Canada: Basel Committee Requires Non-Common Capital Instruments to Be Convertible into Common Shares

Last Updated: January 17 2011
Article by Blair W. Keefe

Earlier today, the Basel Committee released new minimum requirements specifying that all capital instruments issued on or after January 1, 2013 must contain provisions that require them to be converted into common shares if the relevant regulator determines that the bank is no longer viable. These requirements were endorsed by the Governors and Heads of Supervision at its January 10, 2011 meeting and are in addition to the criteria detailed in the Basel III capital rules text that were published in December 2010.

All existing non-common capital instruments outstanding on January 1, 2013 will be considered instruments that no longer qualify as additional tier 1 or tier 2 capital and will be phased out in accordance with the Basel rule text released on December 16 and described in our December 2010 bulletin.

Before the end of January, Canada's Office of the Superintendent of Financial Institutions (OSFI) is expected to release additional guidance on how these minimum requirements are likely to be implemented in Canada and to provide more detail on transitional rules relating to existing non-qualifying capital instruments. As OSFI noted in its December 16 letter, this guidance is expected also to include additional clarity regarding its expectations on the right of redemption using "regulatory event" clauses (in which the instruments can be redeemed by the bank at their issue price before the expected maturity of the instrument instead of a premium, which would normally be the case for an early redemption).

Background

As noted in our May 2010 bulletin, Canadian officials have been promoting contingent capital as the best way to strengthen the banking system and mitigate the risk of taxpayer-funded bailouts in the future. In August 2010 the Basel Committee released a consultative document titled "Proposals to Ensure the Loss Absorbency of Regulatory Capital at the Point of Non-Viability" (August Proposals). That consultation document was issued for comment by October 1, 2010. The comments were almost uniformly negative and substantially similar to the concerns that Torys LLP raised in the May 28, 2010 bulletin. However, despite those concerns, the Basel Committee announced in a press release dated October 19 that it intended to finalize the draft rules by the end of the year.

The final rules are substantially similar to August Proposals. However, they contain the possibility that the new requirements will not apply if

a. the governing jurisdiction of the bank has laws that (i) require such tier 1 and tier 2 instruments to be written off upon such event, or (ii) otherwise require these instruments to fully absorb losses before taxpayers are exposed to loss;

b. a peer group review confirms that the jurisdiction conforms with clause (a); and

c. the relevant regulator and issuing bank disclose in future issuance documents that these instruments are subject to loss under clause (a) in this paragraph.

Footnote 6 to the August Proposals had previously noted that in Japan, preferred shares, together with common shares, are subject to write-downs as stipulated in Article 106 of the Deposit Insurance Act and therefore that regime would satisfy these requirements. It is widely believed that these provisions were inserted at the request of officials from the United States on the basis that the provisions of the Dodd- Frank Wall Street Reform and Consumer Protection Act and other regulatory changes made in that country will satisfy the requirement. The release provides no date when the peer review and determination will be made.

Detailed Requirements

The following are detailed requirements contained in the rules.

Scope and post-trigger instrument

1. The terms and conditions of all non-common tier 1 and tier 2 instruments issued by an internationally active bank must have a provision that requires these instruments, at the option of the relevant authority, to either be written off or converted into common equity upon the occurrence of the trigger event.

2. Any compensation paid to the instrument holders as a result of the write-off must be paid immediately in the form of common stock (or its equivalent in the case of non-joint stock companies).

3. The issuing bank must at all times maintain all prior authorization necessary to immediately issue the relevant number of shares specified in the instrument's terms and conditions should the trigger event occur.

Trigger event

4. The trigger event is the earlier of (i) a decision that a write-off, without which the firm would become non-viable, is necessary, as determined by the relevant authority; and (ii) a decision to make a public sector injection of capital, or equivalent support, without which the firm would have become nonviable, as determined by the relevant authority.

5. The issuance of any new shares as a result of the trigger event must occur before any public sector injection of capital so that the capital provided by the public sector is not diluted.

Group treatment

6. The relevant jurisdiction in determining the trigger event is the jurisdiction in which the capital is being given recognition for regulatory purposes. Therefore, if an issuing bank is part of a wider banking group and if the issuing bank wishes the instrument to be included in the consolidated group's capital in addition to its solo capital, the terms and conditions must specify an additional trigger event. This trigger event is the earlier of (i) a decision that a write-off, without which the firm would become non-viable, is necessary, as determined by the relevant authority in the home jurisdiction; and (ii) the decision to make a public sector injection of capital, or equivalent support, in the jurisdiction of the consolidated supervisor, without which the firm receiving the support would have become non-viable, as determined by the relevant authority in that jurisdiction.

7. Any common stock paid as compensation to the holders of the instrument must be common stock of either the issuing bank or the parent company of the consolidated group (including any successor in resolution).

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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