Investors beat Lloyds in battle of the bonds

Katherine Griffiths  Banking Editor 4-6-2015

Thousands of individual investors with high-yielding bonds in Lloyds that were issued to keep the bank afloat have won the first round of a legal fight after a judge ruled that it could not cancel the securities early.

Lloyds immediately vowed to appeal against a high court ruling yesterday and to continue its campaign to buy back £700 million of bonds at face value rather than pay a premium. It triggered accusations that the bank was being “aggressive” towards its investors.

Mark Taber, a bonds expert who has led several campaigns for better terms, including at the Co-operative Bank, has accused Lloyds of trying to construct a “heads we win, tails you lose” scenario.

Mr Taber said that Lloyds should “take it on the chin” and offer a premium to holders of the investments, known as enhanced capital notes, which the bank issued in 2009 to avoid a further government bailout.

In a capital-raising that pioneered the use of investments that convert into loss-absorbing equity if a bank gets into trouble, Lloyds issued a total of £8.3 billion of these ECNs alongside a £13.5 billion equity rights issue.

The notes were designed to convert into equity if the bank’s core capital fell to 5 per cent. Lloyds sweetened the offer to investors to take them up by offering rates of return of between 6 and 16 per cent a year until maturity at various dates between 2019 and 2029.

They were offered to various investors, including holders of other debt investments whose coupons were cancelled in the financial crisis in recognition of the state aid the bank received. Now, a mixture of retail investors including pensioners alongside professional fund managers and hedge funds hold the notes.

At the heart of the row is whether Lloyds is allowed to cancel the ECNs — an expensive form of capital that it could refinance for about £1 billion less than the current cost — under the terms of the original contract.

In its 2009 “exchange offer memorandum”, which ran to 312 pages, Lloyds set out the terms of the offer to convert existing bonds into the new notes. The document warned if there were a “capital disqualification event”, it would be allowed to buy them back at par. Although the notes were taken into account by regulators when assessing Lloyds’ capital position soon after the financial crisis, they were not included in the latest round of stress tests carried out by the Prudential Regulation Authority in December last year.

This amounted to a capital disqualification event, Lloyds said.

In an eagerly awaited judgment yesterday, the chancellor of the High Court, Sir Terence Etherton, disagreed with Lloyds, saying that, just because the ECNs did not count towards capital for the last set of stress tests, it did not mean they could not be used in the future. As such, he added, a capital disqualification event had not occurred.

The judgment is in relation to £700 million of ECNs but will affect the terms that Lloyds has to pay on £3 billion of outstanding ECNs. Lloyds has already bought £5 billion of ECNs back in an exchange offer last year.

Lloyds said it was disappointed with yesterday’s ruling. The bank has decided to press on with its appeal on the basis that it owes a fiduciary duty to its 3 million shareholders — including the largest register of private investors in the UK — to manage its capital as effectively as possible.

Experts said the case was not over yet. Filippo Alloatti, the senior credit analyst at Hermes Investment Management, said: “This is not the end of the story. Lloyds may win in the end.”

Those involved in the case have been grappling with the definition of high quality bank capital.

That has become tougher in the past six years, as Basel III rules have replaced Basel II. Lloyds’ enhanced capital notes would only convert into equity under the new rules if its core capital fell to 1 per cent, a level so low that the bank would be seen to have failed long before it reached that level. The judge agreed with Lloyds’ argument that the updated definition of capital should be used, the bank said.

The bank’s decision to fight the case was “aggressive”, Gary Kirk, portfolio manager at TwentyFour Asset Management, said.

Lloyds said that regardless of the outcome of an appeal on the enhanced capital notes, it was confident that it would still hit its target of generating a net interest margin of in excess of 2.55 per cent this year and that its return on equity would be between 13.5 per cent and 15 per cent by the end of 2017.



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