Banking, Finance & CM

Austria: New Court Decisions on Banks' Own Funds Instruments

A bank suffering losses (and which may even be in the process of wind-down) may not be in a position to repay loss absorbing instruments in full, which it has issued in the past. Court decisions handed down in 2016 (one by the European Court of Justice and three by the Austrian Supreme Court) provide insight into questions of calculation of loss sharing, and how holders of certain loss absorbing instruments shall be treated in the event of a merger or demerger (which is often also a restructuring measure in the course of a wind-down)

The Austrian Banking Act (Bankwesengesetz – BWG), as in force prior to Basel III (as adopted in the European Union by Regulation (EU) No 5752013 (CRR)), provided for Upper Tier 2 capital of banks in the form of supplementary capital (Ergänzungskapital). Supplementary capital under the BWG used to be loss absorbing, and a coupon was pay-able only in the event that the issuer showed a profit in the preceding financial year (annual surplus prior to movement of reserves). Banks suffering losses (or even in the process of wind-down) could therefore not pay the coupon on supplementary capital in many instances; in addition, the losses incurred over time reduced the amount repayable upon expiry (final maturity) of such instruments. The method of calculation of the loss sharing of supplementary capital has been subject to discussion among legal scholars. The Austrian Supreme Court has decided on how to calculate the sharing of losses by holders of supplementary capital.

It has also been discussed whether holders of supplementary capital (other than holders of participation capital) are creditors of the issuer or holders of securities other than shares which grant special rights in the event of a merger or demerger. This relates to the question whether in the event of a merger demerger holders of supplementary capital may be entitled to compensation by way of cash payment or an amendment to the terms and conditions of the instrument. The European Court of Justice (ECJ) and the Austrian Supreme Court dealt with that issue in 2016.

Qualification of supplementary capital as creditors’ rights or as securities, other than shares, to which special rights are attached?

In its judgment of 7 April 2016 (C 48314, KA Finanz) the ECJ had to deal with a cross-border merger of two credit institutions. The transferring company had issued subordi-nated debt with the proviso that interest on such subordinated debt may only be paid, if, after the interest payment is made, the credit institution still fulfils all own funds requirements under local law. In the course of the cross-border merger the subordinated loan was terminated (with no compensation) based on Art 226 para 3 of the Austrian Stock Corporation Act (Aktiengesetz). Apart from the question whether Art 226 para 3 Aktiengesetz is fully consistent with Art 15 of the Merger Directive (Directive 78/855/EEC), the ECJ touched upon the question whether such subordinated instruments were even covered by the term “securities, other than shares, to which special rights are attached” pursuant to Art 15 of the Merger Directive, and consequently as jouissance rights (Genussrechte) under Art 226 para 3 Aktiengesetz. The ECJ held that only such instruments would qualify as granting special rights which are debentures exchangeable for shares, debentures conferring a right of preemption over share capital to be issued or truly profit sharing debentures. Consequently, only such securities are covered by Art 15 of the Merger Directive, which grant the holders rights which are broader than the mere reimbursement of debt and payment of stipulated interest, for instance, a right of the holders to exchange such securities into shares.

It follows from this ECJ judgment that supplementary capital does not fall within that category of securities to which special rights are attaching. Repayment is always limited to the par value of the instrument (no sharing in hidden reserves or good will). Payment of interest is subject to the issuer having earned profits but payment of interest at a fixed or floating right is just dependent upon such profits without sharing in the profits. In its subsequent decision of 20 July 2016 (6 Ob 80/16g) the Austrian Supreme Court followed the ECJ judgment.

The judgment by the ECJ (dealing with a merger) was confirmed only recently by a judgment of the Austrian Supreme Court of 21 June 2016 (1 Ob 93/16g) dealing with a demerger. Art 13 of the Demerger Directive (Directive 82/891/EEC) covers the same instruments as Art 15 of the Merger Directive. Consequently, the Austrian Supreme Court has held that, in the event of a demerger, the holders of instruments of supplementary capital are not entitled to any compensation (in cash) or that the terms and conditions of the supplementary capital be amended as a result of the demerger.
It follows from those decisions that holders of supplementary capital of an Austrian credit institution will be treated as creditors in the course of a merger or demerger of the credit institution and cannot request that they are compensated or that the terms and conditions of the instrument be amended as a result of the merger or demerger.

Calculation of loss sharing

As mentioned, supplementary capital issued under the BWG was a loss absorbing instrument. The BWG provided that a repayment of supplementary capital prior to liquidation of the credit institution may only be made subject to deducting pro rata net losses incurred during the term of the supplementary capital.

In its decision dated 30 May 2016 (6 Ob 87/16m) the Austrian Supreme Court set out how that loss shall be calculated. It is also clear from this Supreme Court judgment that the relevant provisions of Art 23 para 7 BWG and of the terms and conditions of the individual instrument, continue to apply for past issues, even if the relevant provisions of the BWG have been repealed by the CRR.

The Austrian Supreme Court concludes that the term net losses refers to the annual surplus (annual profit before reserves) or annual loss (before reserves) pursuant to the solo financial statements of the credit institutions. Movements of reserves shall be excluded, inter alia, because supplementary capital is not an instrument granting any interest in hidden reserves or good will and not a perpetual instrument. Reserves existing prior to the issue of the supplementary capital shall also be excluded. The Austrian Supreme Court explicitly states that losses shall not first be attributed to reserves or to the holders of higher quality own funds (such as share capital).

The share of the losses of holders of supplementary capital shall be assessed in the pro-portion of the par value of the relevant instrument of supplementary capital as compared to the par value of the other loss absorbing own funds instruments (prior to Basel III par value of Tier 1 capital and other supplementary capital).

See the following simplified (and hypothetical) example: Assume a share capital of 500 and supplementary capital of 500 (in total 1,000). Hence, share capital and supplementary capital each share 50 % of net losses. Assume a term of supplementary capital of eight years and that the credit institution had six years with an annual surplus (profit) of 10 each and two years with losses of 100 each. This results in a net loss of 140. The supplementary capital will share in those losses with the amount of 70 so that the amount repaid at maturity will be 500 minus 70, ie 430.

This matter of calculation follows a method of calculation of net losses as applied by a number of credit institutions in the past. The judgment by the Supreme Court provides legal certainty on that method of calculation. It may be noted that some Austrian credit institutions have suffered net losses exceeding the par value of the relevant instrument so that those instruments of supplementary capital had to be redeemed at zero.

Still, many old (pre-CRR) supplementary capital instruments are in issue. They raise numerous legal questions. The ECJ and the Austrian Supreme Court have given some guidance in their 2016 decisions. In the event of a merger or demerger of a bank supplementary capital instruments will not be terminated and the holders are not entitled to compensation or an amendment of the terms and conditions. If the issuer has suffered net losses (which reduce the amount repayable), such losses shall be calculated on the basis of the earnings before reserves.