[Harsh Vardhan is a management consultant and Bhargavi Zaveri Shah a doctoral researcher at the Faculty of Law, National University of Singapore and an editor of IndiaCorpLaw Blog]
Last week, the Bombay High Court set aside the Reserve Bank of India (RBI)-appointed administrator’s decision to write off the additional tier (AT1) bonds issued by Yes Bank in 2016 and 2017. In 2020, when a financially beleaguered Yes Bank was restructured, the administrator wrote off several AT1 bonds, disentitling the bond holders from being repaid their investment. In 2021, several bond holders challenged the write off before the Bombay High Court on the grounds of it being arbitrary and unreasonable. In evaluating the merits of the challenge, the Court restricted itself to one question, namely, “[w]hether the Administrator would be competent to write off the AT-1 bonds on March 14, 2020 i.e. the day after the final Yes Bank Reconstruction Scheme 2020 was notified on March 13, 2020.” The Court set aside the write off decision on the ground that Yes Bank’s administrator had exceeded his powers by making a ‘policy decision’ not envisaged under the restructuring scheme, and implementing it a day after the scheme was operationalised. The Court explicitly refrained from questioning the fairness of the write off and restricted itself to the procedural lapses involved in the implementation of the write-off.
In this post, we argue that the Court erred by not questioning the fairness of the administrator’s decision to selectively write off the AT1 bonds. By overlooking the question of fairness, the Court chose to ignore the crux of the issue at hand, namely, whether the administrator’s decision to write off Yes Bank’s AT1 bonds was arbitrary and violated the doctrine of legitimate expectations. We argue that a reasoned determination of this question is critical to the case at hand and for Indian banking generally.
Judicial restraint on questioning fairness
A key concern arising from Yes Bank’s restructuring exercise was the decision to write off the listed, perpetual and unsecured AT1 bonds issued by Yes Bank in 2016 and 2017, without writing down its equity shares. Before the Court, the bond holders argued that this decision was arbitrary, unfair and violated the doctrine of legitimate expectations. The doctrine of legitimate expectations envisages that an administrative authority (in this case, the RBI-appointed administrator) will treat a person in line with expectations that have arisen from an established custom or practice, even in the absence of any legal right to be treated as such. The Court explicitly refused to deal with this argument, in the following words:
“The matter being fiscal in nature, this Court would not dwell into the aspect as to whether the writing off the AT-1 bonds was necessary. We would not enter into a debate as to whether the AT-1 bonds could have been converted into the shares and or whether they could have been proportionately written down. The Court would not possess the necessary expertise of the same.” (para 77)
This rationale offered by the Court for its self-imposed restraint is weak. A determination on whether a statutory administrator could have unilaterally opted to upend the inter se rights and expectations of equity and bond holders is not a matter of a ‘fiscal nature’. Fiscal matters are commonly understood as referring to matters involving government spending.
In Yes Bank’s case, the statutory administrator actively accorded preferential treatment to equity shareholders over bond holders. The question of whether such a preferential treatment violated the legitimate expectations of bond holders is within the remit of judicial adjudication, just like any other question of fairness. For instance, the judgement records that the administrator wrote off only two of the three tranches of AT1 bonds issued by Yes Bank without furnishing reasons. Such a selective write off would warrant questioning the basis for preferentially treating the bondholders who were not written off to the prejudice of those who were. It would similarly warrant questioning the reason for prioritising the rights of equity shareholders over the holders of the written off bonds.
The judgement records other facts which would warrant further questioning. For instance, the Court found that the RBI had originally proposed the conversion of the AT1 bonds to equity shares of Yes Bank at a pre-defined ratio “to balance the interests of all the stakeholders” (paras 18, 35). Further, while the proposal to convert the AT1 bonds was present in the draft scheme published for feedback and consultation by the RBI, it was deleted from the final scheme that was ultimately notified. These findings ought to have motivated questions on the sudden decision to write down select tranches of AT1 bonds. From the judgement, it appears that none of these questions were asked due to the self-imposed judicial restraint.
Prioritising equity over debt violates legitimate expectations
The Court’s restraint on questioning the fairness of the write down implicitly validates the administrator’s decision to prioritise equity shareholders over bond holders. It turns the common understanding of debt and equity contracts on its head without providing any reason for doing so.
