Creditors must contribute to the recovery of banks before State aid is granted. Burden-sharing by creditors in the recovery of banks does not deprive them of their right to property.
Introduction
On 19 July 2016, the Court of Justice rendered its judgment in case C‑526/14, Tadej Kotnik and others v Državni zbor Republike Slovenije.[1] The judgment was in response to a request for a preliminary ruling from the constitutional court of Slovenia concerning the “burden sharing” that the Commission requires before it authorises State aid to banks. Burden-sharing simply means that shareholders and bond holders are bailed-in when a bank receives public support for restructuring.
Slovenian investors had challenged the legality of the Commission’s 2013 banking communication.[2] The communication lays down the principles that
i) aided banks must be capable of becoming viable again, otherwise they have to be closed down [i.e. resolved],
ii) public assistance must be the minimum necessary and avoid moral hazard [i.e. public money is not given for free; a high interest rate is charged], and
iii) no creditor loses more in a situation where the bank receives State aid as compared to the situation where no aid is granted and the bank is liquidated.
Banks are dissuaded from taking on excessive risk and public assistance is minimised when their creditors are bailed-in in order to contribute to the costs of the bail-out. In this way, they bear the consequences of their investment decisions.
The relevant parts of the banking communication are as follows:
“41. Adequate burden-sharing will normally entail, after losses are first absorbed by equity, contributions by hybrid capital holders and subordinated debt holders. Hybrid capital and subordinated debt holders must contribute to reducing the capital shortfall to the maximum extent.”
“42. The Commission will not require contribution from senior debt holders (in particular from insured deposits, uninsured deposits, bonds and all other senior debt) as a mandatory component of burden-sharing under State aid rules”.
“46. “The ‘no creditor worse off principle’ should be adhered to. Thus, subordinated creditors should not receive less in economic terms than what their instrument would have been worth if no State aid were to be granted.”
It follows that not only is burden-sharing necessary, the sequence of contributions is also defined: first, shareholders, then, debt holders and only afterwards comes State aid.
It is worth noticing that uninsured depositors do not have to be bailed in. The communication is from July 2013. The Commission had learned its lesson from the messy bail-in of uninsured depositors in Cyprus in March 2013. The experience of Cyprus was also the reason why the banking communication provides that “45. An exception […] can be made where implementing such measures would endanger financial stability or lead to disproportionate results.” This exception is often invoked by Member States but rarely granted by the Commission. I am aware of only one case where such an exception was made and in that case the exception was based on other grounds [see Commission decision 2014/885 on the restructuring of Greece’s Eurobank].
Is the banking communication binding on Member States?
As a result of the financial crisis, five Slovenian banks experienced capital shortfalls. The Bank of Slovenia [Slovenia’s central bank] adopted several measures which, among other things, included writing off equity capital and subordinated debt. The affected creditors initiated action before Slovenian courts alleging that the Commission’s banking guidelines were contrary to the Treaty provisions on State aid and to secondary legislation and that their rights to property were violated. Because the Slovenian constitutional court was uncertain how to interpret EU law in this situation, it submitted to the Court of Justice seven questions.
The first question was whether the banking communication was binding on Member States. The answer of the Court of Justice begins by reiterating the well-established principles that the Commission exercises exclusive competence in determining the compatibility of State aid with the internal market [paragraph 37]. It also enjoys wide discretion in the exercise of that competence and may adopt guidelines on how to assess the compatibility of State aid with the internal market [paragraphs 38-39]. “40 […] in adopting such guidelines […], the Commission imposes a limit on the exercise of that discretion and cannot, as a general rule, depart from those guidelines”.
Then the Court stresses that “41 […] the Commission cannot waive, by the adoption of guidelines, the exercise of the discretion that Article 107(3)(b) TFEU confers on it (see, to that effect, judgment of 8 March 2016, Greece v Commission, C‑431/14 P, EU:C:2016:145, paragraph 71). The adoption of a communication such as the Banking Communication does not therefore relieve the Commission of its obligation to examine the specific exceptional circumstances relied on by a Member State, in a particular case, for the purpose of requesting the direct application of Article 107(3)(b) TFEU, and to provide reasons for its refusal to grant such a request (judgment of 8 March 2016, Greece v Commission, C‑431/14 P, EU:C:2016:145, paragraph 72).”
