Upholding values: bondholders demand resolution transparency

Banco Popular case could have wider implications for future bank bail-ins

Locked away: lack of transparency over resolution decision has been described as "inexcusable”

Bank resolutions are never pretty or popular. But it would be particularly painful if the first resolution undertaken by Europe’s Single Resolution Board (SRB) – on Spain’s Banco Popular – turned out to be illegal.

This, at least, is the contention of Popular’s junior bondholders. It means that a great deal more than just money now rides on the valuation used by the SRB in making its resolution decision – the reputation of Europe’s newest regulator is also at stake. And the general treatment of bondholders under post-crisis resolution regimes is under the microscope. Next week could be crucial, as the SRB is expected to release a heavily redacted version of the valuation report on or shortly after January 15.

The regulator has been praised for its quick wind-down of the bank last summer without turning to taxpayer funds, but it now faces an embittered legal challenge from junior bondholders, who were wiped out to the tune of €2 billion ($2.45 billion). Among them are giant asset manager Pimco and private equity firm Anchorage capital. Additional tier 1 (AT1) and tier 2 bondholders were wiped out, while senior bondholders were protected. The bondholders’ first priority is to force the SRB to disclose in full a preliminary valuation of the bank’s assets undertaken by Deloitte – something the Brussels-based regulator has so far refused to do.

“I find the lack of transparency somewhat inexcusable, certainly from the perspective of the litigating parties, because they are seeing the possibility of developing a sensible case remarkably impaired,” says Fernando Minguez, a partner at law firm Cuatrecasas, based in Madrid. “I understand the SRB must keep its initial decision-making process secret before a resolution action is taken, but once it has made that decision, I don’t quite see the factual basis for why the valuation cannot be disclosed. This should now be akin to an ex-post forensic exercise.”

At the time of its resolution, Popular was Spain’s sixth largest bank by assets. It had become heavily encumbered with non-performing loans, but it was a run on (mainly corporate) deposits, at the end of May and start of June, that ultimately led to it being determined as failing or likely to fail (FOLTF) by the SRB.

The SRB sold the bank to Spanish rival Santander for a token €1. Bondholders have since brought legal action against the regulator, as well as against the Spanish resolution authority, the Fondo de Reestructuración Ordenada Bancaria (FROB). At the end of August, 51 lawsuits against EU authorities were registered at the European General Court and the SRB will submit its initial defence to the Court of Justice of the European Union (CJEU) this month.

No creditor worse off

Before bondholders can make their case as to why resolution was unnecessary, their lawyers are attempting to get hold of the SRB’s pre-resolution valuation, undertaken by Deloitte. Last year, an SRB appeals panel promised to release the report in mid-January 2018, but lawyers say this is likely to be heavily redacted. It is expected to be published on or around January 15, the date when the court has asked the SRB to provide its preliminary written defence.

One important detail to be leaked from the valuation report last year was the bank’s asset value, put in the range of between –€8 billion and €1.5 billion, with the SRB settling on a figure of –€2 billion before resolution began. This is relevant to the argument that creditors may have been worse off in resolution than in liquidation, which would be a breach of rules under the Bank Recovery and Resolution Directive (BRRD).

“I don’t think Deloitte would have had enough time to complete a suitably thorough report, and it would have been difficult because when you have the first sign of deposit flight, the situation can easily accelerate to the point of non-viability very quickly. The kind of valuation that needs to be done in these circumstance relies on a lot of subjective items,” says Filippo Alloatti, a senior credit analyst at investment manager Hermes.

There was a breach of due process in wiping out bondholders on the basis of such a large range in valuation

Nicola Chesaites, Quinn Emmanuel

Quinn Emmanuel is a law firm representing a group of bondholders hoping to have the resolution of Banco Popular annulled by the CJEU. A key contention is that Deloitte’s financial assessment of Popular undervalued its assets. In a column for Spanish newspaper El Pais on December 28, University of Valencia professor of economic analysis Joaquín Maudos estimated asset value at the time of resolution to be closer to €12 billion. 

“Our argument is that there was a breach of due process in wiping out bondholders on the basis of such a large range in valuation,” says Nicola Chesaites, a lawyer representing Popular bondholders at Quinn Emmanuel. “We’ve had our own experts look at the assets based on publicly available information and Santander’s accounts. Our assessment is that the –€2 billion estimate was well out and was just used to be able to justify going ahead with resolution,” she says.

Transparency versus stability

The problem for the bondholders’ lawyers in making their case is that the detail surrounding the asset valuation is currently not available to scrutinise. Some regulatory experts say one of the ways the SRB may be able to defend its refusal to publish Deloitte’s valuation of Popular in full is to point to a potential financial stability risk in releasing sensitive information to the market. The argument is that if very specific metrics are shown to have been the deciding factor in a FOLTF determination, then creditors of other institutions in a similar situation may also decide to run, creating more liquidity crises.

