Deciding on the Davy proposal
Context: Credit Union investments in highly illiquid floating rate CMS perpetual bonds having accumulated losses at today’s prices of c40%.
The deal on the table means the credit union will
(a) Crystallise losses incurred to date through granting a call option to Davy at an agreed strike price which Davy at its discretion may call and sell the perpetual bonds at some time in the future – presumably when the bonds realise sufficient excess gain to fund Davy obligations under the 10 year “loss recovery” bond.
(b) Recoup these losses over ten years via a ten year zero coupon bond (the loss recovery bond). This will be funded by Davy who will initially fund at c18% of the face value of the perpetuals. It is anticipated this recovery bond will appreciate to mature at 40% of perpetual bond face value.
(c) Agree to a reduction in the perpetual bond coupon to the ECB rate or the coupon rate whichever is lower. Any excess income over the ECB rate will be for Davy who it seems will use the excess to fund its obligations under the 10 year recovery bond structure.
(d) For at least two years the credit union remains exposed to any further losses below the strike price until Davy exercise its call option and or if the bonds fall in value by more that 15% for more than 60 days permitting the credit union to set aside the call option and sell the bonds itself.
(e) Once Davy exercises the option and sells the perpetual bonds the credit union is exposed to income impairment on 40% of its holding for the remaining term, if any, of the ten year bond. Eg Davy sells in year three – credit union will not earn any income on 40% of the face value of the perpetual bond for 7 years.
On the face of it the bargain is a reasonable proposition that a credit union may consider accepting providing it obtains independent advice. It is most important it demonstrates that it took account of the full context of the proposal including legal, investment, taxation, accounting and compliance issues and risks in making its decision.
It is clear there are compliance and resultant legal issues associated with the initial sale and purchase of the perpetuals and within the structuring of the Davy proposal. However it is highly probable that a regulatory blind eye may apply as the deal is in the interest of credit unions whose boards are obligated to ensure the safety of savers funds. Recovering capital losses on investments, whilst foregoing income, is a reasonable proposition when the alternative scenario is considered.
The alternative is to sue to recover in full in the hope that the courts and or the Financial Ombudsman will rule fully in favour of the credit union. Notwithstanding the Enfield case, success is by no means certain and it would take a very confident board indeed to sue. In doing so the credit union may suffer substantial reputational damage as the full extent of its knowledge and competence in investments will be exposed in a court. It is highly likely that a court may find a credit union partially responsible – in which case the actual result could carry a far higher cost than accepting the Davy proposal. The problem is this is an uncertain outcome with inestimable costs.
The decision is either
(a) accept the proposal in the full knowledge of its risks and costs
(b) reject and sue with its uncertainty and potential for reputational damage
(c) reject, book losses now, sell the perpetual bonds when possible and move on
In the final analysis a credit union board will need to ensure it effects a robust informed decision making process through which its decision can subsequently be shown as being made in the best interests of the credit union.
Context: Credit Union investments in highly illiquid floating rate CMS perpetual bonds having accumulated losses at today’s prices of c40%.
The deal on the table means the credit union will
(a) Crystallise losses incurred to date through granting a call option to Davy at an agreed strike price which Davy at its discretion may call and sell the perpetual bonds at some time in the future – presumably when the bonds realise sufficient excess gain to fund Davy obligations under the 10 year “loss recovery” bond.
(b) Recoup these losses over ten years via a ten year zero coupon bond (the loss recovery bond). This will be funded by Davy who will initially fund at c18% of the face value of the perpetuals. It is anticipated this recovery bond will appreciate to mature at 40% of perpetual bond face value.
(c) Agree to a reduction in the perpetual bond coupon to the ECB rate or the coupon rate whichever is lower. Any excess income over the ECB rate will be for Davy who it seems will use the excess to fund its obligations under the 10 year recovery bond structure.
(d) For at least two years the credit union remains exposed to any further losses below the strike price until Davy exercise its call option and or if the bonds fall in value by more that 15% for more than 60 days permitting the credit union to set aside the call option and sell the bonds itself.
(e) Once Davy exercises the option and sells the perpetual bonds the credit union is exposed to income impairment on 40% of its holding for the remaining term, if any, of the ten year bond. Eg Davy sells in year three – credit union will not earn any income on 40% of the face value of the perpetual bond for 7 years.
On the face of it the bargain is a reasonable proposition that a credit union may consider accepting providing it obtains independent advice. It is most important it demonstrates that it took account of the full context of the proposal including legal, investment, taxation, accounting and compliance issues and risks in making its decision.
It is clear there are compliance and resultant legal issues associated with the initial sale and purchase of the perpetuals and within the structuring of the Davy proposal. However it is highly probable that a regulatory blind eye may apply as the deal is in the interest of credit unions whose boards are obligated to ensure the safety of savers funds. Recovering capital losses on investments, whilst foregoing income, is a reasonable proposition when the alternative scenario is considered.
The alternative is to sue to recover in full in the hope that the courts and or the Financial Ombudsman will rule fully in favour of the credit union. Notwithstanding the Enfield case, success is by no means certain and it would take a very confident board indeed to sue. In doing so the credit union may suffer substantial reputational damage as the full extent of its knowledge and competence in investments will be exposed in a court. It is highly likely that a court may find a credit union partially responsible – in which case the actual result could carry a far higher cost than accepting the Davy proposal. The problem is this is an uncertain outcome with inestimable costs.
The decision is either
(a) accept the proposal in the full knowledge of its risks and costs
(b) reject and sue with its uncertainty and potential for reputational damage
(c) reject, book losses now, sell the perpetual bonds when possible and move on
In the final analysis a credit union board will need to ensure it effects a robust informed decision making process through which its decision can subsequently be shown as being made in the best interests of the credit union.
Many consider that perpetual bonds should never have been sold to or bought by credit unions. They remain innappropriate investments and are no longer permitted under regulatory guidance notes. If it was wrong to sell them, it was also wrong to buy them. Who may have been more wrong than the other is not the issue. What matters now is the commercial reality is dealt with in which case option (a) is the only reasonable way forward.
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