Understanding What's Happened to the Co-op Bank......

As a simple lawyer I write on this with trepidation. But my passion for the Co-op Movement means I want to get my head round this.

Why did Moody's downgrade the Co-op Bank's credit rating last Thursday? What are the ramifications of that for the Co-op Group, and co-operatives more widely?

So, I've done what I can to research it and share here what I have found from the press and other sources, providing, as far as possible, links to useful sources and some attempt to explain them.

What Moody's Said

The Moody's downgrade can be read in full here.

The key point seems to be:

“RATINGS RATIONALE

The lowering of the BCA to b1 reflects Moody's view that the bank's 2012 revaluation of its risk exposures announced in March indicates that the significant deterioration in the credit quality of the bank's non-core portfolio has exceeded the bank's expectations and that its earlier valuation reserves and provisions built against these risks may well be inadequate. Most of these risks stem from the legacy portfolio of Britannia Building Society, which the Co-operative Bank acquired in 2009. Moody's believes that the bank underestimated the risks of that acquisition, especially against the backdrop of the continued weak economic environment. Moreover, the bank's ability to generate the earnings needed to replenish capital, if higher losses materialise, is diminished by its slow progress in realising merger-related revenue and cost benefits.

Moody's believes that the combination of (1) low capital levels; (2) a low problem-loan coverage ratio relative to other UK banks; and (3) weak internal capital-generation capacity suggests that the bank's capacity to absorb future losses is now too low to support an investment grade rating and that it possesses only speculative standalone strength, subject to high credit risk in the absence of extraordinary external support. The ratings assigned to the bank's subordinated and junior subordinated debt reflect the possibility that losses may be imposed on holders of these securities in order to achieve the capitalisation levels that the UK regulators require.”

….. and The Guardian Elaborates

As Patrick Collinson's Guardian commentary, says, CRE (commercial real estate) loans, mainly from Britannia, formed most of the increase from 8.1% to 10.9% in the bank's problem loan ratio by the end of 2012. As a result, £1.7bn of the bank's total £9.4bn commercial loan book is impaired and this is apparently down to 12 big loans. Moody's argues that this is worse than the bank expected and may worsen further beyond the £351m total impairment loss shown in the 2012 accounts.

To compound this, Collinson and Moody's both report that, although the bank's capital ratio improved from 8.8% to 9.2% during 2012, and was above the regulatory minimum, as Collinson says, it compares badly with Lloyds at 12.5%.

Moody's also takes the view that the Bank's ability to improve its capital ratio is limited due to low likely profitability, partly because it has been slow to generate benefits from the Britannia deal. That is because the integration of the two systems has been on hold pending Project Verde which was aborted last month .

Collinson points out that although the average loan to value on residential loans is 54%, 10% of them are above 100% i.e. more is owed than the property is worth. That again comes from Britannia through its subsidiary “Platform”, which leant through intermediaries, sometimes with minimal income checks or self-certification. Arrears on those are running at twice the industry average.

As “UK Taxpayer” succinctly put it in a comment on the FT Alphaville piece on 10^th May:

“It was the Britannia Building Society that did it. Nationwide was far more canny when they took over Dunfermline, in ensuring that the Government took over the problem loan portfolio”

However, other FT comments point to issues with Moody's behaviour. “OrderOrder” argues that Moodys have been “irresponsible” by first giving a high credit rating and then dropping it “dramatically” (six points) “on data that was evident earlier according to their own report (the impact being their 2009 purchase of Britannia)”. Paul Munton suggests that the PRA should step in with their own analysis of the Co-op Bank's credit risk to set the record straight.

According to the supportive Independent, the Bank of England and PRA are refusing to comment in public at present, although the Co-op is obviously in discussions with both of them. The Independent also argues that customer loyalty stemming from the ethical policy makes a run on the Co-op Bank less likely and allows the Bank of England and the PRA off the hook.

