A key principle of Chapter 11 corporate reorganizations is the “absolute priority rule.” It requires that the claims of a dissenting class of creditors be paid in full before any stakeholders in a class junior to such dissenting class may receive or retain any property in satisfaction of their claims. As a consequence, creditors cannot be forced to accept cuts if shareholders are not completely wiped out. This principle is also central to legal frameworks governing the restructuring of banks. For example, Article 34(1)(a) of the European Bank Recovery and Resolution Directive (BRRD, 2014) stipulates that “Member States shall ensure that, … resolution action is taken in accordance with the following principles: (a) the shareholders of the institution under resolution bear first losses ….”
Against this background, one would have expected that the write-down of the Additional Tier 1, or AT1, bonds in the Credit Suisse (CS) bailout would not have happened without its shareholders also being wiped out. But the unexpected did happen: The bonds were written down, and CS’ shareholders received UBS shares worth $3.25 billionunder the bailout deal.
In this post, we analyze the motives and mechanics of the write-down and argue that the prospect for a legal challenge is slim. At the same time, we question the merits of the write-down. Bondholders should fare no worse than common equity, regardless of whether a financial institution is put in an insolvency proceeding or bailed out, and the applicable bond terms should reflect this. We also raise the issue of a more principled approach to bailouts generally.
CS’ demise can be summarized by the exchange between Bill and Mike in Hemingway’s “The Sun Also Rises.” “How did you go bankrupt?” Bill asked. “Two ways,” Mike said. “Gradually and then suddenly.” The SEC probed various accounting errors at CS eight months before the bank’s collapse. The nail in CS’ coffin came on March 15, 2023, when the chairman of its main shareholder, the Saudi National Bank, uttered the now infamous “absolutely not” when asked about an additional liquidity injection into the bank. Despite an immediate liquidity backstop by the Swiss National Bank (SNB) of up to CHF 50 billion, market pressure mounted, and during the weekend of March 17-19, SNB, the Swiss Financial Market Supervisory Authority (FINMA), and the Federal Council (the Swiss government), engineered a takeover of CS by rival bank UBS. CS’ shareholders received $3.25 billion in UBS shares, the AT1 bondholders were wiped out, UBS received an additional CHF 100billion liquidity line from SNB backed by a federal default guarantee, and the Swiss government also provided a conditional loss guarantee to UBS of up to CHF 9billion.
The bailout deal is noteworthy for many reasons. First, Switzerland has a bank resolution regime comparable to the BRRD. But the Swiss finance minister believed that the regime would not work in an emergency and that following the existing protocols “would have triggered an international financial crisis.” If resolution according to a dedicated regime set up after the 2007-2008 financial crisis would not work in Switzerland, what can we expect in other jurisdictions with similar regimes?
Second, to carry out the rescue, the Swiss government passed an Emergency Ordinance on March 16, 2023 (amended on March 19). New provisions include the granting of powers to FINMA (i) to bypass the need for general meetings to approve transactions involving systemically relevant banks (Article 10a) and (ii) to require the write down of “additional core capital” (Article 5a). As a consequence, the bailout was implemented by administrative fiat, bypassing both parliament and the shareholder assemblies of the affected banks.
Third, based on Article 5a and the applicable bond terms, the holders of CHF 16 billion of AT1 bonds in CS were completely wiped out while equity holders, despite being materially diluted, were not. The Swiss authorities apparently believed that it was more important to placate CS shareholders than the AT1 bondholders. Shareholders could have initiated blocking litigation, anchor investors are needed to meet future financing needs, and employee shareholders must be motivated to come to work. Further, the identity of the AT1 bondholders – primarily sophisticated institutional investors – might also have played a role. Converting the bonds into equity – and offering the bondholders shares in UBS – might have disrupted the current governance structure.
For sure, the bondholders are upset. But their chances of succeeding in litigation are slim because thecontractual terms of the bonds are quite clear. They stipulate a write-down to zero following the occurrence of a “Write-down Event.” This can be either of two types: a “Contingency Event” or a “Viability Event.” Under the former, the CET1 ratio (Common Equity Tier 1 Capital / Risk-Weighted Assets) of CS must fall below 7 percent at any reporting date. Under the latter, “the Regulator” must determine that a write-down is essential to prevent CS from becoming insolvent or from ceasing to carry on its business (scenario 1); alternatively, CS must have received an “irrevocable commitment of extraordinary support from the public sector” (scenario 2).
These triggers, especially the “Contingency Event,” are designed to kick in before the bank faces insolvency and to restore the specified capital ratio. In other words, the function of the AT1 bonds is to absorb losses before an existential crisis wipes out the bank’s equity. FINMA claims that the write-down of the bonds was done on the basis of the extraordinary support received by CS (scenario 2), and this seems right. The complete write-down of the bonds is the automatic consequence of the irrevocable commitment of public support. An exercise by FINMA of its Article 5a powers is not even necessary for this.
