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The Credit Suisse AT1 bond controversy highlights the inherent complexities of financial instruments and the delicate balance between risk, transparency, and investor responsibility. While the legal challenges mounted by bondholders are entitled to judicial scrutiny, it is crucial to recognise the clarity and comprehensiveness of the AT1 bonds' terms and conditions balancing higher returns with higher risks for a reason.
Understanding Additional Tier 1 Securities
In the wake of the 2008 financial crisis, European banks issued a considerable volume of securities known as "Additional Tier 1 Capital Securities" or "AT1s", also frequently referred to as "contingent convertibles" or "CoCos". The main characteristics of AT1s are that AT1s resemble bonds with a fixed face value and regular interest payments. They are perpetual, meaning the bank has no repayment obligation. However, the bank may in its discretion redeem the AT1s after five years, and frequently does so. However, if the bank's Common Equity Tier 1 (CET1) capital ratio, a regulatory capital metric, falls below a certain percentage, the AT1 is written down to zero. It is effectively cancelled, with no repayment obligation.
AT1 Bonds, a Calculated Risk Proposition
Accordingly, AT1 bonds are not conventional bond investments. Unlike conventional bonds, AT1 Bonds are perpetual in nature and thus, the investors are not paid the principal amount. Their primary purpose is to secure long-term capital for the issuing banks. AT1s are, fundamentally, a hybrid instrument. To investors, they may appear as ordinary bonds with features like interest payments and an expected, if not explicit, redemption. They offer increased returns in exchange for elevated risks. In exchange for receiving higher interest payments, AT1 investors take on the risk that the issuing bank, should it run into trouble, may suspend interest payments, convert the bond into equity, or entirely write down the bond altogether. Therein lies the crux. For the financial regulators, they function as a form of equity. If a bank encounters material difficulties, it can bolster its capital base by writing off the AT1s. Unlike traditional bonds, they come with the potential for significant losses for investors, as they are designed to be the first to absorb losses in the event of financial distress, even preceding common shareholders.
Credit Suisse and the AT1 Bonds
In 2020 and 2021, Credit Suisse issued CHF 8 billion worth of AT1 bonds with clear and well-defined terms outlining the inherent risks and potential for losses. The instruments were as a matter of fact named "Perpetual Tier 1 Contingent Write-down Capital Note" for the very reason that they were intended to be written down if the bank ran into serious difficulties. These terms were readily available to all potential investors through prospectuses and other disclosure documents. As an example the following wording was included:
Write-down
Following the occurrence of a Write-down Event, on the relevant Write-down Date,
(i) the full principal amount of each Note will be written down to zero and all references to the principal amount of the Notes in these Conditions shall be construed accordingly;
(ii) 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, and the Holders will be deemed to have agreed to the foregoing (bedingte Aufhebung einer Forderung durch Übereinkunft);
(iii) all rights of any Holder for payment of any accrued but unpaid interest or any other amounts under or in respect of the Notes (including, without limitation, any amounts arising as a result of, or due and payable upon the occurrence of, an Event of Default) will become null and void, irrespective of whether such amounts have become due and payable or such claims have arisen prior to the occurrence of the Write-down Event, the date of the Write-down Notice or the Write-down Date; and
(iv) the Notes will be permanently cancelled.
Pursuant to the terms of the AT1 Write-Down Notes, a Write-Down would take place on the occurrence of a Write-Down Event, including a Viability Event (as defined therein):
" ... customary measures to improve CSG’s capital adequacy being at the time inadequate or
unfeasible, CSG has received an irrevocable commitment of extraordinary support from
the Public Sector (beyond customary transactions and arrangements in the ordinary
course) that has, or imminently will have, the effect of improving CSG’s capital adequacy
and without which, in the determination of the Regulator, CSG would have become
insolvent, bankrupt, unable to pay a material part of its debts as they fall due or unable
to carry on its business."
Investor Misunderstanding
Specifically, it appears that certain investors have tended to assume AT1s hold seniority over equity, believing that the common stock must be completely depleted before AT1s incur losses. This is a misconception not based on the terms and conditions of the Credit Suisse AT1s. The very design of AT1s dictates that they are written down if the CET1 capital ratio drops below the predefined percentage. In this scenario, the common stock retains some value. The AT1s are by design subordinate to the common stock. Their core function is to be written off while the bank remains a going concern with positive equity: Should the bank's equity become insufficient (but not entirely depleted), the AT1 is sacrificed to replenish equity. This was the reason behind Credit Suisse issuing these instruments and entirely aligns with regulatory expectations.
Investor Responsibility and Due Diligence
The onus lies with investors to conduct thorough due diligence before investing in any financial instrument, particularly complex instruments like AT1 bonds. This includes meticulously reading and understanding the terms and conditions, which explicitly outline the potential for losses and the discretionary nature of interest payments. It is unreasonable to expect complete protection from risk, especially when investing in instruments expressly designed to be written down in a viability event and reserved for sophisticated investors who are expected to be able to evaluate the accompanying risks in exchange for higher returns. This applies even more so, in the case of professional fund managers who are mandated and paid by their clients to review and select the proper investment instruments on behalf of their clients.
Legal Challenges and the Broader Context
While legal challenges are a common recourse for aggrieved investors, it is important to note that the terms and conditions of the AT1 bonds were transparent and readily available. The prevailing investor argument appears to hav been that "bonds possess seniority over stock". As AT1s are hybrid bonds, investors purchased them expecting to be repaid before shareholders in any adverse situation. They overlooked the clear terms and conditions of the Credit Suisse AT1, even its very name, which indicate situations where the shares retain value while the AT1s are wiped out. The focus should be on individual investor responsibility to understand the complexities of the financial products they choose to invest in. However, another common challenge by investors has been to claim that because AT1 bonds in the United Kingdom and other jurisdicitons have different terms or are handled differently in the local markets, then the Swiss-law governed Credit Suisse AT1 Write-Down Notes should conform to that, irrespective of the terms and conditions set out therein. This is clearly not a viable argument and 'comparing apples and oranges' will not turn the one into the other merely because both are fruits in general. It appears that a certain section of the professional investors have not treated the investments with the adequate care and professional responsibility needed, but have solely focused on the stated returns, without reviewing the risks. Following the write-down event, it was convenient for them to blame the issuer rather that to admit failures in the investment decision-making process. Unfortunately, a number of plaintiffs' law firms have seized on the opportunity to file speculative claims with a view to obtain a settlement, where no compensation was due in the first place.
Looking Forward: A Call for Balance
The Credit Suisse AT1 bond controversy serves as a call for balance in the financial landscape. It is important to note that most AT1s outside Switzerland do not feature permanent write-downs. While transparency and investor protection are paramount concerns, professional investors also need to approach complex financial instruments with adequate due diligence and a clear understanding of the associated risks that give rise to the higher returns. This fosters a more responsible investment environment where both issuers operate with transparency and accountability and investors invest adequate time assessing their fixed income investment assets, especially when acting as fund managers on behalf of clients.
Conclusion
The Credit Suisse AT1 bond controversy underscores the importance of clarity, responsibility, and informed decision-making in the financial markets. While legal challenges are ongoing, it remains critical to recognise that the terms of the bonds were transparent and readily accessible, placing the onus of comprehensive understanding on the investors themselves. By striking a balance between transparency and investor responsibility, the market can strive for a more informed and robust financial ecosystem for all stakeholders. Professional investors and fund managers must duley review the terms and conditions of their investments, and cannot abdicate from their responsibility by making unjustified claims against better judgment.
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