Credit Suisse's AT-1 Bondholders: A Closer Look at the Credit Suisse Merger and Repayment Structure.

Credit Suisse Group (NYSE: CS) has sent shockwaves through the global financial markets with its recent announcement of a merger agreement with Switzerland's largest bank, UBS Group (NYSE: UBS), made public on March 19, 2023. This agreement comes amidst the Swiss Government's intervention and a $54 billion liquidity backstop from the Swiss National Bank, just one week prior. Notably, a core provision of this agreement stipulates that the Additional Tier 1 (AT-1) Bonds of the target, valued at approximately $17 billion, will be written off to zero.

This development has created unprecedented controversy in the $275 billion Contingent Convertible Capital Market and has prompted a number of AT-1 Bondholders to consider legal action against Credit Suisse and other parties involved. Lawyers at Quinn Emanuel Urquhart & Sullivan have confirmed this on March 21, 2023. This article delves into Credit Suisse's position on the matter and why this has become one of the most contentious issues in today's capital markets.

Who is Credit Suisse, and What has Happened Thus Far?

Credit Suisse Group, and its subsidiary companies, offer an array of financial services, including wealth management, risk management, investment banking, lending, and related solutions across the Americas, APAC, and EMEA regions. Despite its prior success as a dominant player in the banking industry during the early 21st century, Credit Suisse has encountered various obstacles over the past decade, ultimately resulting in the demise of the 167-year-old Swiss bank.

Due to a sequence of unfortunate events, the company's publicly traded shares have undergone a significant decline in value. As indicated in Fig. 1, although not exclusively, the decline in Credit Suisse's share price began during the financial crisis of 2008/09. This trend persisted into 2021 and was exacerbated by the massive $5.5 billion loss incurred by the company in connection with Archegos Capital Management. The company’s present situation marks the culmination of a series of scandals, changes in top-level management, and notable financial losses.

Apart from issues caused by the company itself, macroeconomic factors have also had its contributions. During a significant portion of 2022 and the early part of 2023, financial institutions worldwide have been substantially affected by the implementation of quantitative tightening policies by central banks, aimed at curbing inflation. High rates of default, declines in deposits, underperformance of investments, and slow business growth have been the primary drivers of the crisis faced by many financial service firms, including Credit Suisse. Recent reports indicate that regional banks such as Silicon Valley Bank, First Republic Bank, and Signature Bank have also suffered from this contagion, with the ripple effect causing other regional banks, including Western Alliance Bancorporation and Truist Financial, to experience significant declines in their public market value.

These events had a negative impact on Credit Suisse's liquidity, prompting the bank to take action to address the situation. Despite its efforts to improve its liquidity, its primary investor, the Saudi National Bank, reportedly indicated that it would be unable to offer additional assistance. As a result, on March 16, 2023, Credit Suisse announced its intention to take decisive action to preemptively strengthen its liquidity position. This involved exercising its option to borrow up to CHF 50 billion (or $53.68 billion) under a Covered Loan Facility, as well as a short-term liquidity facility, from the Swiss National Bank (SNB).?

NB: It is worth mentioning that Ammar Al Khudairy, Chairman of the Saudi National Bank, has denied reports of his bank's refusal to provide assistance to Credit Suisse. According to him, "there have been no discussions with Credit Suisse about providing assistance." It appears that the reports arose due to the fact that the Saudi National Bank is unable to make additional investments to increase its 9.9% stake in the company due to regulatory constraints.

Additionally, Credit Suisse also stated in that announcement that it plans to initiate a cash tender offer for 10 senior debt securities denominated in U.S. Dollars amounting to an aggregate consideration of up to $2.5 billion, and 4 senior debt securities, denominated in Euros, for an aggregate consideration of up to €500 million. The deadline for the offers is Wednesday, March 22, 2023, subject to the terms of the offer documents.?

The markets had a fairly positive reaction to this announcement, as Credit Suisse’s shares increased by +8% that day, and maintained stability till Friday, March 17 March. Then, on Sunday, March 19, Credit Suisse confirmed that it had entered into a merger agreement with UBS, Switzerland’s largest bank, with UBS being the surviving entity. The following day, Credit Suisse’s shares fell by -53%.

What are Some Key Terms of UBS and Credit Suisse’s Merger Agreement?