Under Indian banking law, perpetual bonds issued by banks (often called “Perps” by the debt market participants) are counted as “additional tier I capital” or Additional Tier I (AT1) bonds. These bonds form an important source of capital for banks, especially the public sector banks. These bonds are de jure perpetual, that is, they have no maturity. They carry coupon interest like any other bonds. An important feature of these bonds in India is that they have all been issued so far with a call option. Thus, while the bonds do not have a defined maturity, this option gives the issuer (the banks) a right but not an obligation to ‘call’ these bonds at a pre-defined maturity. For most of the bonds, this call option date is five years from the issuance date. This implies that the issuing bank may call these bonds after five years from the issue date. In fact, all the issuers of AT1 bonds have, so far, have exercised the call option and redeemed these bonds.
For market participants, the call option exercise date had become the de facto maturity date reflecting a tacit understanding that the issuer would redeem these bonds on this date. In other words, there was a legitimate expectation that the bonds will be redeemed by the issuer bank on the call option date. Thus, while these bonds are de jureperpetual, de facto they have a maturity determined by the exercise date of the call option on them. Institutional investors (such as mutual funds), for all practical purposes, treated the call option exercise date as the maturity date of these bonds.
As a part of the ‘rescue plan’ for Yes Bank, the administrator wrote off the AT1 bonds. While such a writing off is permitted as per the covenants of these bonds, the fact that these bonds were written off before writing down common equity capital was against the market expectations and conventions. For instance, the Basel III norms of capital that guide banking regulators across the world and the RBI’s Master Circular of 2012 which reflect these norms, clearly stipulate that the Tier I bonds are ‘junior to all other debt but senior to the common equity capital of the bank’. With this norm and the market practice of redeeming these bonds on their call option date, investors in these bonds expected to not bear any losses before common equity was completely wiped off.
Impact on cost of risk capital for banks
Finally, the Court’s abstention from adjudicating the question of fairness has implications for the limited risk capital available for Indian banks. This is evident from the events that immediately transpired after the write off.
Following the Yes Bank episode, there was anxiety in the bond investor community regarding the status of AT1 bonds. It was generally believed that the regulatory approach in the case of Yes Bank could be also used in other banks facing solvency problems. After this episode, for some time the AT1 bond issuances almost stopped and the secondary market prices of these bonds declined resulting in a decline in the net asset values of mutual funds that had invested in these bonds.
Consequently, the Securities and Exchange Board of India (SEBI), as the regulator of mutual funds, was compelled to step in. The main rule change that SEBI brought in was about the way these bonds were valued by the investors including mutual funds. In the past, most investors would treat the call option date on these bonds as the effective maturity date for the bonds and value them accordingly. SEBI, however, mandated that the bonds must be valued assuming a maturity period of 100 years. Valuing these bonds at such a long maturity would dramatically reduce their value, impacting the funds that invested in them. While SEBI later deferred the implementation of these new valuation norms, it became clear that the de facto maturity that funds used to value these bonds will eventually not be permitted.
In the past, Indian courts have refused to adjudicate upon matters involving economic policy or the fairness of contracts, even if inconsistently so. The question of the fairness of writing off debt before equity in Yes Bank’s restructuring exercise is not an economic policy because it is a decision applied to one particular case and not at a policy level. It is not about the fairness of the contract between Yes Bank and the written off bond holders because the decision was unilaterally taken by a statutory administrator, and not by any of the parties to the contract.
The Court’s refusal to question the fairness of the write off has significant implications for future bank restructuring exercises. First, it lays down the precedent that the courts will not intervene in questions of fairness in bank restructuring, thereby considerably expanding the scope of discretion of the RBI and the Central Government in bank restructuring exercises. While discretion in restructuring may be favoured for the sake of efficiency and capital preservation, a decision to override legitimate expectations by preferring one group of right holders over another must be supported with reasons. Second, and perhaps more importantly, the Court’s refusal to adjudicate on the fairness of the write off validates the notion that in a future bank restructuring, AT1 bonds could be forced to absorb losses before common equity. This will significantly increase the perceived risk in these bonds and investors will price this risk. The yields to be offered to investors for absorbing this an equity-like risk will have to rise resulting in an increase in the overall cost of capital for banks. Going ahead, we may well see AT1 bonds become as expensive a layer of capital as equity for Indian banks.
– Harsh Vardhan & Bhargavi Zaveri Shah