What Happened Then

The immediate result of the Moody's announcement on Friday was the announcement that Barry Tootell was stepping down as CEO. According to the Guardian, that had already been agreed and only the announcement was speeded up.

It is not known how much Mr Tootell will receive by way of pay off but his predecessor, Neville Richardson, inherited from Britannia, left early in 2011. This morning's Daily Telegraph reports that he left with:

"a package worth £4.6m, including a £1.4m payment for “loss of office”, as well as £1.39m in “compensation” for leaving."

The Group Board are reported to be considering trying to recoup some or all of that as the Telegraph reports that:

"The Co-op Bank is among the lenders to have brought in so-called “malus” clauses for its staff to allow it to claw back pay from current and former staff if it is discovered that the lender’s performance at the time the pay was granted was based on taking positions that subsequently soured."

The report suggests that such clauses apply to the bank but not the Group itself.

On the Markets, the value of the Bank's 10 year Bond, maturing in 2021 fell 25% on Friday raising the yield from 9% to 15% (see this Stock Exchange Chart). In addition, the value of Co-op Group debentures fell significantly. This makes it more expensive for the Bank and the Group to raise capital on the markets until the values recover as a result of new developments.

Most of the newspapers estimate the capital shortfall at the bank at around £1bn. However, that depends both on how much can be raised and on the valuation of assets, which in turn depends on the loan portfolio and whether the performance of loans deteriorates further.

The Co-op Group has pointed out that, “like the rest of our banking sector peers” they need to strengthen their capital position due to the economic downturn and the imminent introduction of stricter regulatory requirements.

The current plan seems to be to raise £600m plus from the sale of the general insurance arm of CIS to add to the £219m to be raised from the already agreed sale to Royal London of the life insurance arm.

What Happens Next

According to the Sunday Telegraph  (12.05.13), Euan Sutherland, who takes over as CEO from Peter Marks at next Saturday's AGM of the Co-op Group, will launch a review to evaluate all the group's main businesses to decide which to sell to raise capital. The results of that review may be available by August. The article suggests that Mr Sutherland feels that “the supermarket business is at the heart of the mutual's operations”.

Iain Dey in The Sunday Times reports that the Bank has already submitted a rescue plan to the Bank of England. He estimates the “black hole” as £750m but asserts that the £650m the Group hoped to raise by the sale of non-life insurance is seen by the City as optimistic. This morning's Times talks about the sale of property and of assets that came with Britannia as an additional source of capital.

Speculation on the Options

All this seems to focus the options facing the unfortunate Euan Sutherland and acting bank CEO, Rod Bulmer, on a limited number of possibilities, none of which look great.

1. Leave banking and concentrate on the core retail business.

The problem here would seem to be how to exit. This does not look like a good time to be selling a bank. New and tougher regulatory requirements affect all banks. We have seen the problems Lloyds TSB have had unloading the branches the Co-op had hoped to buy. They are now launching them on the Stock Exchange. That implies the Co-op being on the wrong side of a fire sale of just the kind it was hoping to exploit buying those Lloyd TSB branches for a low price through Project Verde. Holding nerve and gradually sorting the mess out seems like a better strategy.

2. Soldiering on with the bank

This means plugging the gap in its capital and the PRA and Bank of England would expect the Group to find the funds. To see the current regulatory requirements in detail, peruse the new Genpru and Bipru sections of the PRA's Handbook. Then consider the additional requirements being developed for implementation soon. Of course, the sale of other parts of Co-op Financial Services would be the first resort. But what happens if more is needed? That suggests the sale of other parts of the Group's family of businesses. Presumably that's one of the issues the review reported in the Sunday Telegraph will look at.

3. Partial disengagement from banking.

Reduction in the scope of the activities of the bank might help especially if it could be done so as to reduce the level of capital requirements or ease the position on the poorly performing loans inherited from Britannia. There might be some element of realising further assets of the bank as part of that as well.

