Hundreds of retail investors holding special high-income bonds in Lloyds Banking Group have succeeded in taking the bank to court over its plans to buy back the debt at face value.
The state-backed lender said on Tuesday that it had received permission from the Prudential Regulation Authority to redeem certain “enhanced capital notes” — hybrid bonds that pay coupons as high as 16 per cent a year.
The special debt instruments, launched by the bank after the financial crisis, pay bond-like income but switch into equity if the lender’s capital buffer falls below a certain level.
Lloyds had issued about £8.3bn of these types of bonds to both retail and institutional investors in 2009 following the financial crisis, as a way to shore up capital buffers.
But the bank decided in December to redeem about £700m of the bonds at par value after the lender passed the regulator’s tough stress test on its capital buffers.
Investors who believe the bonds are worth far more than par value and are reliant on the income have lobbied politicians, the regulator, the bank and the trustee Bank of New York Mellon against the decision over the past few months.
As a result, BNY Mellon has notified Lloyds that it is seeking a “declaratory judgment”, meaning the issue will be taken to court to clarify particular points within the bond contract.
Rita Baskeyfield, a bondholder, said: “My husband and I are elderly, being 94 years and 89 years of age respectively, so are not an age when we are able to battle the complex issues involved with the Lloyds ECNs.
“As you can imagine, we rely on the regular income from the investment and, as we understood it was valid until 2024, were happy to continue with the arrangement as it suited our needs.”
Mark Taber, who has campaigned on behalf of bondholders against the proposed redemption, believes the declaratory judgment is a step in the right direction for investors.
“The verdict of the declaratory judgment will bind all ECN bondholders, so I suspect other funds might come out of the woodwork,” he said.
Mr Taber said taking the issue to court is “the best way” of attempting to resolve the situation. “If you have a dispute of a contract, the answer should come from court, in a controlled manner.”
He estimates that there are about 20,000 retail investors who will be affected, although he believes many are not yet aware of this situation.
For Lloyds, the move to redeem the bonds comes after changes to the regulatory landscape for banks’ capital requirements have rendered them an expensive and obsolete form of funding.
In the latest set of stress tests on UK banks in December, the ECNs were not included in the bank’s buffers because the point at which they converted into equity — based on Lloyds’ capital falling below a certain level — was too low.
The bonds, which do not count as “core tier one capital”, would convert only if the bank’s buffer dropped to as low as 2 per cent, according to people familiar with the situation.
As a result, the bonds no longer contribute to bolstering the bank’s regulatory capital requirements, which was the original thinking behind the creation of such instruments.
Lloyds maintains this triggers a clause in the contract that allows the bank to redeem the bonds at par, in what is dubbed a “disqualification event”.
Meanwhile, the PRA’s role is to measure the capital impact of redeeming the bonds. As these bonds essentially no longer count as core tier one capital therefore mitigating any impact on the bank’s buffers, the regulator has given the green light for the bonds to be bought back.
But Mr Taber and other investors are arguing the exact wording in the terms and conditions that allow Lloyds to claim a “disqualification event”.
“It relates to the stress tests at the time in 2009 and is not based on future stress tests,” said Mr Taber. “The wording was specific to stress tests of 2009, but they are using it for future ones to call the bonds.”
The other issue, Mr Taber said, is how the main risk was portrayed as the bonds converting into equity, rather than the fact the bank could call the bonds in before maturity.
“They’re using this stress test as a catalyst to do this,” he said. “So they say if we struggle, you lose bonds; but if we do well, then we can buy your bonds back on the cheap.”
Lloyds last year offered to swap many of its retail ECNs at market value for cash, while institutions were offered AT1 notes. However, only 12 per cent of retail investors took up the cash offer.
Lloyds said: “We welcome the fact that PRA has granted permission for us to redeem our ECNs in accordance with regulatory requirements, and will work together with the Trustee on the declaratory judgment in order to provide certainty for all involved.”