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Central & eastern EuropeSeptember 3 2006

Light at end of the tunnel over Czech IPB fiasco

After six years of bitter legal wrangling over who was to blame for the downfall of the once mighty IPB bank, Nomura Securities and the Czech government may be about to bury the hatchet. Robert Anderson recounts the acrimonious tale.
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The forced takeover of Investicni a Postovni Banka (IPB), once the third largest Czech bank, in June 2000 has become the costliest and most controversial bank failure ever in central and eastern Europe. Since armed police stormed IPB’s Prague headquarters and put it under forced administration, the Czech government has had to pay about Kc130bn (€4bn) to repair the stricken bank’s balance sheet. It now faces more costs and potential embarrassment from a bitter legal dispute with Nomura Securities of Japan, the bank’s minority owner.

For its part, Nomura has lost its once commanding position in the Czech investment banking business and also faces serious allegations over its behaviour at IPB. A Nomura representative has been charged with criminal offences and both the government and Ceskoslovenska Obchodni Banka (CSOB), IPB’s new owner, are pursuing it for huge damages.

This March, Nomura seized the upper hand by winning the first of two United Nations Commission on International Trade Law (Uncitral) arbitrations under the Czech-Dutch bilateral investment protection treaty over the loss of its stake in IPB.

Arbitration

The tribunal ruled that the state failed to accord Nomura fair and equitable treatment. Unless the government is successful in an appeal in the Swiss courts, it could face a bill of up to Kc30bn plus interest and costs next year. Its only hope lies in a second arbitration, in which it is claiming Kc111bn from Nomura, which should also be concluded next year.

The IPB crisis provides lessons for both governments and foreign investors in the banking sector in emerging markets:

  • Governments must think long and hard before privatising retail banks to investors not specialised in that business.
  • Governments must ensure the banking sector is properly supervised so that they get as much warning as possible about potential problems.
  • Governments must act swiftly but also fairly in a crisis to avoid increasing the costs the state will have to cover and to avoid becoming entangled in legal disputes.
  • Foreign investors must take proper account of the risks of getting involved with heavily politically connected banks and should cultivate links with all main political parties as an insurance policy.
  • Foreign investors should buy a bank primarily for its banking business and not for its equity shareholdings.
  • Foreign investors should exercise real control of the bank’s management and properly supervise their own local representatives.

Nomura became involved with IPB almost by accident. Randall Dillard, Nomura’s Miami-born former head of European merchant banking, had been active in the Czech market since the fall of communism in 1989, first working mainly as a government adviser but increasingly hunting equity investments for the bank’s own account. By the mid-1990s, Nomura was the most important investment bank in town.

Mr Dillard, a tireless dealmaker who never carried a mobile phone and kept details of transactions in his head, had long had his eye on the untapped potential of Czech breweries. Unfortunately so had IPB and Mr Dillard emerged bruised but impressed after going head-to-head with Libor Prochazka, IPB’s reclusive but feared deputy chief executive, in a battle for control of the Radegast brewery. “They were rough,” he recalled afterwards. “Our first contacts with them were not friendly. They were hard merchant bankers. I admired it. It’s what you have to be in the equity markets. You can’t take prisoners.”

Mr Prochazka and his partner, Jiri Tesar, had won control of IPB from the state by using subsidiaries and associated companies to buy IPB shares. They went on to build a financial and industrial empire, using the bank’s cash to amass controlling stakes in companies through subsidiaries and loans to entrepreneurs. “Banks enable concentration of ownership,” he told this correspondent in a rare interview.

By the mid-1990s, IPB was the country’s dominant financial group, leading the Czech Republic to be nicknamed “IPB land” by cynical observers. IPB had very close links with the ruling Civic Democrats – the prime minister’s chief adviser was even on its supervisory board.

Hidden losses

Much of the loan book was bad – eventually 75% was found to be non-performing – but the bank shrugged off any criticism. Its accounts were difficult to understand, blurred by a web of subsidiaries and associated companies, and the central bank did not take any action. When auditors Coopers & Lybrand pointed out a Kc20bn provisioning gap, IPB simply replaced them with Ernst & Young (which were later fined by the Czech Chamber of Auditors for their record at IPB).

