Credit Suisse AT1 bond ‘rip-off’ could cost Swiss taxpayer

Investors argue that normal market rules were reversed when Credit Suisse bonds were struck off. © Keystone / Michael Buholzer

The Swiss financial regulator is being dragged before the courts, accused of ripping off Credit Suisse AT1 bondholders during the forced takeover by UBS. An adverse court verdict could land Swiss taxpayers with a bill of billions of francs.

On top of that, the reputation of the Swiss financial centre is being dragged through the mud, which could have negative consequences for Swiss banks.

On March 19, the Swiss Financial Market Supervisory Authority (FINMA) caused consternation by controversially scrapping $17 billion (CHF15.5 billion) of so-called AT1 bonds that had been issued by Credit Suisse.

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Some 2,500 bondholders, spread around the world from the United States to Japan, have since filed complaints with the Federal Administrative Court.

What are AT1 bonds?

Additional Tier 1 (AT1) bonds are financial debt instruments created after the 2008 banking crash, which are designed to protect banks against collapse when they run into trouble.

Regulators such as FINMA insist that large banks issue a certain amount of this debt instrument as a buffer against bankruptcy.

Investors accept that the bonds will be converted into bank shares in times of exceptional financial difficulty. In exchange, AT1s pay out higher coupons (interest payments) than normal bonds.

In the case of the Credit Suisse takeover, AT1 investors got nothing while the bank’s shareholders were offered new shares, albeit at an extremely low value of CHF0.76 per share.

The bond write-off reversed the standard priority of creditors in a failing business, which usually prioritises bondholders ahead of shareholders.

‘Investors must accept risk’

The complainants want the court to declare the bond write-off as illegal and to reinstate the debt instrument. If the court upholds this demand, UBS would inherit the $17 billion of debt.

An indebted UBS would then become the aggrieved party, having been promised by FINMA and the finance department that the bonds would be written off as part of the takeover deal, says University of Bern law professor Peter V. Kunz.

“I’m sure UBS would protest because they trusted the authorities,” Kunz told SWI swissinfo.ch. “They might ask for some billions back from the Confederation.”

According to FINMA, it was always clear that the bonds would be written off in a so-called “viability event” – when the bank was certain to go bust without state support.

Swiss Finance Minister Karin Keller-Sutter, who played a key role in the takeover, told Swiss public broadcaster SRF that investors must sometimes accept losses. “Ultimately, that is capitalism,” she said. “Whoever takes on risk must be aware that it can go the wrong way.”

The plaintiffs

The Swiss Federal Administrative Court has received 230 complaints about Credit Suisse AT1 bonds, representing around 2,500 investors.

Quinn Emanuel Urquhart & Sullivan is representing some 1,000 investors from Europe, the United States, Africa, the Middle East and Asia.

Private banks, cantonal banks, pension funds and “many” private individuals have had their investments wiped out, according to Quinn Emanuel Urquhart & Sullivan managing partner Thomas Werlen.

The pension fund of Migros, Switzerland’s largest retail chain, is among the legal challengers, having lost CHF100 million when the bonds were written off.

Some top Credit Suisse managers were also reported to be lining up lawsuits, as part of their bonuses were affected by the write-down, but were later persuaded to withdraw their claims.

Law firm Pallas Partners says it represents 90 “global institutional investors and asset managers” who had $1.35 billion of the written-off bonds, plus “retail and family office clients” with $160 million in claims.

Law firms in Singapore and Japan are also preparing lawsuits against the Swiss authorities, possibly by triggering arbitration proceedings under international investment treaties the countries have with Switzerland.

Appropriate and proportionate?

But law firm Quinn Emanuel Urquhart & Sullivan, representing hundreds of clients who bought around CHF5.5 billion of the bonds, says the write-off was unjustified because while Credit Suisse was hit by an extraordinary bank run, it was otherwise a viable company with plenty of capital. This raises the question of whether a true “viability” event ever occurred by legal definition.

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“The question is: was this an appropriate measure to solve Credit Suisse’s problems? I refute that,” Thomas Werlen, a managing partner of the law firm, told the Finanz und Wirtschaft newspaper.

The complaint was given a boost when Credit Suisse documents came to light showing that the bank itself had disputed FINMA’s decision to write off the debt instruments.

How much compensation?

It will be up to the courts to decide whether the decision to write off the bonds, backed by the government’s emergency law, was a proportionate response to the drama surrounding Credit Suisse. This is a legal “grey area”, according to Kunz.

If the court refuses to reinstate the bonds, the plaintiffs will still demand compensation, arguing that their investments were “expropriated” by FINMA in the same way that private land can be forcibly taken for public use.

The exact amount of compensation is debatable given the volatile nature of Credit Suisse AT1 bonds as they traded in the build-up to the frenetic takeover weekend. The bonds were trading at around 40% of their face value on March 17, the last day of stock-market trading before they were wiped out by FINMA – a market value of around $6.8 billion.

The courts could order FINMA – and ultimately the taxpayer – to hand this sum over to aggrieved bond investors. But it’s by no means clear if judges would use this calculation as a benchmark for compensation.

To win any compensation in the first place, the complainants must convince judges that the government’s emergency law backing the Credit Suisse takeover was equivalent to expropriation. Reaching such a verdict is also subject to legal interpretation.

Reputational damage

Large Swiss banks could experience collateral damage even if the courts reject all the plaintiffs’ demands. AT1 bonds are an essential ingredient for banks to meet capital requirements. If the financial market lacks trust in Swiss-issued bonds, then banks will have to pay higher rates of interest to entice investors to buy their debt instruments.

“If this is left to stand, how can you trust any debt security issued in Switzerland, or for that matter in wider Europe, if governments can just change laws after the fact,” David Tepper, the billionaire founder of the Appaloosa Management investment company, told the Financial Times.

Both the European Central Bank and the Bank of England were quick to declare that they would not cancel AT1 bonds as easily as FINMA in the event of a banking failure, which isolates Switzerland from the rest of Europe.

“A ‘Swiss legal uncertainty premium’ would be an unlucky outcome, as it would result in a permanent competitive disadvantage for the systemically relevant Swiss banks compared to their foreign peers,” said Andreas Ita, managing partner of the Orbit36 risk consultancy.

To avoid this problem, Ita believes future Swiss AT1 bonds may have to change their terms and conditions to give investors greater certainty. This would require a change to Swiss capital markets regulation, Ita added.