind T2 in the hierarchy. Holders of such instruments should expect to be exposed to losses in resolution or insolvency in the order of their positions in this hierarchy.”

Similarly, bank supervisory and resolution authorities in the EU, namely, the European Central Bank (ECB), the Single Resolution Board (SRB) and the European Banking Authority issued a joint statement as follows:

“[T]he resolution framework…after the Great Financial Crisis has established, among others, the order according to which shareholders and creditors of a troubled bank should bear losses.

In particular, common equity instruments are the first ones to absorb losses, and only after their full use would Additional Tier 1 be required to be written down. This approach has been consistently applied in past cases and will continue to guide the actions of the SRB and ECB banking supervision in crisis interventions.”

What do these statements mean for the Yes Bank challenge before the Supreme Court? While statements issued by foreign supervisory authorities are obviously not meant to bind authorities or courts elsewhere, the signalling value of these statements is tremendous. These statements re-emphasize the basic tenets of corporate finance and the fact that the decision taken by the SNB and the RBI, of prioritising equity shareholders over bond holders, is an aberration that they do not intend to follow in their own bank resolution processes. At the least, these statements emphasize the need to convey clarity on the manner in which different instruments in banks’ capital structure will rank in the event of a bank failure. That is, what should an investor expect when she buys a bond or an equity share of a bank.

The Bombay High Court had the opportunity to provide this clarity when the AT1 bond holders of Yes Bank, who were wiped out by the RBI, challenged the RBI’s decision. In January 2023, when the High Court ruled in favour of Yes Bank’s AT1 bond holders, we had argued that the Bombay High Court had correctly decided in favour of the bondholders. However, the judgement did not serve to provide the clarity on the loss absorption waterfall. We argued that the Court had erred by grounding its decision in technicalities, and that it ought to have looked into the fairness of the RBI administrator’s decision. A reasoned determination of this issue was critical for the banking industry. The recent developments in the Credit Suisse case and the statements on creditor hierarchy issued by supervisory and resolution authorities reinforce our arguments on the need to look into this question on merits.  The lack of clarity on this important issue would make this source of capital expensive for banks.

Bhargavi Zaveri Shah & Harsh Vardhan

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Bhargavi Zaveri

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