In the case that is cited by the Court, Greece claimed that the Commission failed to assess aid that it had granted to farmers on the basis of Article 107(3)(b) of the Treaty. This Article allows aid for the purpose of remedying a serious disturbance in the economy of a Member State. It is the legal basis on which the Commission has approved all aid that has been granted to banks since 2008. In the Greek case, the Court agreed with the Commission that Greece had not proven why the Commission should have deviated from its own guidelines. Therefore, it is not sufficient that Member States ask the Commission to ignore its own guidelines and rely instead directly on the Treaty. They must demonstrate that the guidelines do not apply to their situation because of “specific exceptional circumstances”.
The Court concludes its analysis with the observation that “43 […] the effect of the adoption of the guidelines contained in that communication is equivalent to the effect of a limitation imposed by the Commission on itself in the exercise of its discretion, so that, if a Member State notifies the Commission of proposed State aid which complies with those guidelines, the Commission must, as a general rule, authorise that proposed aid. […] Member States retain the right to notify the Commission of proposed State aid which does not meet the criteria laid down by that communication and the Commission may authorise such proposed aid in exceptional circumstances.”
In other words, the guidelines provide assurance to Member States that, if their aid measures are conform with the requirements of the guidelines, the Commission will find the aid to be compatible with the internal market. However, in general, Member States are also free to deviate from the guidelines if they can prove that they are not suitable for the problems that their aid measures address. And, the banking communication, in particular, acknowledges that no burden-sharing may be imposed when it would “endanger financial stability or lead to disproportionate results”.
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Then the Court formulates its answer to the first question as follows: “44 […] the Banking Communication is not capable of imposing independent obligations on the Member States, but does no more than establish conditions, designed to ensure that State aid granted to the banks in the context of the financial crisis is compatible with the internal market, which the Commission must take into account in the exercise of the wide discretion that it enjoys under Article 107(3)(b) TFEU.”
But the situation is not as simple as it appears in paragraph 44 of the judgment. It is true that the Commission cannot impose obligations on the Member States. But the Member State that refuses to comply with Commission guidelines will not succeed to have its State aid approved by the Commission. Of course, a Member State can ask the Commission to assess its aid directly on the basis of the Treaty. But as is clear from the Greek case mentioned above, the Member State that wants the Commission to deviate from its own guidelines has to prove the existence of “exceptional circumstances”, which is not an easy task. That Member State will in effect be entering into unchartered territory for the simple reason that it will not know how the Commission will respond to its arguments and evidence or how it will apply the relevant provision in the Treaty.
More broadly, the practice of the Commission when it adopts guidelines is to ask Member States whether they agree with them. Member States are free not to agree. But then the Commission opens the formal investigation procedure whenever a disagreeing Member State notifies a measure to the Commission for its approval. The formal investigation is a long process without a predetermined duration, whereas a measure that is notified on the basis of some guidelines has to be assessed by the Commission within two months. The formal investigation procedure is a formidable instrument. Recently, the Commission proposed to France and Belgium to withdraw certain tax privileges that they had granted to ports. The two exercised their prerogative to refuse. The Commission promptly proceeded to open formal investigations [see Official Journal C 302, 19/8/2016]. Now any competitor can submit comments which are unlikely to support the view that the tax benefits enjoyed by Belgian and French ports do not distort competition in the internal market. Member States can ignore Commission guidelines and proposal only at their peril.
With respect to the banking communication, in particular, Member States also have the option to argue that financial stability will be endangered or results will be disproportionate. Proving that argument is not an easy task either.
And indeed, the statistics indicate that the Commission rarely loses a legal battle when it comes to the assessment of the compatibility of State aid to financial institutions. Since the outbreak of the financial crisis, the Commission has examined more than 450 measures. Most of the aid was approved with no objections from Member States, especially where the Commission imposed specific conditions. Where Member States challenged the findings of the Commission, they all failed with the single exception of the Dutch aid to ING [which was in fact repayment by ING of the aid it had received earlier. Although there was no question that the initial payment by the Dutch government was state aid, the issue at hand was whether the repayment at a lower rate of remuneration was also State aid (see T-29/10, ING v Commission, confirmed by C-224/12 P, Commission v ING)].
Must burden-sharing precede State aid?