4. Capital Injection

The Co-op bank is a PLC. It only issues preference shares and so the Group keeps 100% control. There is a precedent along the lines of the 2011 JV with Thomas Cook used to ease out of the travel business.

Maybe that could involve a partnership with equity investors in the ownership of the Bank? That would be a shame, but the subsidiary structure (as opposed to direct member ownership of the bank) opens up the possibility of tapping the equity market or using that as part of a strategy to put in more capital by agreement with a partial buyer. That approach, undesirable as it is on co-operative grounds, might be preferable to stripping out assets from the rest of the Group to prop up the Bank. At least it would be clear what remained a co-operative and what did not.

Of course, if the perennial problem of capital for co-operatives could be resolved that would help the Group for the future, and retain its co-operative nature. It might even be part of the solution to the current problems.

Co-operative Capital

For co-operatives registered as industrial and provident societies capital raises difficult legal and regulatory issues.

Shares classified as withdrawable give the holder an exit possibility as the society can pay the money back and cancel the shares. This is contrary to the usual rule that corporate bodies (e.g. companies) are not permitted to buy back their own shares without special procedures and safeguards for creditors and remaining shareholders. However, apart from withdrawable shares held by other societies, only up to £20,000 worth of those shares can be held by any person (individual or company).

Non-withdrawable shares in societies are not subject to any limit on the value of a holding but they probably cannot be bought back by the society at all under the governing common law rule in Trevor v Whitworth. This is unfair to societies as companies, as long as they follow certain procedures and provide some safeguards, can buy back their own shares out of profits available for distribution or, in the case of private companies, even from capital not so available.

Primary legislation is needed to deal with this issue and to put societies in the same position as companies in that respect. If that were passed, it would significantly ease the position of all co-operative societies, including the Co-operative Group.

The other way to ease the position of co-operative societies is to create and develop a secondary market in non withdrawable shares but that would, at best, be a long term project and, to develop that, careful thought would have to be given to the conditions attached to those shares and the operation of any such market. That mechanism might be useful for smaller co-ops but is unlikely to help large well established societies.

Lessons from the Story of the Bank

It is rather early to try to draw lessons from these events but a few questions seem to be raised by them.

Can Growth and Governance by Members be Combined?

Edgar Parnell has pointed out in an email sent out last week (edgar View 12.05.13) that “chasing growth to the detriment of the real interests of the membership has proved to be the downfall of major consumer co-ops in many countries in Europe”. He cites the 1998 collapse and later liquidation of Coop Dortmund-Kassel in Germany after a DM45m investment in modernisation with fundraising from investor members with high share dividends and the reduction in the role of members as well as the 1995 bankruptcy of Konsum Austria.

However, this raises the issue of whether co-operatives are destined always to remain small or whether growth while retaining member control is possible. It would seem to be a counsel of despair to insist that co-ops always have to be small and marginal.

Surely, we must work to ensure that democratic control and sensible governance can still prevail in large co-ops.

Is a Group Structure a Problem?

Since the resolution of the debates between the Webbs and GH Cole in the early twentieth century, British consumer co-ops rejected large scale co-partnership between employees and consumer members in favour of outright ownership by consumers.

The consolidation of the consumer movement after WW2 then concentrated the business in the Co-operative Group – particularly after the merger of CWS and CRS in the early 21^st century to deal with problems at CRS and the merger with United Norwest to recruit Peter Marks as Group CEO.

The Group has kept its complex hybrid structure of Corporate members and individual members and reflects that in its board and general meetings. Of course, it has adapted significantly since those mergers by having outside Independent “expert” Non-Executive directors on both the CFS and the main Group boards to improve the chances of challenging management. It has also rationalised its governance and regional structure and adopted recommended corporate governance practices. However, as events have shown, none of that provides any guarantee against mistakes such as the acquisition of Britannia and the attempt at further expansion before it was properly integrated.

