April 2020: Quinn Emanuel Secures Settlement for Tier 1 Bondholders in Hamburg Commercial Bank Thwarting Attempted Accounting Gimmickry
The firm represented a group of investors in litigation against HSH Nordbank AG based in Hamburg (meanwhile renamed Hamburg Commercial Bank AG) before the Kiel District Court. The amount in controversy was in excess of EUR 1 bn.
The litigation centered on hybrid capital instruments (so-called Tier1 instruments), indirectly issued by HSH. The instruments were based on silent partnership agreements between HSH and special funding vehicles. The funding vehicles held silent participations in HSH. They issued derivative, publicly traded instruments in their own name. With respect to these instruments, profit share, coupon payments etc. were directly dependent on the book value of the silent participations. The book value of the silent participations was linked to the annual balance sheet loss/profit generated by the bank. The overall nominal value of the instruments was approximately USD 2 billion.
As of 2008, and as a result of the financial crisis significantly affecting the shipping market, HSH being one of the world’s largest shipping financiers made significant losses. HSH’s loan book was full of non-performing shipping loans. The bank turned to its state owners (Hamburg and Schleswig-Holstein) and those injected about 20 billion Euros in capital. However, the European Commission viewed this bail out as impermissible state aid under EU rules and demanded that the bank be privatized or liquidated.
In preparation of its sale to private buyers, HSH made extensive use of a provision in the German Commercial Code, permitting banks to allocate funds to a "fund for general banking risks" in their accounts. This fund did not count as a reserve for balance sheet purposes (which would mean that allocations would have to come out of profits) but as an expense and, therefore, reduced the available annual profit. This had a severe impact on the book value of the silent participations and, consequently, the value of the bonds. The allocations to that fund consumed essentially all available profits from 2011 onwards and, in several years, turned a profitable year into a loss-making one. Since the bank thus started to show an annual balance sheet loss, the bonds' face value was written down and coupon payments ceased.
In early 2018, the sale of the bank to a group of private equity firms led by New York based hedge funds Cerberus and J.C. Flowers was about to close. The sale of the bank was structured as a combination of a loan portfolio sale and an outright sale of shares with the same group of investors buying both assets. The loan portfolio was sold at a huge discount against the already depressed book value, resulting in a balance sheet loss of HSH of about EUR 1 billion. Accordingly, the book value of the silent participations and the bond prices fell.
The bank’s new owners then announced that they intended to keep the balance sheet loss as “loss carry forwards”, potentially indefinitely, and use it to write down the face value of the bonds each year - a scheme used by other privatized Landesbanken and known as “double burden strategy”. They also gave notice of their intent to call the bonds by the end of 2020 and repay the remaining face value, expected to be well below 10 cents on the Euro.
Quinn Emanuel then filed suit against HSH. As the investors lacked a direct contractual relationship with the bank (since the bonds had been issued by offshore funding subsidiaries), the firm used a German law concept known as “contract with protective effect for third parties.” This concept had been established through case law in the early 20th century as an exception to the privity of contract. The firm argued that the silent partnership agreement between the bank and its funding subsidiary had protective effect for the holders of bonds issued by the funding subsidiary. The bank only used the structure with their funding subsidiaries so they had one counterparty and could avoid the inconvenience of having to contract with a plurality of investors who each bought relatively small amounts (some as low as 50,000 Euro). For all intents and purposes, the bondholders were the counterparties providing the silent contributions.
On that basis, the firm argued a breach of contract by the bank based on the bank’s accounting irregularities (misuse of the “fund for general banking risks” to secure against specific loan risks and in relation to the state bail-out) and the undervaluation of the loan portfolio. Approximately one year after the firm had filed suit, the client group and the bank entered into a settlement agreement. The parties agreed on the transfer of the bonds to the bank at a price of 37.5% plus reimbursement of all litigation expenses. This is a significant improvement over the bank’s intended repayment at a price well below 10% in 2021.