Because the sixth question asked by the Slovenian court relates to the issues addressed above it makes more sense to review it at this point and before continuing to the reply of the Court to the second question. The sixth question of the Slovenian is whether “95 […] the measures for conversion of subordinated rights or write-down of the principal thereof […] constitute a necessary and sufficient condition for State aid falling within the scope of that communication to be declared to be compatible with the internal market”.
That is, if a bank does not have the minimum required capital, must the write-down of subordinated rights offset in full the losses of the bank or is it possible that the reduction of losses can be only partial so that State aid makes up the rest of the shortfall?
As can be recalled, paragraph 44 of the banking communication stipulates that State aid may not be granted before equity and subordinate debt have fully contributed to offset the losses of the bank that is experiencing a shortfall in its minimum required capital.
The Court replies that “99 it follows that the fact that a measure of State aid meets the criteria set out in point 44 of the Banking Communication constitutes a condition that is, as a general rule, sufficient ground for the Commission to declare that measure to be compatible with the internal market, but is not strictly necessary to that end.”
The Court concludes that “100 A Member State is not therefore compelled to impose on banks in distress, prior to the grant of any State aid, an obligation to convert subordinated rights into equity or to effect a write-down of the principal thereof, or an obligation to ensure that those rights contribute fully to the absorption of losses. In such circumstances, it will not however be possible for the contemplated State aid to be regarded as having been limited to what is strictly necessary, as required by point 15 of the Banking Communication. The Member State, and the banks who are to be the recipients of the contemplated State aid, take the risk that a Commission decision declaring the aid incompatible with the internal market will stand in its way.” Again, this means that Member States have no other option but to comply with the banking communication.
The Court goes on to add a point which in fact repeats earlier findings and can be confusing. “101 The Banking Communication provides, in point 45 thereof, that an exception to the requirements of, inter alia, point 44 of that communication may be made where the implementation of measures for converting debt or writing down its principal ‘would endanger financial stability or lead to disproportionate results’. Accordingly, an obligation to effect the conversion, or write-down, of subordinate rights in their entirety before the granting of State aid cannot be imposed on a bank if, inter alia, the conversion, or write-down, of a part of the subordinate rights would have been sufficient to overcome the capital shortfall of the bank concerned.”
Although the two sentences in this paragraph are related, the second sentence does not follow from the first. The first sentence says that a full write-down is not required when it will cause instability. The second sentence says that a full write-down is not required when it is not necessary; i.e. when smaller write-down is sufficient to re-capitalise the bank. But in this case, no State aid is necessary. Therefore, the unavoidable logical conclusion is that full write-down is necessary before State aid is authorised, unless the instability exception can be invoked.
In this connection, it is worth pointing out that the Commission in decision 2016/1208 prohibited aid to the Italian Banca Tercas primarily because there was no burden sharing but also because there was no viable restructuring plan. The Commission noted in paragraph 206 of that decisions that Italy could not resort to the instability exception because the small size of Banca Tercas would not have any impact on the Italian financial system.[3] Banca Tercas has appealed but it is unlikely that the Commission will lose this case. [T-196/16, Banca Tercas v Commission]
Is burden-sharing contrary to State aid rules in the Treaty?
The second question of the Slovenian constitutional court is whether the condition of burden-sharing in the banking communication is contrary to the State aid rules in the Treaty.
The Court observes that “49 within the discretion conferred on it by Article 107(3)(b) TFEU, the Commission is entitled to refuse the grant of aid where that aid does not induce the recipient undertakings to adopt conduct likely to assist attainment of one of the objectives referred to in that provision. Such aid must be necessary for the attainment of the objectives specified in that provision, in the sense that, without it, market forces alone would not succeed in getting the recipient undertakings to adopt conduct likely to assist attainment of those objectives. Aid which improves the financial situation of the recipient undertaking but is not necessary for the attainment of the objectives specified in Article 107(3) TFEU cannot be considered to be compatible with the internal market”. In a nutshell, aid must remedy a market failure.
On the basis of these principles the Court finds that:
- Burden-sharing prevents State aid from being used as a tool to solve the [private] financial problems of recipient banks [paragraph 55].
- Burden-sharing ensures that the amount of State aid granted is limited [paragraph 56].
- If creditors do not contribute, then banks receive more state aid than is necessary to solve their problems. This distorts competition to a greater extent [paragraph 57].
- If creditors do not contribute, the problem of moral hazard is not overcome. This also causes more distortion of competition [paragraph 58].
