The “preferentes” fraud: arbitration or lawsuit ?

Posted on Posted in Company Law, Publications
In 2013 tens of thousands of Spanish and foreign retail investors (as many as 700.000 according to press sources) have lost billions of Euros invested in a toxic financial product called preferred bonds. In many cases this investment represented their entire’s  life savings. Far from being unknown, this giant fraud was backed  by the Financial Supervisor (“Comision Nacional del Mercado de Valores”) and, in he case of bonds issued by banks, was sponsored by the Bank of Spain. Here is the story.
Preferred bonds (“participaciones preferentes”) are negotiable debt instruments issued by a company which do not confer equity interest or voting rights. Are perpetual, that is, they do not have a maturity date, and their yield is generally variable, not guaranteed.
Their yield the first year is usually fixed. From the second year on, the yield is generally linked to the Euribor (or some other benchmark) plus a determined spread .  One of the key features of preferred bonds is that the interest is conditional upon the issuer getting a predetermined level of profits.
This is a complex and risky instrument that can generate high returns, but also losses of the capital invested. The risk of this instruments are basically the price risk (also called interest rate risk) and the liquidity risk. Like most fixed income instruments, the price of them is negatively correlated with interest rates. Thus, an increase in interest rates will cause the price of the bond to fall substantially. This potential risk is leveraged by the lack of liquidity of this market. Preferred bonds in Spain were traded in a secondary market called AIAF, which was intended to serve institutional investors. Since it is a very illiquid market the bid – ask spread is huge, and retail investors are likely to suffer extensive slippage if they want to sell their bonds.
At those times nobody seriously  thought about  another risk, which is the most deadly risk an investor can face,  the so-called credit risk. Credit risk  is the potential  loss derived from the issuer failing to pay interest or principal or both; that is, a default due to the issuer insolvency. Unfortunately, this risk became true with regard of most preferred bonds issuers, the saving banks, the “Cajas de Ahorros”.
Considering the features explained above (non redeemable, price risk, liquidity risk and eventually credit risk) it is extremely surprising the success of this instrument among retail investors.
The reason for this success was , to put it simply, the organized scam operated by the banks with the implicit consent of the regulatory bodies, which were willfully blind. Preferred bonds were sold to retail investors as investments equivalent to certificates of deposit, assuring people that they could be repaid at sight or with a couple of days of prior notice. Investors were not informed that, not being bank deposits, they were not insured by the Deposit Insurance Fund “Fondo de Garantia de Depósitos”. In other words, that they were just  holding unsecured debt instruments.
One could think that the yield of preferred bonds should have been much higher than most fixed income or bank deposits because the risk involved were much higher. Again, this was generally not the case. Many bonds had a coupon as low as 3 % (bonds of La Caixa, for instance), which were much lower than any corporate bond at that time.
It is important to remark that preferred bonds have not any intrinsic flaw. They are not fraudulent. What was fraudulent was the way they were sold to investors. As a matter of fact, not only banks issued preferred bonds. A few big name companies like Telefonica and Iberdrola also issued preferred bonds. These companies have now repurchased these bonds or exchanged them for interest bearing fixed maturity corporate bonds, or even for shares, with only minimal losses for bond holders. Many companies issued preferred bonds for one important reason: according to Spanish GAAP, this bonds could be recorded as equity for accounting purposes, therefore giving a better look of their financial statements. This accounting approach is sensible; at the end of the day a debt that is never due to be repaid is not an actual debt. Sadly, from the other side of the transaction (the bond holder) this statement is also true: a credit whose repayment can never be enforced is not an actual credit. The problem is that they were not shareholders either. They had the worst of both worlds although it is now clear that  very few bond holders really understood this fact.
As long as the economy kept up growing there were not many problems. Issuers  had enough profits to honour the interest on the preferred bonds and investors willing to sell their bonds could do it reasonable quickly. Like in any Ponzi scheme, there were new investors coming in with fresh money to replace the older ones. But we all know how Ponzi schemes finish; it is just a matter of time and this time was not different.
