A tale of three banks: The good, the bad and the ugly?

On a not so hot Sunday evening of August 3, Portuguese TV networks broadcasted an unusual and dramatic statement from the governor of the Portuguese central bank Banco de Portugal, proclaiming the collapse of Banco Espírito Santo, S.A., and its break up into a ‘good bank’ (Novo Banco) and a ‘bad bank’ (BES).

The deliberation to apply a resolution measure to Banco Espírito Santo was approved in an extraordinary meeting of the board of directors of the central bank, “in articulation with the European authorities and taking into account the legal framework in force.”

At the time, Banco Espírito Santo was one of the oldest Portuguese banks – its origins date back to 1869, according to the bank’s 2013 annual report – and it was the second largest bank in terms of assets.
Banco Espírito Santo was part of a, by Portuguese standards, large international conglomerate with interests in activities related to banking, insurance, telecommunications, real estate, tourism, and others, controlled by the Espírito Santo family.

While rumors about potential financial and liquidity debilities at Banco Espírito Santo had previously been denied by Portuguese regulators and supervisory authorities, the bank’s reported profitability in terms of net income had exhibited a negative trend.

However, the public announcement of the break-up of BES applied under the ‘resolution measure,’ must have stunned most BES stakeholders who were not privy to privileged information.

And a number of puzzling questions have been raised by the ‘resolution measure’:

  • (i)    Why did the monitoring of BES’ economic and financial condition, including the so called ‘stress tests,’ not alarm its various regulators and supervisory authorities earlier?
  • (ii)   If the bank’s financial distress has been detected earlier, why did regulators and supervisors not act more promptly?
  • (iii)  How should the ‘endorsement statements’ of the bank’s May 2014 common stock issue be interpreted?
  • (iv)  How could the (first) ‘resolution measure’ be adequately prepared in two or three days?
  • (v)   Who can provide an accurate and convincing description of BES and BES Angola’s (BESA) relationships during the last years?
  • (vi)  What criteria, if any, were used to split assets into the ‘good’ and the ‘bad’ bank?
  • (vii)  Has a legal and judicial risk assessment of BES’ ‘resolution measure’ been conducted?
  • (viii) If such an analysis has been conducted what was the expected ‘value at risk’?

Buy on the rumor, sell on the fact…

One of the most disturbing issues of the collapse of Banco Espírito Santo is related to its public stock offering and admission to trading on Euronext Lisbon. In fact, on May 20, 2014, in compliance with the Portuguese Securities Code, the bank stated in the prospectus of the public offering that the financial situation of Espírito Santo International, S.A. (ESI) could affect the reputation of BES and ultimately its share price.

However, and in accordance with the Portuguese Securities Code, the bank’s board of directors declared in Grupo Banco Espírito Santo’s 2013 annual report that:

  • (i)    BES’ individual financial statements for the 2012 and 2013 fiscal years were prepared in accordance with the Adjusted Accounting Standards (AAS), as determined by the Bank of Portugal;
  • (ii)    BES Group’s consolidated financial statements for the 2012 and 2013 fiscal years were prepared in accordance with the International Financial Reporting Standards (IFRS) adopted in the European Union and transposed into Portuguese law;
  • (iii)    to the extent of their knowledge the financial statements referred to in (i) and (ii) provided a “true and appropriate image of the assets, liabilities, equity and earnings of respectively BES and BES Group, in accordance with the referred standards, and were approved by the board of directors at its meeting of March 17, 2014;” and
  • (iv)    “the annual report describes faithfully the evolution of the businesses, the performance and the financial position of BES and BES Group in 2013, as well as the main risks and uncertainties with which they are faced.” (See Grupo Banco Espírito Santo’s 2013 Annual Report, p. 87).

In that statement, BES noted that the 2013 consolidated financial statements of Espírito Santo International, which is at the top of a chain of holding companies tied to the bank, had been subject to a special purpose limited review by an external auditor.

The review found irregularities in the accounts and concluded that Espírito Santo International was in serious financial condition. It was also reported that the group’s audit commission had identified material irregularities in ESI’s accounts.

From an asymmetric information theory standpoint, those two statements produced by the BES Group’s management bodies, arguably, represent both adverse selection and moral hazard problems.