After the battle over Radegast, Mr Dillard and Mr Prochazka began to work together and Nomura ended up buying the brewery and taking a 10% stake in IPB itself.

The two dealmakers eventually agreed that Nomura should buy the state’s remaining 36% stake. This would give the bank a facelift while maintaining Mr Prochazka’s power behind the scenes. In return, Nomura would be allowed to buy IPB’s shareholding in Plzensky Prazdroj, brewer of Pilsner Urquell, the most famous Czech beer brand, for Kc9.2bn ($416m). The two transactions eventually took place on the same day in March 1998. The following year, Nomura sold the merged breweries for $650m.

Nomura takes over

The state still had to be persuaded but after long negotiations the government eventually recognised that it had lost control of IPB. With the bank’s finances deteriorating, in March 1998 the government agreed to sell its stake for Kc2.9bn, slightly less than the then share price.

Afterwards Nomura took part in an equity increase, bringing its total investment in the bank to Kc7.2bn. The government was later to accuse it of violating its undertaking to inject Kc6bn of subordinated debt. Nomura says that subsequent market conditions made it impossible to issue the debt.

Mr Dillard believed that IPB was undervalued and Nomura could triple this investment over time, particularly if it held on until the Czech Republic entered the EU, as it eventually did in 2004. “We knew we were coming at just the right moment,” he said in 1999. “We thought it was the time to buy when everyone was in despair.” Looking forward he added: “The real plan is to hold it until the EU. The optimal value will be in 2006 because the rhythm will be there and European banks will be keen to get market share.”

Yet Nomura’s risk committee was not so convinced and Mr Dillard had to make sure it was protected in case his investment did not work out. The IPB shares were held by Saluka Investments, a Dutch-based special purpose vehicle, and Nomura announced that its 46% stake was only a portfolio investment. Mr Dillard himself became only vice-chairman of the supervisory board.

Through offshore companies, Nomura also took out a put option in which it could exchange its shares in IPB for the shares in the breweries. When IPB collapsed it exercised its option, exchanging the now worthless IPB shares for shares in the breweries. The tribunal found Nomura was under no obligation to disclose its put option to the Czech authorities.

Underestimating the problems

Nomura knew IPB was a risky investment. There had already been runs on the bank and at the time of the sale an Ernst & Young audit had shown the need to strengthenprovisions by Kc16bn. However, Mr Dillard believed the problems were manageable and IPB had the biggest potential of the four big banks, which it could exploit because it was the first to be privatised. “There were problems but we understood the dimensions of the problems and they could be worked out,” he said in 1999. “We could get double book value eventually.”

Analysts at the time of the sale were pleasantly surprised that the state had not been forced to offer guarantees. After the crash, Mr Dillard admitted ruefully that he had underestimated the problems and that PricewaterhouseCoopers, Nomura’s advisers, had not been able to get full access to IPB’s books.

After the acquisition, Nomura helped reorganise risk management at IPB and introduced a work-out structure, which included transferring about Kc45bn of mostlynon-performing loans off balance sheet.

Nomura also helped build up IPB’s retail business to the point where it had 2.9 million clients, 22% of deposits and was challenging Ceska Sporitelna, the state savings bank, for the number one spot. Yet Nomura lacked the expertise to really transform IPB’s retail activities. Mr Dillard admitted afterwards: “We should have brought in a commercial banking partner earlier.”

Nor did Nomura have control over IPB’s lending decisions, which Mr Prochazka kept firmly in his hands. Only just before the crash did Nomura assert its true power in the bank, persuading Mr Prochazka to resign from the board of directors. Mr Tesar stepped down as chairman of the supervisory board and Mr Dillard took his place. “As we saw the problems occur we became more involved,” Mr Dillard said afterwards. “We tried to do what we could but without control of the bank we could not do enough in an environment that was not friendly.”

