Heta distressed debt restructuring reviewed

The EU’s new tools for winding down banks were tested for the first time in the Heta distressed debt restructuring. They prevented one Austrian province from becoming insolvent

The implications of the bail-in tools created by the Bank Resolution and Recovery Directive (BRRD) on distressed debt restructurings are still being understood across Europe. Although commentators disagree whether bail-in tools are an effective means of reducing systemic risk of failing banks, almost all agree that they create substantial new powers for European member states to impose losses on creditors. European member states are able to leverage these powers to force terms on otherwise recalcitrant creditors outside of insolvency proceedings. While the rules of out-of-court debt restructurings still apply, European member states are now more likely to reach a negotiated solution with the bail-in powers given to them under the BRRD.

The recent restructuring of the liabilities of the former Hypo Alpe Adria demonstrates how bail-in tools can effectively be used by European member states to successfully implement an out-of-court debt restructuring.

The so-called bad bank Heta Asset Resolution was created in 2014 as a wind down unit of the former Hypo Alpe Adria International following the demerger of Hypo Alpe Adria in 2014. Based on the Austrian Federal Act on the Restructuring and Resolution of Banks (BaSAG) implementing the BRRD in Austria, the Austrian Financial Markets Authority imposed a temporary moratorium on all outstanding debt of Heta in March 2015 to plan for an orderly resolution of Heta's creditors.

A significant portion of the liabilities of Heta, constituting approximately €11 billion ($11.87 billion) of outstanding senior and junior debt, were covered by deficiency guarantees granted by law from the province of Carinthia and Kärntner Landesholding committing them to cover any deficiency under the guaranteed debt after all legal remedies had been pursued. The province asserted, however, that if the deficiency guarantees were enforced, it would become insolvent. It was critical for the province and for the republic of Austria that a resolution of the deficiency guarantees be found.

EU member states are more likely to reach a negotiated solution with the bail-in powers under BRRD

The solution developed by Austria was to introduce a collective action clause with retroactive effect that would allow a qualified majority of creditors subject to a deficiency guarantee to limit the total amount of liabilities under that guarantee. Collective action was to be implemented through an offer to all creditors of the same class on the terms set forth in the newly enacted section 2a of the Austrian Financial Market Stability Act (FinStaG), which came into force on January 8 2016.

Section 2a (4) FinStaG provides that an offer to one or many classes of debt instruments will limit the liability of a statutory deficiency guarantee, binding all creditors, if the offer is accepted by (i) at least a quarter of the total nominal amount of each class of debt instrument subject to the offer, and (ii) a qualified majority of at least two-thirds of the total nominal amount of all classes of debt instruments subject to the offer.

Section 2a also sets forth a number of other procedural steps related to the offer. These include, for example, publication requirements with respect to the offer, the permitted offer period, and whether withdrawal rights are available. In addition, section 2a required a statement in the offer documents identifying the portion of the consideration for each debt instrument that represented the guarantee compensation amount, being the amount that the deficiency guarantee would be limited to if the offers were accepted. Under section 2a, this guarantee compensation amount is required to reflect the 'economic capacity' of the deficiency guarantor – in other words, the amounts that the statutory guarantor could afford to pay creditors after taking into consideration funds needed in order to maintain the constitutional and administrative functions of that guarantor.

On January 20 2016, a special purpose vehicle established under the laws of the province of Carinthia called the Carinthia Compensation Fund (Kärntner Ausgleichzahlungs-Fonds or KAF) offered to purchase all outstanding debt instruments subject to the deficiency guarantees, representing over 200 senior and subordinated instruments. Senior instruments were offered 75% of the adjusted specified denomination of each instrument in cash plus a contingent payment right payable on recovery under the instrument, and subordinated instruments were offered 30% of the adjusted specified denomination of each instrument in cash plus the same contingent payment right.

Prior to the offer, certain creditors representing close to a majority of the principal amount of the instruments subject to the offer formed an ad hoc group and entered into a lock-up agreement binding all members of the group to reject any offer below par. Creditors of the ad hoc group believed that in the event the province of Carinthia was unable to make good on the deficiency guarantee then the republic of Austria would be required to step in. The republic of Austria, however, disagreed with this position, asserting that it would not be required to bail-out the province in the event of an insolvency. Insolvency of the province of Carinthia would have been unprecedented, and no legal regime exists in Austria to manage such an insolvency at the province-level.

The ad hoc group of creditors did indicate that they were willing to reach a negotiated solution on terms reflecting international standards. Nevertheless, as a result of the formation of the ad hoc group and lock-up agreement, the first offer was not accepted and expired on March 11 2016.