- The Commission did not encroach in the competences of the Council by adopting the banking communication [paragraph 59].
This reasoning leads the Court to answer to the second question that the banking communication is not contrary to the State aid rules of the Treaty.
Does burden-sharing violate the right to property, the principle of legitimate expectations and provisions in secondary legislation?
The third and fourth questions, which are examined together by the Court, are whether the principle of protection of legitimate expectations and the right to property are violated by points 40 to 46 of the banking communication. As can be recalled, those points require burden-sharing.
The Court first explains that “62 […] the right to rely on [the principle of protection of legitimate expectations] presupposes that precise, unconditional and consistent assurances […] have been given […] by the competent authorities of the European Union.” “63 However, the shareholders and subordinated creditors of banks who are subject to burden-sharing measures […] cannot rely on the principle of protection of legitimate expectations”.
“64 The reason is that, on the one hand, the shareholders and the subordinated creditors of the banks concerned were given no guarantee from the Commission […]. On the other hand, those investors received no assurance that [the measures that dealt with capital shortfall would not be] […] prejudicial to their investments.” Moreover, “73 […] shareholders of public limited liability companies must fully bear the risk of their investments”. And, burden-sharing measures can be adopted voluntarily. The banking communication does not interfere with investors’ right to property [paragraph 72]. In essence, there is no guarantee that investors will not lose part or all of their money when they buy bank shares or bonds. Hence, the burden-sharing requirement does not deprive them of any property rights because those property rights were attenuated by the investment in bank shares and bonds.
The Court further observes in paragraphs 65-66 that just because in the early stages of the financial crisis the Commission did not ask for burden-sharing, investors cannot expect that the Commission will maintain the same position, especially in view of the changing economic situation. It follows that the Commission is at liberty to change its views in response to economic developments and, indeed, the 2013 banking communication reflected a considerable tightening of the conditions for authorisation of State aid.
In addition, the Court observes that the principle that no creditor should be worse off under State aid implies that, “78 […] the burden-sharing measures […] cannot cause any detriment to the right to property of subordinated creditors that those creditors would not have suffered within insolvency proceedings that followed such aid not being granted.”
The Court also points out that the right to property does not trump the need to ensure financial stability.
The Court concludes its ruling by answering the last two questions raised by the referring Slovenian court. They concern the interpretation of Directives 2012/30 on the protection of investors in public limited companies, Directive 2014/59 on banking recovery and resolution and Directive 2001/24 on the reorganisation and winding up of credit institutions. The Court finds that burden-sharing does not contradict any of the provisions of those Directives.
Conclusions
This judgment may have come as a shock to investors in banks or financial experts, but on the whole it does nothing more than restate principles which are well established in the field of State aid. First, the Commission is the sole authority in the EU with powers to determine the compatibility of State aid. Second, the Commission enjoys considerable discretion in exercising those powers. Third, the Commission has to abide by its own guidelines. Fourth, Member States are not obliged to comply with the guidelines. However, if they refuse to comply with the requirements of the guidelines, the Commission may not approve the aid. Fifth, Member States always have the right to ask the Commission to assess their aid measures directly on the basis of the Treaty, if they can show that the guidelines are not suitable. Sixth, the banking communication also affords Member States the possibility to invoke reasons of financial stability or disproportionate results.
With respect to the banking communication in particular, the Court has confirmed that, first, burden-sharing does not contravene State aid rules or EU directives. Second, burden-sharing is not contrary to the right to property or to the principle of protection of legitimate expectations. Third, bail-in of creditors is a pre-condition for the authorisation of State aid. Fourth, before State aid is granted the maximum extent of bail-in must first be exhausted. In this sense, the banking communication can be stricter than the Directive on banking recovery and resolution which sets a limit of 8% of the liabilities that must be borne by creditors.
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[1] The full text of the judgment can be accessed at:
[2] The full text of the banking communication can be accessed at:
http://eur-lex.europa.eu/legal-content/EN/TXT/PDF/?uri=CELEX:52013XC0730(01)&from=EN.
[3] The full text of the Commission decision 2016/1208 is published in OJ L2013, 28/7/2016. It can be accessed at: http://eur-lex.europa.eu/legal-content/EN/TXT/PDF/?uri=CELEX:32016D1208&from=EN.