The government-brokered deal carried a valuation of CHF 3 billion (or $3.25 billion) for all shares in Credit Suisse. Under the terms of the deal, shareholders of Credit Suisse will receive 1 share in UBS for every 22.48 shares held in Credit Suisse. In addition, the Swiss Financial Market Supervisory Authority (FINMA) will allow Credit Suisse to entirely write off its Additional Tier 1 (AT-1) Bonds, which resulted from the issuance of Tier 1 Capital Notes, totaling approximately CHF 16 billion (or $17 billion).?

It is pertinent to note that, according to the emergency ordinance issued by the Swiss Federal Council, shareholder approval is not required for the implementation of this merger.

Here are further details of the transaction.

What are AT-1 Capital and AT-1 Bonds?

Under the Basel III Framework, banks are required to meet a “total regulatory capital” requirement, which is divided into Tier-1 Capital (Going Concern) and Tier-2 Capital (Gone Concern).?

Tier 1 capital includes equity capital (Common Equity Tier-1 i.e. CET-1) and disclosed reserves, which are the most fundamental and permanent forms of capital that a bank can hold. This capital is considered the highest quality of capital and provides the strongest protection against losses in times of financial distress. On the other hand, Tier 2 capital includes subordinated debt, hybrid capital instruments, and certain types of reserves. This capital is less permanent and less valuable than Tier 1 capital, but still provides a significant level of protection against losses.

An example of how Tier-1 capital provides protection to the banks is how shareholders who provide a perpetual form of capital with no fixed maturity dates, bear losses by seeing a reduction in the value of their shares without any repayment or redemption. Their capital possesses loss-absorbing attributes, meaning that they are the initial resources utilized to counterbalance losses or fulfill obligations when encountering financial distress.

Additional Tier-1 Capital falls under the Tier-1 capital, and before any security is included under AT-1 Capital, some requirements it must fulfil include:?

1. It must be issued and paid-in.
2. It must be subordinated to depositors, general creditors and subordinated debt of the bank, meaning that claims of these stakeholders will be given priority over AT-1 Capital providers.
3. It is neither secured nor covered by a guarantee of the issuer or related entity or other arrangement that legally or economically enhances the seniority of the claim vis-à-vis bank creditors.
4. It is perpetual, i.e. there is no maturity date and there are no step-ups or other incentives to redeem.

In recent years, regulators have sought to increase loss-absorbing capital for banks, leading to the introduction of “hybrid securities” such as the Additional Tier-1 Bonds (AT-1 Bonds). To fulfil regulatory requirements, these AT-1 Bonds are usually structured similar to equity instruments. Some of the key defining features that make them similar to equity and different from other types of bond instruments include that they are perpetual, unsecured, callable, subordinated to other debt capital, and are convertible.?

As a form of Contingent Convertible Capital (CoCos), in the event of certain trigger events, AT-1 Bonds can either be converted into shares of the institution’s common stock or be written-down, usually to zero. This is how AT-1 Bonds help banks absorb losses in times of financial distress. As a result, they are usually always riskier and more complex than other forms of debt instruments, and require a high level of due diligence on the investor’s part. Nevertheless, with high risk comes high reward, and AT-1 Bond investors are typically rewarded with higher yields compared to other debt holders.

What Does Credit Suisse’s Prospectus Say About A Write-Down of AT-1 Bonds?

Bloomberg recently shared that Credit Suisse had 13 Contingent Convertible Bonds outstanding worth a combined $17.3 billion, issued in Swiss francs, U.S. dollars and Singapore dollars, which is just above 20% of its total debt pile.?

According to Credit Suisse's AT-1 Bond Prospectus, the incidence of a write-down event will only happen upon the occurrence of a viability event or a contingency event. A contingency event occurs when the bank’s capital falls below 7% of its risk-weighted assets, and a viability event occurs when measures to boost its capital are deemed to be unfeasible or insufficient to prevent insolvency. It is inferred that its current write-down was precipitated by concerns regarding the bank's viability.

Additionally, the prospectus clearly states that upon occurrence of a write-down event;?

1. “The full principal amount of each note will be written-down to zero,
2. The holders will be deemed to have irrevocably waived their rights to, and will no longer have any rights against the issuer with respect to, repayment of the aggregate principal amount of the notes,
3. All rights of any holder for payment of any accrued but unpaid interest or any other amounts under or in respect of the notes…will become null and void…,?
4. The notes will be permanently cancelled. As a result, holders will lose their entire investment in the notes.”

Why is this a Controversial Matter?