By chance, the Financial Stability Board released a consultation in late 2017 on principles for bail-in execution, which stated clearly: “Authorities should disclose ex ante information to the market on the overall valuation framework and process. Ex post information on the actual valuation of a firm in resolution should also be disclosed where possible.”

However, the FSB goes on to say that “ex post information should not be disclosed if it risks jeopardising resolution objectives”, which is likely to preclude information that might induce a market shock. The FSB adds that “home authorities should also be mindful of the risk of setting a precedent and in certain circumstances there will be a need for confidentiality”. The consultation closes on February 2.

James Wigand, a managing director at advisory firm Millstein & Co and former deputy director for franchise and asset marketing in the division of resolutions and receiverships at the Federal Deposit Insurance Corporation in the US, says giving away too much information on valuation may allow some in the market to “game the system” of resolution.

Now that Santander has acquired Popular, if detailed valuation information were to be disclosed, that could put Santander at a competitive disadvantage

James Wigand, Millstein & Co

“Stakeholders always want more information. And not only stakeholders, but also parties who were not directly involved, for the sole purpose of looking at future opportunities, perhaps gaming the resolution process. Think about it, if you know what assumptions the authorities are using to make their decisions, you can start looking at arbitrage opportunities,” he says.

“Also, now that Santander has acquired Popular, if detailed valuation information were to be disclosed, that could put Santander at a competitive disadvantage – competitors could obtain proprietary financial information associated with Popular’s former businesses. More valuation information might be disclosed later on, but in the meantime, you have to strike that balance of the interests of transparency against the interests of the public authorities and the acquiring entity.”

The lawyers’ appeal for the Deloitte valuation to be published is pending. In comments sent to Risk.net, an SRB official points out the three stages of valuation that must take place in resolution, but would not comment on the extent to which Deloitte’s first-stage valuation will be disclosed publicly or to bondholders.

Deloitte is also conducting a more thorough third-stage evaluation, which has not yet been completed. This is another bone of contention for bondholders, whose lawyers argue it is essentially investigating and passing judgement on its own preliminary evaluation. This was defended by Elke Koenig before her reappointment as SRB chair on December 4. She said the BRRD itself requires that first- and third-stage valuations are conducted by the same entity. 

Who caused liquidity squeeze?

The SRB official also says the FOLTF assessment, when considering Deloitte’s initial valuation, came down to liquidity rather than solvency. This may offer the SRB some flexibility if it can establish the viability of the bank was subject to rapid deterioration and required a speedy intervention, therefore diminishing the usefulness of a point-in-time initial valuation.

“As the ECB and SRB have disclosed, the FOLTF situation of Banco Popular was driven [by] an acute liquidity crisis, that – while there is always some link between solvency and liquidity – is an autonomous reason to declare the bank FOLTF,” says the SRB official.

But one of Quinn Emmanuel’s central arguments is that the liquidity crisis at Popular was precipitated by leaks and comments from within the SRB and European Commission. On May 23, Koenig told Bloomberg TV – in a transmission that is still available online – that Banco Popular “is a case we are watching”, after being quizzed on the falling price of Popular AT1 bonds. Then, on May 31, an “EU official” told Reuters the SRB had issued “an early warning” about Banco Popular to other EU authorities. Immediately afterwards and entering June, the bank’s share price plummeted by 50% and deposit outflows increased substantially.

At a hearing on June 19, Spanish member of the European Parliament Ramon Tremosa claimed the depositors who abandoned Popular were specifically Spanish local and regional governments, and possibly the social security system.

“The key here is the process. No-one is attacking the BRRD, but if the SRB head makes statements that the SRB may potentially resolve a bank, and then everyone immediately withdraws their deposits, that precipitates a liquidity crisis,” says Chesaites at Quinn Emmanuel. “The regulation makes very clear, and sets out that the SRB should not disclose or identify in any way, any bank that is under its review. If you look at the share price and deposit outflows following leaks to the press, it was unprecedented from May 31.”

The SRB official states accusations about the SRB leaking information to the market “are very grave and it should be noted the SRB takes its responsibility of keeping information of resolution cases confidential extremely seriously”.

“Moreover, we have not, and do not, confirm the alleged quotes made by the Chair of the SRB. It is important to note that the SRB never issues warnings about banks, as preparing and drafting resolution plans is our usual daily core task.”

A Paris-based resolution lawyer, who did not want to be named, says the CJEU is unlikely to consider declarations made by regulators leading up to the crisis as justification for annulling the resolution decision.