IPB’s collapse two years after Nomura’s entry was part of a systemic banking crisis that was a direct result of the government’s slowness in privatising the sector. Through inexperience, fraud and government pressure, state-owned banks had handed out billions of crowns of loans that could neither be repaid nor recovered because of the poorly functioning legal system.

When the economy spiralled into recession in 1997-99 and the central bank tightened provisioning rules, IPB, as well as state-owned Ceska Sporitelna and Komercni Banka, all became in effect insolvent. By the end of 1999, non-performing loans represented one-third of all loans or 26% of gross domestic product (GDP).

The Social Democrat government, elected in mid-1998 ,felt forced to clean up the state-owned banks and privatise them (for much higher sums than Nomura had paid for IPB). Privately owned IPB was left out of the bail-out programme, a decision the arbitration tribunal would rule represented discrimination in state aid without reasonable justification.

Nomura argues the state aid granted to its rivals in the late 1990s hurt IPB’s competitiveness and eventually led to the fatal bank run. “The way the government approached the systemic banking crisis made it impossible for IPB to survive,” says Dan Jackson, head of Nomura International.

For its part, the government blames the bank’s management for its problems. IPB’s finances were in the worst state of all the banks, partly because it had kept lending when its rivals had stopped, the government claims.

IPB managers, including Mr Prochazka and a Nomura representative, have also been charged with criminal offences, mainly related to the sale of the breweries, accusations they deny.

In the case of the bank, Mr Prochazka is charged with falsification of data, breach of duty with others’ assets and misuse of information. Eduard Onderka, who remains head of Nomura’s Prague office, is charged with misuse of information. The cases are still before the Czech courts. A legal expert points out that many of the charges would not be offences in other jurisdictions.

Yet the new government was also hostile to IPB and Nomura because of their close ties with the right-wing Civic Democrats, as well as the profits Nomura had made from the sale of the breweries. “We hoped they would have compensated for those profits by restructuring the bank,” says Jan Mladek, the then deputy finance minister in charge of the negotiations.

Mr Dillard said after the collapse that he had made a mistake by ignoring the political dimension and underestimating the pent-up hostility of the central bank to IPB’s management. “You’re always unpopular if you’ve worked with the previous government,” he said. “We became guilty by association. We were just a foreign scapegoat. We were an easy target to blame.”

House of cards

A crisis began to loom during the spring of 2000 as both Ernst & Young, IPB’s auditors, and the central bank pored over the bank’s books. The central bank had taken the opportunity of IPB’s loss of political protection to start to ask tough questions about its off-balance sheet schemes.

Ernst & Young never finished its audit of 1999’s accounts but it informed the central bank that the provisioning gap was at least Kc21bn. The result of the central bank’s special probe was even more alarming: a survey of about half the loans had found a shortfall of Kc40bn.

The central bank and the government began pressing Nomura to recapitalise IPB but Mr Dillard insisted it was just a portfolio investor. Meanwhile, one small shareholder used legal action to block an equity increase. “Shareholders were either unwilling or unable to help the bank,” Josef Tosovsky, the then governor of the central bank, said afterwards. “They were only negotiating, delaying the process.”

Mr Dillard preferred to bring in a foreign investor but found himself constantly outbid by the government as it privatised first Ceska Sporitelna to Erste Bank of Austria, and then launched Komercni’s sale with extensive state guarantees. During their sales Nomura desperately tried to merge IPB with both banks but was rebuffed.

Mr Dillard’s negotiations with a consortium of UniCredit of Italy and Allianz of Germany dragged on as the bidders tried to make sense of IPB’s books and waited for Nomura to procure sweeteners from the state.

Mr Dillard’s brinkmanship backfired. The government was angered by what it saw as his attempt to push them into giving a handout while maintaining control.

Mr Mladek tried to talk to Nomura in Japan but it directed him back to Mr Dillard. “[Nomura] gave him all the power,” said Mr Mladek. “It never gave us anyone else to negotiate with.”