The Bank has always been a subsidiary (latterly part of CFS) and the relationship between the Bank and Group CEO's always seemed a little mysterious. We now see that the Bank impacts the whole group despite the separate corporate entities because of the regulatory requirements for banks. Maybe further adjustment of governance will emerge as part of the clarification and simplification of the Group as a result of the present review of all its businesses.

We can only wish the new Group CEO and his team well in dealing with all these problems and hope that the input of the two boards, the members, and the executives can together result in a stronger, if perhaps a leaner and more focused, Co-operative Group.

Tough decisions seem inevitable.

Protect the "Co-operative" Name - contact BIS by 22.05.13

It is vital that everyone supports Co-operatives UK's campaign on the Government's proposal to remove the current protection for the use of the word “Co-operative” in the name of a company, LLP, sole trader, limited partnership, or unregistered general partnership. Do that by sending your opinion BY 22^nd May 2013 to catherine.crowsley@bis.gsi.gov.uk

It may be helpful to give some of the technical legal background to the proposal here and to explain its importance to UK co-operatives.

Co-operatives UK's excellent response  to the consultation provides practical evidence and coherent and convincing arguments against the change mooted by the government. I support that 100%. This short post elaborates the background and some of the arguments to complement the Co-operatives UK response.

Why Is Protection Needed?

In the UK legal system there is no requirement for co-operatives to use any particular business structure. Many co-ops use a society registered under the Industrial and Provident Societies Acts 1965 to 2003 (IPSA's) - soon to be renamed Co-operative or Community Benefit Societies Acts. But many co-ops use registered companies and limited liability partnerships because they find them more convenient. It is also possible for co-ops to use a limited partnership registered under the Limited Partnerships Act 1907 or an unregistered general partnership governed by the Partnership Act 1890 for a co-operative, although this is less common due to problems with liability in those cases. While a co-op cannot, by definition, be a sole trader, protection of the name against abuse by sole traders is important.

This freedom to choose any business structure arises from our liberal tradition of business law and has advantages. It allows flexibility and the development of new co-op businesses and initiatives without the constraint of one rigid legal straitjacket. On the other hand, as the whole concept of a co-operative is based on values and principles, some protection of their identity is needed.

The FCA Mutual Registrations team require that any society registered as a co-op under the IPSA's, meets the ICA definition. In the case of other business structures, protection against misuse of the name “co-operative” depends on the legislation now being reviewed by the Department for Business Innovation and Skills (BIS).

These protections are vital to ensure that the public are not misled into believing that they are dealing with a co-operative when they are not. They also prevent the co-operative idea from being tarnished by fraud and abuse.

How Does the Current Protection Work?

The regulation of words used in business names is governed by the Companies Act 2006 and regulations made under it. However, the protection extends to all business structures and not just to companies. How does this work?

Section 55  and Part 41  of the 2006 Act set the system up.

Section 55 requires permission from the Secretary of State (in practice Companies House) for the use of certain words in company or LLP names- See reg 2 of SI 2009/2615  for the application of this to LLP's.

Sections 1192 and 1194 require the same permission for any of those words to be used to carry on business in an unregistered or limited partnership or as a sole trader. They make it a criminal offence for anyone to do that in the UK.

Under The Company, Limited Liability Partnership and Business Names (Sensitive Words and Expressions) Regulations 2009 SI 2009/2615the word “co-operative” is protected from use in a company name, an LLP name, or to carry on business using any unregistered structure.

What Change is Proposed?

The current consultation by the Department for Business Innovation and Skills (BIS) questions whether any of the names on the list in those regulations should remain protected.

It does this by asking whether regulations are necessary at all and, if so, whether they can be “reduced, simplified or improved”.

Why Does it Matter?

In paragraph 39 of the consultation document the rationale for the protection is set out:

“39. All the words specified as “sensitive” and listed in Schedule 1 of SI 2009/2615 (see Annex A) were included to protect the public from being misled by a business’ name as to either its status or the nature of its businesses activities (e.g. charity, co-operative, Institute). However, as language evolves words, which may have been considered worthy of protection at the time, may no longer be considered such a risk”

In paragraph 52 certain names are suggested as being particularly in need of protection:

“52. Those which appear to be particularly important to protect include: Accredited, Bank, Charity, Institute, Insurance, Police and University. Misuse of these words poses a high risk to the general public.”