The first problem is that BES Group’s accounts do not allow investors to assess the true risk and return characteristics of BES Group’s company securities, and therefore leave investors unable to estimate the fair value of those financial assets.

Moral hazard problems may have resulted from the involvement in actions (or omissions) that, ex post, BES Group’s companies might have engaged in actions detrimental to investors’ wealth, including not reporting operations that determined the increase of the financial and the business risk profile of (some) of those companies, in circumstances where investors had not the possibility to adjust their required rates of return to the risk levels that they were actually exposed to.

In these instances, investors, taxpayers and citizens in general may well wonder what BES Group’s watchdogs were really watching… Let’s pray that judicial enforcement officials will be more attentive…
The implications are nonstop…

The breakdown of Banco Espírito Santo had many implications which can be loosely characterized as financial, political and legal.

Financially, the good bank has to go public at some point in the future, although the exact time span is unclear. There have been different perspectives on the matter and this ambiguity forced the resignation of the first appointed administration of the good bank in September 2014. Portuguese banks have been considerably concerned about this process, since any possible loss from the sale of the good bank will have to be borne by a purposely created Resolution Fund – the only owner of the good bank.

This fund has been endowed with a 4.9 billion euro loan from the government, but it is owned by the Portuguese banks, as each bank has a share of the Resolution Fund.

Politically, an ongoing parliamentary inquiry has investigated the possible financial crimes committed by the BES board of directors and alleged regulatory failures. The emerging details show all sort of problems with the way Banco Espírito Santo was managed and its involvement in a network of possible illegal actions, including alleged fraud, tax evasion, corruption and mismanagement of other corporations such as Portugal Telecom.

At the same time, the government and the central bank have been under pressure to explain their choice of breaking up, rather than nationalizing, the bank.

Apparently senior governmental officials wanted to avoid replicating a previous case, the failure and nationalization of Banco Português de Negócios, which took place in November 2008. The current center-right government had been extremely critical of this option by the then center-left government. Recently the actual cost borne by the taxpayers has been put at almost 3 billion euro, significantly more than the amount estimated in 2008.

Legally, as expected, the BES board of directors is under investigation for all the possible illegal actions and crimes committed in the last eight years, taking into account the existence of strict statutes of limitation that might complicate the discovery process in Portugal and elsewhere.

The Portuguese criminal justice system is known for its ineffectiveness and slowness. So far, no member of BES’ administration has been indicted, although several BES directors, including the previous CEO and CFO, have been indicted in a different criminal case in relation to tax evasion and fraud in the late 2000s.

Several lawsuits have already been filed in Portugal and abroad in relation to the Banco Espírito Santo affair. Depending on the identity of the defendant, we can characterize three classes of lawsuits.

Firstly, lawsuits against the former BES directors in relation to mismanagement of assets and information provided to shareholders as well as other possible violations of corporate law. These lawsuits involve various challenges under Portuguese, American, Swiss and Luxembourg law.

Secondly, lawsuits against the good bank for liabilities concerning the assets transferred from BES and misrepresentation of other important banking liabilities. The government has suggested, but not yet implemented, its willingness to offer full immunity to the good bank, therefore transferring any future liabilities to taxpayers.

Thirdly, lawsuits filed against the government and regulators for several different issues, including the possible illegality of the law that imposed the break-up of BES. The claims made range from lack of legal competence, illegal confiscation of property and the illegal transfer of privately-owned property to the violation of constitutional rights.

They also concern regulatory actions, such as the freezing of bank accounts of the Espírito Santo family without judicial review, and possible regulatory, supervisory and auditing failures: for example, the extent to which the public offering subscription of March 2014 was tainted by illegalities.

Early conclusions…

The debacle and subsequent breakdown of BES in the summer of 2014 was presented as an early test for the application of the new European Directive on deposit guarantee schemes to insolvent credit institutions.

In that context, we can say that the new system has largely failed the test. Not only the financial and banking implications are problematic and require further analysis, but the legal implications are extremely costly, uncertain and complex.

At this point, none of the authors can make any reasonable prediction about the legal developments in the nearby future which obviously impacts the entire banking system in Portugal.