In a recent article, Bloomberg states that in a normal write-down scenario, shareholders are the first to take a hit before AT-1 Bondholders face losses, as Credit Suisse had also indicated in an earlier presentation to investors. However, under the terms of the government-brokered deal, Credit Suisse shareholders are set to receive CHF 3 billion ($3.2 billion) and apparently, AT-1 Bondholders receive nothing.?

Investors are commonly categorised on the capital stack based on the priority of their claims on a company's assets and cash flows, particularly in the event of a liquidation. This prioritisation is typically based on the nature of the securities held and the expected level of risk and return.

1. Senior Debt Holders, includes banks and institutions that offer debt instruments like loans. They are provided the most secure and lowest expected return.
2. Subordinate Debt Holders, includes high yield bonds, mezzanine warranted and warrantless bonds, Payment in Kind (PIK) notes, vendor notes, etc. They are offered higher risk and rewards than senior debt holders.
3. Additional Tier-1 Bonds Holders are offered higher returns and risk than subordinate debt holders, but naturally take priority over equity holders due to the debt feature inherent.
4. Equity Holders first includes preferred shareholders on the stack, then common shareholders (e.g. CET-1). They are at the bottom of the stack, meaning that they are exposed to the highest risk and return.?

Credit Suisse's recent repayment structure has upended the existing order of investor prioritisation. In fact, according to Bloomberg Intelligence, no other European banks besides Credit Suisse and UBS have provisions that would allow for the full write-down of AT-1 Bonds, while maintaining some value for equity investors.?

This may be a result of the fact that Switzerland is not a member of the European Union which provides under Article 34 of its European Banking Authority’s Bank Recovery and Resolution Directive, that in a situation such as this, “the shareholders of the institution...bear first losses; creditors of the institution...bear losses after the shareholders in accordance with the order of priority of their claims under normal insolvency proceedings, save as expressly provided otherwise in this Directive.”

What Are Potential Negative Impacts of this Preferential Treatment?

While this repayment structure may have averted an impending financial crisis and instilled confidence among equity investors in the banking industry, it is essential to acknowledge the possible adverse repercussions that this agreement may potentially cause.

First, it is possible that the huge losses incurred by Credit Suisse’s AT-1 Bondholders will result in detrimental impacts on the reputation of UBS Group, the acquiring entity, in the short to long term. This could potentially impede their capacity to raise capital in the future.

Second, investors in the bond market may start to lose confidence in risk-bearing assets like AT-1 Bonds, causing reduced demand and pricing for these securities. As we have seen above, AT-1 Bonds are critical to the capital structure of banks, and play a part in averting financial crises.?

Third, as Quinn Emanuel confirms, there are indications that certain investors are contemplating legal action against Credit Suisse and other parties involved in the transaction. Given that these investors were the sole group to incur losses in the acquisition, it is possible that a meritable legal argument could be made based on claims of discrimination and inequitable treatment, or even misrepresentation.

Finally, a potential repricing of the preferred shares of Credit Suisse and UBS might ensue. Once the momentary upward trends in the shares of these entities stabilise, investors could begin factoring in a perceived risk stemming from the numerous potential impacts mentioned earlier, among others. This, in turn, may cause increased volatility in the value of their shares on the public market.?

In conclusion, it is noteworthy that the precedence of prioritising equity investors to AT-1 Bond investors is not novel to financial markets. This was demonstrated in 2020 when YES Bank in India wrote off around $1.1 billion worth of AT-1 Bonds to zero and provided limited protection to its equity investors. This phenomenon is something that high-yield investors in Asia are familiar with, as highlighted by Bloomberg's Shuli Ren.

While this preferential treatment has been observed in Asia and non-European Union (EU) countries, EU-member countries have been unable to adopt this practice widely, due to regulatory restrictions, as previously noted. In 2017, Spain's Banco Popular faced financial difficulties and was acquired by Banco Santander, resulting in a complete write-off of its AT-1 and 2 Bonds, and this ultimately led to a complete loss of investments for its equity investors as well. A similar outcome happened in 2015 when Austria’s Heta Asset Resolution AG wrote off its AT-1 Bonds to zero.?

Overall, the terms of the merger agreement between Credit Suisse and UBS, with regards to AT-1 Bondholders only highlights the criticality of performing comprehensive due diligence and effectively managing risk as an investor, particularly when investing in high-yield opportunities. As aptly phrased by Shuli Ren , “While a loss of this magnitude can ignite strong emotions, it is also a fine reminder to traders not to bring textbooks to the real world.”