“To be honest, I don’t think the Popular bondholders have much chance of success. If the central argument is based on comments from the SRB to the press in May that are alleged to have caused a liquidity crisis, it’s not a very strong case. I think they are grasping at straws. The existence of a manifest error in the valuation or underlying assumptions, if it can be proven, would be a more powerful argument,” she says.

If Banco Popular’s stress was mainly down to liquidity rather than solvency, some have also questioned why emergency liquidity was not offered to the bank. This will not directly inform the argument put forward on behalf of bondholders, but others are asking why this was not considered an option by the ECB and Spanish central bank.  

“First, if it is a systemic bank in Spain, and it was a liquidity crisis rather than a problem with solvency, then the question might be asked, ‘why didn’t the ECB offer liquidity to it?’ says Panicos Demetriades, who was governor of the Central Bank of Cyprus during the country’s financial crisis between 2012 and 2014.

“If it is all to do with liquidity, I have trouble with allowing a healthy institution to fail because of reluctance of the ECB to provide liquidity. Then, if it was insolvent, why didn’t regulators pick up on that earlier?”

Where the law lies

Law and regulation experts say it is possible the CJEU could focus on the procedural aspects of Banco Popular’s resolution and whether the SRB applied its powers appropriately, rather than a technical debate about the precise valuation of Popular’s assets at the start of June. Although the initial valuation by Deloitte and how accurate it was is central to the case brought by bondholders, it may be enough for the SRB to prove it acted within its remit and applied its powers at the correct point in time in exactly the way they were designed to be used.

Minguez (pictured) at Cuatrecasas says bondholders may try to establish a failure of due process, but that this is likely to be a weak argument, as the Spanish implementation of the BRRD appears sound.

“The stronger argument is establishing that there were, de facto, insufficient grounds for intervention. This will likely be based on whether the decision taken was made on the basis of sufficient evidence and that other options would have been more detrimental than resolution,” he says

If the bondholders’ lawyers do win their case, it is likely the resolution of Banco Popular will be annulled, which would be complicated by the fact the bank has already been purchased by Santander. The Paris-based resolution lawyer points to Article 85 of the BRRD, which outlines the rights of third parties to be maintained, which she says would need to apply in the event of an annulled resolution, with the bondholders being awarded compensation but not reinstated as Popular bondholders.

If this decision has to be annulled, the SRB would have to reverse the decision

Nicola Chesaites, Quinn Emmanuel

The BRRD states: “The annulment of a decision of a resolution authority shall not affect any subsequent administrative acts or transactions concluded by the resolution authority concerned which were based on the annulled decision.

“In that case, remedies for a wrongful decision or action by the resolution authorities shall be limited to compensation for the loss suffered by the applicant as a result of the decision or act.”

Chesaites at Quinn Emmanuel says the complications of annulment should not invalidate its possibility, however, and points to other cases where mergers have been unravelled by European courts.

“If this decision has to be annulled, the SRB would have to reverse the decision. Although people are saying, ‘well how could that be done given Santander’, it is a fact that European courts do annul mergers so it’s not impossible. If it is annulled, the CJEU cannot dictate what happens next, but the SRB will have to do what’s necessary to comply with the CJEU’s ruling and unravel Popular from Santander. The SRB may also have to use its own funds for compensation,” says Chesaites.

A spokesperson for Santander declined to comment.

The financial stability implications of an annulment decision are not for the court to worry about, lawyers say, but rather something to be addressed by the SRB. Some add that the potential upset following an annulment could be enough for EU policymakers to consider amending the BRRD itself and revising SRB powers, if what was considered a successful test case for the SRB turns sour after the fact.

Whatever the outcome of the case, the precedent set by CJEU judges is likely to inform all future resolution decisions in the EU. Although there is scepticism as to the strength of the case against the SRB, it is also clear to many that if the SRB loses the case, it could undermine its current mandate in the EU and the structure of the banking union itself, as well as fundamentally altering how resolution authorities treat bondholders in the future.

Paul Tucker (pictured), an ex-deputy governor for financial stability at the Bank of England who now chairs the Systemic Risk Council, says an important question is whether the court restricts itself to judging only whether the SRB decision was reasonable in the use of its powers, not whether any other options before resolution might have been possible.

“This is more for lawyers, but a central question the CJEU will likely be asking is whether the SRB’s actions were proportionate to their core objectives. It will matter whether the court explores every counterfactual and what could have been done differently, which would set a different kind of precedent. I have long thought that, however well done the valuation and preparations, the first users of bail-in were always pretty likely to attract litigation,” he says.

Additional reporting by Samuel Wilkes.