In IPB’s last days, Mr Dillard offered to hand Nomura’s shares back to the state for €1 but insisted on keeping the offshore structures and overseeing the reprivatisation process. These conditions were unacceptable to a government that had lost all trust in Nomura.

Mr Dillard had left it all too late. “It is unclear to me why Nomura let the process go on until the very end,” Jan Klacek, the figurehead chief executive installed by Nomura, said afterwards. Mr Dillard was to leave Nomura a year after the crash to found his own hedge fund in London.

The final nail

The end came after a bank run in February 2000 in which IPB lost Kc25bn in four days, 10% of its deposits. The tribunal accused a deputy finance minister of helping to trigger the bank run with loose talk. “Having created the tinderbox the government threw the match on the sticks,” says one Nomura executive.

Police closed the bank’s doors on Friday, June 16 and by Monday it had a new owner: CSOB, the fourth largest bank (majority owned by KBC Bank of Belgium) and one with good links with the central bank. Over the weekend, CSOB became the country’s largest bank and it has maintained its dominance since.

The tribunal found that the government did not negotiate in good faith during the crisis and therefore acted in an unreasonable and discriminatory way. Finance minister Pavel Mertlik and Mr Tosovsky had recently met the heads of CSOB and KBC in Paris to watch a Powerpoint presentation of a potential takeover of IPB. In the crisis the government faithfully followed this plan, swiftly transferring IPB’s assets to CSOB with full guarantees for a price later assessed at Kc4.3bn.

Yet for the central bank and the finance ministry, CSOB was the best partner and the only one able to take over IPB immediately and prevent panic spreading. “The possibility of systemic risk was certainly there,” said Mr Tosovsky afterwards. “There was no alternative that would have been less costly for taxpayers. If I could go back I would not change anything.”

It is hard to believe that any solution would have been more costly than the one the government eventually chose. CSOB used its blanket guarantee to the full, transferring virtually IPB’s entire loanbook back to the state, leading to a dispute with the government that still rumbles on.

For Nomura, the consequence was the loss of its 46% shareholding without any compensation (the value of the bank after the crash was assessed at minus Kc67.8bn) and its effective exclusion from doing business in the country. Nomura assesses the value of its shareholding before the crash at Kc25bn-Kc43bn. Nevertheless, overall it still made a huge profit from its involvement with IPB, given that it transferred its IPB shares for the breweries through the put option. Therefore, it may not get the full compensation it is claiming when the tribunal makes its award next year.

Bygones be bygones

Both the government and Nomura have shown willingness to settle outside court. Nomura is keen to restore its reputation and re-enter the Czech market. There is also a risk that it could lose the second arbitration launched by the government and a separate legal suit brought by CSOB in the Czech courts for Kc24bn.

The government is also eager to settle, though it has been obstructed by its continuing disputes with the more hardline CSOB, which will have to be persuaded to drop its own legal claims. The key protagonists in the finance ministry and central bank have long since moved on and ministers now want to cut their losses.

The recent general election may lead to some kind of pact between the Social Democrats and Civic Democrats. This could finally produce a government that has the strength to bury the hatchet with Nomura and end this depressing saga.

TIMELINE: IPB'S COLLAPSE

1998

March 8: Nomura agrees to acquire 36% stake in IPB from the Czech state, taking its shareholding to 46%. At the same time it buys Plzensky Prazdroj brewery from IPB.

June 19-20 : General election brings Social Democrats to power.

December: Government begins bail-out programme at state-owned banks.

2000

February 28: Depositors withdraw Kc30bn (€1bn) in run on IPB.

April 25: IPB managers Libor Prochazka and Jiri Tesar resign. Randall Dillard becomes chairman of the supervisory board.

May 30: Finance minister Pavel Mertlik and central bank governor Josef Tosovsky meet secretly with CSOB and KBC chief executives on sidelines of conference in Paris.

June 12: Second run on deposits starts.

June 16: IPB is put under forced administration by the central bank.

June 19: IPB’s assets are transferred to CSOB.

2006

March 19: International arbitration panel rules that the Czech government failed to accord Nomura fair and equitable treatment.

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