Bank rescue: The EU Court of Justice says that the financial stability if EU financial markets prevails over the shareholders’ rights

The judgment handed down the Court of Justice of the EU (CJEU) in Dowling and Others[1] focuses on the interaction between reorganization measures adopted by a EU Member States on the basis of EU Law and the protection of the rights of shareholders and creditors enshrined by the Second Company Directive. In that judgment, consistently with its past case law, the CJEU reached the conclusion that, in some circumstances, the need to preserve the stability of financial markets prevails should be preferred over the protection of shareholders’ rights.

Irish Life and Permanent (ILP), now Permanent TSB, was a credit institution (the Bank) operating in Ireland, whose share capital of ILP was wholly owned by Irish Life and Permanent Group holdings (ILPGH or the Company), now Permanent Group Holdings. Sadly, the Bank was severely affected by 2008 financial crisis. Under the 2010 Memorandum of Understanding signed by Ireland with the European Commission and in accordance to the EU Decision 2011/77, Ireland committed to recapitalize the national banks on the basis of the results of the Prudential Capital Assessment Review (PCAR) and a Prudential Liquidity Assessment Review (PLAR) to be conducted by the Central Bank of Ireland. Compliance with such commitments was a necessary condition for making available to Ireland the financial assistance provided for by Regulation 407/2010 pursuant to the European financial stabilisation mechanism. The deadline to recapitalize ailing banks was July 2011.

The results of the PCAR and PLAR were not positive for ILP and accordingly the Central Bank of Ireland ordered the Bank to raise additional capital of € 4 billion. Later in 2011 the MF made a proposal to the ILPGH shareholders to raise the required additional capital. Interestingly, the MP proposal did not consist in rising the capital of the Bank, but rather in increasing the capital of the Company with a capital injection of € 2,7 billion. The extraordinary general meeting of ILPGH, however, rejected this proposal, preferring alternative options. Pursuant to the Credit Institution (Stabilisation) Act 2010 (the 2010 Act) the MF filed with the High Court an application for a direction order that was adopted by the court. In practice, by the direction order the High Court imposed on ILPGH to issue, in return for the capital injection of € 2,7 billion, new shares in favour to the MF at the prices determined by the latter and 10% lower than the quoted share price of 23 June 2011. The result of the direction order was that the MF owned 99,2% of the share capital of the Company without the approval of the general meeting of ILPGH. Accordingly, the shares of the Company were also delisted from the Irish and London Stock Exchanges.

Mr. Dowling and other individual shareholder of the Company appealed the direction order before the High Court, claiming that the share capital increase was carried out in violation of Articles 8(1)[2], 25[3] and 29[4] of the Second Company Directive. The High Court stayed proceedings and referred a preliminary question to the CJEU pursuant to Article 267 TFEU. What the High Court asked was whether Articles 8, 25 and 29 of the Second Company Directive should be interpreted as precluding a measure, such as the challenged direction order adopted in presence of a serious disturbance of the economy and financial system of a Member States threatening the EU financial stability, the effect of which was: i) to increase the share capital of a public limited liability company, without the approval of the general meeting of that company; ii) the issue of shares at a price lower than their nominal value; iii) the refusal to grant to the existing shareholders any right pre-emptive right to subscribe the new rights issue.

The CJEU started by pointing out that the EU Decision 2011/77 imposed the obligation for the recapitalization of banks but it did not specify in which way the ailing banks should be recapitalized. Accordingly, the Irish authorities could fulfill this obligation also by increasing the share capital of ILPGH. Moreover, the challenged direction order handed down by the High Court was the only means of complying with the obligation within the deadline.

That said, the CJEU went on by dealing with the question whether the shareholders’ rights can be compressed to preserve the financial stability of markets. In that regard, the CJEU considered that the protection of shareholders and creditors enshrined in the Second Company Directive does not apply to national measures, like the decision order. More precisely, such measures are adopted in a scenario where there is a serious disturbance of the economy and financial system of a Member States. These measures are aimed to deal with the threats to the EU financial stability coming from a capital shortfall in the company concerned. Consistently with its previous judgment in Kotnick and Others[5], the CJEU ruled that under the above circumstances is possible to adopt exceptional measures affecting the share capital of a public limited liability company, without the approval of the general meeting of that company thereby disregarding the provisions in the Second Company Directive. Such measures, as stressed by the CJEU, can be adopted where there is a serious disturbance of the economy and financial system of a Member States with the objective of preventing a systemic risk and ensuring the financial stability of the EU. Therefore, the Second Company Directive cannot be invoked to prevent the adoption of a measure like the decision order.

The CJEU also distinguished the facts of Dowling and Others from those of Pafitis and Others[6]. In that case, which was about the insolvency of a single bank, the CJEU ruled that the Second Company Directive applied to ordinary reorganization measures, whereas it did not adjudicate on extraordinary reorganization measures to be adopted in case of danger  for the EU financial stability. The CJEU also made the point that its judgment in Pafitis and Others was released before the start of the third stage of the implementation of the Economic and Monetary Union with the related amendments to the EU Treaties. Crucially at this point, the CJEU noted that, though that there is a clear public interest recognized throughout the EU to a strong protection of the rights of shareholders and creditors, such interest cannot always prevail over the public interest in preserving the stability of financial systems resulting from the completion of the Economic and Monetary Union. This ruling mirrored what the CJEU held before in Kotnick and Others.