Background

Skadden advised the province of Carinthia and the KAF on the KAF’s tender and exchange offer for €11 billion of existing debt instruments of Heta, the first ever distressed debt offer by a European financial institution under the BRRD. Also, for the first time ever in Europe, the transaction resulted in a haircut for creditors of a financial institution backed by the guarantee of a sub-sovereign province of a highly rated and solvent European member state. The transaction constitutes an important precedent in Europe because of the demonstrated new ground rules imposed by the European member states as a result of the implementation of the BRRD resulting in a negotiated sub-sovereign distressed debt resolution also involving creditors. Implementation of the tender and exchange offer at hand raised a number of novel legal issues, required the negotiating of fundamental principles of banking, insolvency and capital markets regulation and involved navigating a complex political environment not only in Austria but across Europe.

On April 10 2016, the Austrian Financial Market Authority set EU precedent by becoming the first regulator to apply the bail-in resolution tools in the BRRD to outstanding Heta debt, resulting in a full loss participation of all capital instruments including a 100% haircut on all junior liabilities, a haircut of 53.98%. on senior unsecured liabilities, an extension of the maturities of all senior unsecured liabilities to 2023 and a cancellation of all interest payments on liabilities from March 1 2015.

The effect of the bail-in was to inject a significant amount of legal uncertainty around the enforcement of the deficiency guarantees. Creditors asserted that even if the bail-in measures resulted in a write-down of the underlying Heta debt instruments, the measures would not affect the rights under the deficiency guarantees. This assertion was untested in Austrian courts. In addition, legal proceedings were ongoing for a number of other aspects related to the bail-in, including cases in both Austria and Germany regarding application of the BRRD to Heta and cases in Austria regarding the constitutionality of section 2a FinStaG. Thus, creditors, the province of Carinthia and the republic of Austria risked entering into a legal minefield in the event an out-of-court solution could not be reached, and all parties therefore agreed to sit down at the negotiating table.

The creditors' position was not fully united. Some creditors had indicated that they would accept an offer that resulted in a payout of 92%, whereas other creditors were insisting on a full payout with potentially an extension of maturity. From its side, Austria was not initially willing to make an offer greater than what it was offering in January 2016.

Following roughly a month of negotiations, on May 18 2016, the Austrian Federal Ministry of Finance announced the terms of a revised offer under section 2a FinStaG agreed in a memorandum of understanding (MoU) between the Republic of Austria and the ad hoc group. Under the revised offer, creditors would be offered, as in the January 2016 offering, a cash payment of 75% for senior debt instruments of Heta subject to the deficiency guarantees and 30% for subordinate debt instruments of Heta subject to the deficiency guarantees. Alternatively, the creditors would be offered a zero coupon bond of the KAF with a term of approximately 13.5 years, in respect of which creditors would be allowed to subscribe in a ratio of 1:1, and subordinated creditors in a ratio of 2:1. These zero coupon bonds represented an economic value of approximately 90% of the senior Heta debt instruments and approximately 45% of the subordinated Heta debt instruments. As an alternative for subordinated creditors, a zero coupon bond or zero coupon Schuldschein loan with a term of 54 years would also be offered. The zero coupon bond of the KAF would be backed by a guarantee of the republic of Austria. In addition, the KAF would commit to repurchase the zero coupon bonds for an 180-day period following completion of the offer, effectively offering creditors a cash-out after a few months. Finally, all accepting creditors would receive the contingent payment right per the requirements of Section 2a FinStaG.

Although the economic terms of the revised offer were agreed in the MoU, a number of additional steps needed to be taken before the offer could be commenced. Creditors, the republic of Austria and the province of Carinthia needed to negotiate the precise terms of the zero coupon bond, the guarantee from the Republic of Austria and the pledge of the acquired Heta debt instruments, the repurchase commitment of the KAF, and the offer itself, including the contingent payment right. In addition, the Republic of Austria and the province of Carinthia required confirmation from the European Commission that the offers would comply with European state aid rules. On September 6 2016, the KAF commenced the revised offer, which was accepted by just under 99% of the Heta creditors.

The Heta offer showed that the implementation of bail-in tools under the BRRD combined with private negotiations with creditors could lead to a successful debt restructuring and will likely serve as a useful precedent for European bank resolutions going forward.

Although the bail-in tools provided leverage for the Austrian government, resolution ultimately came from negotiations with creditors. None of the parties at the table were eager to pursue court action in light of the significant legal uncertainties flowing from implementation of the BRRD and the FinStaG. Coupled with an attractive offer, representing, for senior instruments, a premium of approximately 15% above the expected recovery under the Heta debt instruments, creditors ultimately accepted the restructuring. The transaction itself was a first of its kind and resolved a significant burden to the province of Carinthia and the Republic of Austria.

By Stephan Hutter, partner (Frankfurt) and David Quartner, associate (London) at Skadden Arps Slate Meagher & Flom