Then, the financial crisis came and the great recession of 2007 hit, specially highly indebted countries, like Spain. The real estate market bubble collapsed, leaving many bank customers underwater, that is, they owed more than the value of their properties. Families and developers could no longer pay their loans and start defaulting on their obligations. Saving banks had basically all of their assets invested in loans to families and developers linked to the acquisition of real estate and had to recognize huge losses on these loans. Basically, these financial institutions, which broadly represented 50 % of all the Spanish Financial system, were insolvent. As they did not get any profits they suspended the payment of interest on preferred bonds.
Holders of preferred bonds found themselves with  unsecured debt instruments issued by  insolvent entities, which were not paying any interest and without the possibility of selling the bonds, since the market was closed. But things got a lot worse.
If you are an unsecured creditor of an insolvent company, you must know that you will only get a percentage of the face value of your credit. This percentage vary depending on the ratio between the company’s assets and liabilities. For instance, if the assets are 40 % of the liabilities, unsecured creditors will get 40 cents per Euro. This is not a good scenario, but at least is a fair one. One of the basic principles of the Insolvency Proceedings Act is known as “par conditio creditorum”, which means that creditors should be treated equally. It would not be fair that some creditors are fully paid while others only get a tiny part of their credits.  Had saving banks been wound up according to the Insolvency Act, this would have been the outcome of the case. But they were not allowed to fail. They were bailed out by the Rescue Fund set up by the Spanish Government( the “FROB”) funded with tax payer’s money and with loans from the European Stability Mechanism (“ESM”). It should be noted that among the saving banks creditors there were many French, German and Dutch banks, which would have suffered massive losses in case of a standard liquidation of the former.
Then the allocation of the saving banks losses among the creditors took place  in a rather odd but predictable way. Yes, you are right. All the losses were allocated to the retail investors and to the Spanish tax payers (through the FROB) while big foreign creditors were saved.
Conventional thinking suggest that German tax payers bailed out Spanish Banks, but my view is that it would be much more accurate to say that Spanish tax payer’s bailed out German banks.
The amount of losses allocated to retail investors is difficult to ascertain. Let us examine the case of Bankia who had issued about seven billion Euros ( !!!) in preferred bonds and other hybrid financial instruments. These bond holders were obliged to exchange their bonds for shares of Bankia. The exchange ratio applied meant an average built in loss for bond holders of 54 % of the face value of said bonds, according to the figures of the Rescue Fund or FROB. But this is a deceiving figure, because it is based on a value of Bankia shares of 1,35 Euro. However, the very same day the debt for equity swap took place and bond holders received the shares of Bankia, the company was trading in the Madrid Stock Exchange at 0,6 Euro per share. Thus the actual  loss, although not realised, was as high as 80 % or more.
Now, investors must decide what to do. The Spanish Government is really concerned by the expected high number of lawsuits against preferred bond issuers. Note that nationalized banks may not be able to assume the cost of these cases without further financing coming from the ESM, which at the end is more public debt. The Government is trying to limit the damages to the nationalized banks sponsoring the resolution of disputes according to an arbitration procedure held before the Consumers Institute (Instituto Nacional de Consumo), which is a Public Agency dependent of the Ministry of Social Affaires. The members of this arbitration body are public officers.
The resolution of disputes by means of an arbitration procedure, theoretically,is a sensible course of action. Arbitration is a flexible, consensual process for resolving disputes in a binding and enforceable manner. Arbitration has many advantages over litigation because of its neutrality, finality, enforceability, procedural flexibility, and the ability to choose the arbitrators .Arbitration is generally much cheaper and faster than litigation and the final decisions of the arbitrators (called award) can not be appealed.
However, note that arbitration is based on the neutrality of the arbitrators, which are normally chosen by agreement between the parties in dispute. This is not true in the case of the arbitration held before the Consumers Institute. This is a public agency, funded by state funds. Since the cost of the awards must be paid, at the end of the day, with tax payer’s money (the ESM is only giving loans, which must be repaid by the FROB with the guaranty of the Kingdom of Spain), the arbitrator is not neutral. In my view, the effort of the Spanish Government to promote the use of arbitration to settle the disputes brought  by preferred bond holders is an attempt to control the process and limit the damages to the public finances at the expense of retail investors. In short, it is a trap.
Retail investors would be better off bringing their cases before the Courts. Spanish Civil Code is clear: when one party makes false or misleading representations, inducing the counter party to enter into an agreement that, otherwise, would have never entered, the contract is void. And that is exactly what happened to most retail investors. They are entitled to get the refund of their hard-earned money.