The internationally accepted ICA Statement of Co-operative Values and Identity  gives a clear focus for the meaning of the word “co-operative” and clear criteria against which to judge a business or person seeking to use the name.

The misuse of the word “co-operative” leads to similar risks to the misuse of the words listed in paragraph 52 (above) of the BIS document.

People may well wish to trade with a firm because it is a co-operative and because the name implies certain standards of behaviour and an ownership structure which protects and facilitates that. For legal structures other than industrial and provident societies, there is no other agency or government body that provides that assurance so the preservation of this protection is essential.

The use of the name is not restricted in the IPSA's because the flexibility to use a range of business structures for co-operatives is beneficial. In addition, to impose such a restriction, primary legislation would be required. Such a change would not amount to a consolidation so it could be achieved as part of the current Law Commission and HMT project.

If the regulations are to be removed or reduced radically, it is essential that protection is retained for the word “co-operative – and extension to the words “coop” and “co-op” is desirable.

Maybe the function could be removed from BIS to the FCA which carries out the same role for societies, or to Co-operatives UK as the custodian of co-operative values in the UK.  However, that would be unlikely to reduce red tape as a different government body would be involved in the process on the registration of a company or LLP and in prosecuting for violations by sole traders or unlimited and limited partnerships.

It makes sense for the function of approving the name to remain with the body involved in company and LLP registrations and for the prosecuting function to stay with the same body.

UK International Obligations

The International labour Organisation in its Recommendation 193 of 2002 makes clear the expectation that states who have signed up to the ILO Convention will promote co-operatives. That applies to the UK.

Paragraph 7(2) of the recommendation provides that:

"Cooperatives should be treated in accordance with national law and practice and on terms no less favourable than those accorded to other forms of enterprise and social organization."

To fail to protect the identity of co-operatives taking advantage of the flexible system of business structures in the UK would fail to meet that requirement.

Under paragraph 10 states are to adopt  legislation and regulations on cooperatives guided by the cooperative values and principles. The removal of the protection afforded by the UK Business Names rules would fail to do that.

Given that governments are also urged in paragraph 10 "to consult cooperative organizations in the formulation and revision of legislation, policies and regulations applicable to cooperatives", the submission of Co-operatives UK should carry particular weight.

As a member state of the European Union, the UK should also have regard to the European Commission's Communication of 23rd  23.02.2004 (COM(2004)18) on the Promotion of Co-operative Societies in Europe. In paragraph 3.2.4. the Commission emphasises the importance of  the co-operative definition, values and principles set out by the International Cooperative Alliance (ICA) in 1995, and refers to their endorsement by the UN and the ILO. It goes on the state:

"Consequently national legislators should be based on the co-operative definition, values and principles when drafting new laws governing co-operatives. In this context however Member States  are required also to be sufficiently flexible in order to enable co-operatives to compete effectively in their markets and on equal terms with other forms of enterprise."

That Communication has been endorsed and applied by the European Court of Justice.

This all shows that the removal of the protection of the word "co-operative" would be a violation of the principles expressed by the EU, the ILO and the UN. This adds weight to the campaign on this issue.

What To Do

You can help :

• Check out the Co-operatives UK draft response  and
• email your own to catherine.crowsley@bis.gsi.gov.uk 
• Write to your MP

BY 22^nd MAY 2013

© Ian Snaith 2013 This work is licensed under the Creative Commons Attribution-NonCommercial-Noderivs 2.0 England and Wales Licence. To view a copy of this licence visit http://creativecommons.org/licenses/by-nc-nd/2.0/uk/ or send a letter to Creative Commons, 559 Nathan Abbott Way, Stanford, California 94305, USA