Therefore, the CJEU replied to questions posed by the referring court by ruling that:  Article 8(1) and Articles 25 and 29 of the Second Company Directive must be interpreted as not precluding a measure, such as the Direction Order at issue in the main proceedings, adopted in a situation where there is a serious disturbance of the economy and the financial system of a Member State threatening the financial stability of the EU, the effect of that measure being to increase the share capital of a public limited liability company, without the agreement of the general meeting of that company, new shares being issued at a price lower than their nominal value and the existing shareholders being denied any pre-emptive subscription right.

In conclusion, in Dowling and Others the CJEU weighted two conflicting interests: the interest in the protection of the rights the Second Company Directive confers on shareholders and creditors of a company; the interest to preserve the financial stability of EU markets from systemic risks. The CJEU ruled that the preservation of financial stability prevails over the protection of the rights of the shareholders and creditors provided two conditions are met: i) the measure restricting the rights of shareholders and creditors is adopted when a serious disturbance of the economy and the financial system of a Member State exist that threatens the EU financial stability; ii) the measure is designed to overcome such systemic threat. Dowling and Others strengthens the idea that Member States may adopt extraordinary reorganization measures to recapitalize ailing banks to dela with systemic risk threatening the stability of the EU financial markets. It is noteworthy that by the implementation of the capital injection, the MF would substantially confiscate the previous shareholders of the Company of all their shares in the equity capital of ILPGH. In practice, the direction order amounted to a burden-sharing measure targeting the shareholders of the Company. In that regard, Dowling and Others is consistent with the principles of burden-sharing and bail-in that, in accordance with the Bank Recovery and Resolution Directive (BRRD) apply to public intervention to rescue ailing banks.

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[1] Judgment of 8 November 2016, Case C-41/15, Dowling and Others v Minister for Finance, ECLI:EU:C:2016:836.

[2] Article 8 (1) lays down that: ‘Shares may not be issued at a price lower than their nominal value, or, where there is no nominal value, their accountable par’.

[3] Articles 25 rules that:

1. Any increase in capital must be decided upon by the general meeting. Both this decision and the increase in the subscribed capital shall be published in the manner laid down by the laws of each Member State, in accordance with Article 3 of Directive 68/151/EEC.

2. Nevertheless, the statutes or instrument of incorporation or the general meeting, the decision of which must be published in accordance with the rules referred to in paragraph 1, may authorize an increase in the subscribed capital up to a maximum amount which they shall fix with due regard for any maximum amount provided for by law. Where appropriate, the increase in the subscribed capital shall be decided on within the limits of the amount fixed, by the company body empowered to do so. The power of such body in this respect shall be for a maximum period of five years and may be renewed one or more times by the general meeting, each time for a period not exceeding five years.

3. Where there are several classes of shares, the decision by the general meeting concerning the increase in capital referred to in paragraph 1 or the authorization to increase the capital referred to in paragraph 2, shall be subject to a separate vote at least for each class of shareholder whose rights are affected by the transaction.

4. This Article shall apply to the issue of all securities which are convertible into shares or which carry the right to subscribe for shares, but not to the conversion of such securities, nor to the exercise of the right to subscribe.

[4] Articles 29 rules that:

1. Whenever the capital is increased by consideration in cash, the shares must be offered on a pre-emptive basis to shareholders in proportion to the capital represented by their shares.

2. The laws of a Member State: (a) need not apply paragraph 1 above to shares which carry a limited right to participate in distributions within the meaning of Article 15 and/or in the company's assets in the event of liquidation ; or (b) may permit, where the subscribed capital of a company having several classes of shares carrying different rights with regard to voting, or participation in distributions within the meaning of Article 15 or in assets in the event of liquidation, is increased by issuing new shares in only one of these classes, the right of pre-emption of shareholders of the other classes to be exercised only after the exercise of this right by the shareholders of the class in which the new shares are being issued.

3. Any offer of subscription on a pre-emptive basis and the period within which this right must be exercised shall be published in the national gazette appointed in accordance with Directive 68/151/EEC. However, the laws of a Member State need not provide for such publication where all a company's shares are registered. In such case, all the company's shareholders must be informed in writing. The right of pre-emption must be exercised within a period which shall not be less than 14 days from the date of publication of the offer or from the date of dispatch of the letters to the shareholders.

4. The right of pre-emption may not be restricted or withdrawn by the statutes or instrument of incorporation. This may, however, be done by decision of the general meeting. The administrative or management body shall be required to present to such a meeting a written report indicating the reasons for restriction or withdrawal of the right of pre-emption, and justifying the proposed issue price. The general meeting shall act in accordance with the rules for a quorum and a majority laid down in Article 40. Its decision shall be published in the manner laid down by the laws of each Member State, in accordance with Article 3 of Directive 68/151/EEC.

5. The laws of a Member State may provide that the statutes, the instrument of incorporation or the general meeting, acting in accordance with the rules for a quorum, a majority and publication set out in paragraph 4, may give the power to restrict or withdraw the right of pre-emption to the company body which is empowered to decide on an increase in subscribed capital within the limits of the authorized capital. This power may not be granted for a longer period than the power for which provision is made in Article 25 (2).

6. Paragraphs 1 to 5 shall apply to the issue of all securities which are convertible into shares or which carry the right to subscribe for shares, but not to the conversion of such securities, nor to the exercice of the right to subscribe.

7. The right of pre-emption is not excluded for the purposes of paragraphs 4 and 5 where, in accordance with the decision to increase the subscribed capital, shares are issued to banks or other financial institutions with a view to their being offered to shareholders of the company in accordance with paragraphs 1 and 3.

[5] Judgment of 19 July 2016, Kotnik and Others, C-526/14, EU:C:2016:570.

[6] Judgment of 12 March 1996, Pafitis and Others, C-441/93, EU:C:1996:92.