To understand the frustration of the bondholders, one must consider other bond terms. A section on “Events of Default” stipulates that, inter alia, the commencement of an involuntary bankruptcy case against CS constitutes such an event. The consequences are set out in a section on “Subordination of the Notes.” These shall rank “senior to the rights and claims of all holders of Junior Capital.” While this seems to suggest that the bondholders would rank before shareholders in a bankruptcy proceeding, the following paragraph qualifies that all bondholders’ claims shall be subject to and superseded by a “Write-down Event … irrespective of whether the relevant Write-down Event has occurred prior or after the occurrence of an Event of Default.”
So, if there is no (superseding) “Write-down Event,” the bondholders would rank before the bank’s shareholders. But a superseding “Write-down Event” can occur even in a bankruptcy proceeding. Could this create a legitimate expectation by the bondholders that their instruments would be treated at least no worse than equity under all circumstances? We do not think so. The AT1 bonds were held by sophisticated investors with access to top-tier advisers and the warnings of credit rating agencies and federal banks who reviewed this type of instrument.
But there is no denying that the full write-down of the AT1 bonds is an unusual sanction if shareholders are not also wiped out. By contrast, Eurozone AT1 bonds often contain an equity conversion feature which lets the bondholders rank at least pari passu with the shareholders (post-conversion) if a trigger event occurs. Alternatively, bonds may be of the (reversible) partial write-down type. Immediately after the bailout, both the European Central Bank and the Bank of England rushed to issue statements that what happened with CS would not happen elsewhere in Europe.
And there are good reasons for writing AT1 bond contracts such that bondholders fare no worse than shareholders in a bailout, resolution, or bankruptcy. Somewhat ambiguous contractual language, as in the CS case, feeds different expectations as to what will happen in a crisis. Against the background of these ambiguities and the international prevalence of the “absolute priority rule” or at least a pari passu regime, the bondholders probably hoped that no (complete) write-down would occur, and the price of the bonds apparently reflected this. CS “traded” on this ambiguity to minimize its financing costs, and regulators such as FINMA rely on it to strengthen banks’ financial position and financial stability.
Resolving the ambiguity is important to reduce unnecessary transactions costs, as evidenced by the litigationtriggered by the current write-down event. It is also important to eliminate the perverse incentive for the bondholders to accelerate the demise of the issuer by filing for insolvency in an attempt to preserve their presumed rank above shareholders. Moving to (at least) a (post-conversion) pari passu regime could avoid the need to significantly increase the price for AT1 bonds with a clear “total write-down” feature. The pricing of these bonds would continue to be based on the principle that debt should not rank lower than equity – a cardinal principle and focal point of bankruptcy laws world-wide.
The implications of the CS bailout go beyond the (future) treatment of the AT1 bondholders. It is remarkable that the Swiss government resorted to an ad hoc bailout outside the applicable framework for bank resolution to restructure CS. Similar ad hoc bailouts of “critical” non-financial firms have occurred and will continue to occur in the aftermath of geopolitical or macroeconomic shocks such as the COVID-19 pandemic or the energy crisis following the war in Ukraine. Arguably, the applicable bankruptcy laws suffer from certain structural limitations which can make an ad hoc bailout the better restructuring tool.
Bankruptcy and bank resolution are heavily regulated. In contrast, ad hoc bailouts are not regulated at all. The potential for abuse (of taxpayer money) and arbitrary decision-making is significant. Establishing some regulatory guideposts could assist regulators and governments to act consistently and based on principles in a bailout scenario. For example, the principle that shareholders should bear losses first is a cornerstone of corporate bankruptcy laws and policies world-wide. International institutions such as UNCITRAL or UNIDROIT should begin work on “Principles on Ad Hoc Bailouts of Critical Firms” that would fill the current regulatory void and provide some certainty for all affected parties.
 AT1 bonds are a type of hybrid debt issued by banks. In a financial crisis of the bank (“trigger event”), they are written down or converted into equity. Hence, AT1 bonds are also known as “contingent convertible” or “CoCo” bonds. Their key function is to provide (Additional) Tier 1 capital for regulatory purposes under the Basel III framework.
 A detailed list of the bonds that were written down was published by FINMA here. For the purposes of our discussion, we will refer to the terms and conditions of the $1.650 billion 9.750 percent Perpetual Tier 1 Contingent Write-down Capital Notes (ISIN US225401AX66/USH3698DDQ46), as per their “Information Memorandum” of June 16, 2022. These terms and conditions are typical.
This post comes to us from Horst Eidenmüller, Statutory Professor of Commercial Law at the University of Oxford, and Javier Paz Valbuena, departmental lecturer in law & finance and DPhil candidate at the University of Oxford.