OSFI's Final Advisory On Non-Viability Contingent Capital

On August 16, 2011 the Office of the Superintendent of Financial Institutions (Canada) ("OSFI") released its final Advisory Non-Viability Contingent Capital (the "Advisory"), marking the latest development in Canada's implementation of Basel III. The Advisory provides that capital instruments, other than common shares, issued by banks, bank holding companies and federal trust and loan companies (collectively "DTIs") must, in order to qualify as regulatory capital, contain a feature providing for automatic conversion to common shares upon the occurrence of a "trigger event".

The Advisory is largely consistent with OSFI's draft Advisory on this subject published in February 2011 and implements requirements established by the Basel Committee on Banking Supervision.¹

The Advisory addresses the following:

1. the principles governing inclusion of non-viability contingent capital ("NVCC") instruments in regulatory capital;
2. the process by which OSFI will confirm whether such instruments qualify as regulatory capital;
3. the issuance of capital instruments prior to January 1, 2013; and
4. the criteria that the Superintendent of Financial Institutions (the "Superintendent") would consider prior to triggering the conversion of NVCC instruments into common shares.

This Bulletin highlights and comments on key points from the Advisory, including notable changes from the draft Advisory.

Background Regarding NVCC

During the recent financial crisis a number of non-Canadian distressed banks were rescued by capital injections from the public sector. As a result, Tier 2 capital instruments (mainly subordinated debt), and in some cases Tier 1 instruments, did not absorb losses incurred by certain banks in other countries that would have failed without this support.

The NVCC requirements, which are set out in Minimum requirements to ensure loss absorbency at the point of non-viability published by the Basel Committee on Banking Supervision on January 13, 2011, are intended to ensure that all classes of capital instruments absorb losses at the point of a DTI's non-viability before taxpayers are exposed to loss. The NVCC requirements support the capital standards set out in Basel III: A global framework for more resilient banks and banking systems.

OSFI's Principles Governing NVCC

Effective January 1, 2013, all Tier 1 and Tier 2 capital instruments issued by DTIs other than common shares must comply with the following principles set out in the Advisory:

1. They must include a clause in their contractual terms requiring a full and permanent conversion into common shares of the DTI upon the occurrence of a trigger event. The Advisory states that OSFI will consider and permit the inclusion of NVCC instruments with alternative mechanisms, including conversions into shares of a parent firm or affiliate, on a case-by-case basis (an option that was not contemplated in the draft Advisory).
   
2. They must meet all criteria for the inclusion as Additional Tier 1 or Tier 2 capital under Basel III in addition to the NVCC requirements.
   
3. The contractual terms must include two specified trigger events:
   
   (a) a public announcement by the Superintendent to the effect that the DTI has been advised that the Superintendent is of the opinion that the DTI has ceased, or is about to cease, to be viable and that, after the conversion of all contingent instruments and taking into account any other relevant factors, it is reasonably likely that the viability of the DTI will be restored or maintained; or
   
   (b) a Canadian federal or provincial government publicly announces that the DTI has accepted or agreed to accept a capital injection or equivalent support. The Advisory defines "equivalent support" as support for a non-viable DTI that enhances the DTI's risk-based capital ratios or is funding provided on terms other than normal terms and conditions. The Advisory notes that equivalent support does not include certain forms of assistance and support provided by the Bank of Canada or the Canada Deposit Insurance Corporation.²
   
   Under the trigger event described in (a), it is the Superintendent who decides, not the institution. She may have considered the option of a merger or sale before or be contemplating one after the trigger event.³ Certainly, the option of being able to convert to common shares is preferable to the investors than the other option of a write-off which was also provided for under Basel III.
   
4. The conversion terms of new NVCC instruments must reference the market value of common equity on or before the date of the trigger event. Importantly, the conversion method must include a cap on the number of shares issued upon a trigger event, thereby ensuring that holders of NVCC instruments suffer some degree of loss. The Advisory does not address how NVCC instruments to be converted into common shares are to be valued for purposes of determining the conversion method (e.g., face or market value). One conversion methodology that has received high level attention would see sub debt converted into the number of common shares determined by (a) multiplying the principal amount of such debt and any accrued and unpaid interest by a fraction, the denominator of which is the average mid-day market value of all outstanding preferred shares based on the last 10 trading days and the numerator of which is the aggregate stated value of such preferred shares and then (b) dividing such product by the average mid-day per share market value of common shares during the last 10 trading days. NVCC preferred shares would be converted into the number of common shares determined by dividing the stated value of such preferred shares by the average mid-day per share market value of common shares during the last 10 trading days.
   
5. The conversion method should take into account the hierarchy of claims in liquidation⁴ and should result in the significant dilution of pre-existing common shareholders. This is reflected in the conversion methodologies discussed at 4 above.
   
6. To the extent that it is within the issuing DTI's control, there are to be no impediments to conversion so that conversion will be automatic and immediate. Among other things, this means that DTIs will need to have an unlimited number of common shares or, if there is an authorized number of common shares, the number of authorized common shares will need to be sufficiently large given the maximum number of common shares into which NVCC instruments could be converted.
   
7. The terms and conditions of the non-common capital instruments must specify that conversion does not constitute an event of default under that instrument and the issuing DTI must take all commercially reasonable efforts to ensure that conversion is not an event of default or credit event under any other agreement entered into by the DTI (senior debt agreements and, in particular, derivative contracts). As well, the terms and conditions of other agreements must not provide for the prior consent of the parties in respect of the conversion.
   
8. The NVCC instrument should include a mechanism to deal with NVCC investors that are prohibited under the DTI's governing legislation from acquiring common shares in the DTI (e.g., DTIs are generally prohibited from issuing shares to governments or government agents and agencies) upon a trigger event. The specific reference to trust arrangements that was included in the draft Advisory has been removed in the final version of the Advisory. The NVCC instruments should allow persons prohibited from acquiring common shares in the DTI to transfer their entitlements to a person that is permitted to own shares in the DTI and allow such transferee to thereafter receive direct share ownership.
   
9. For DTIs that are subsidiaries of foreign financial institutions subject to Basel III capital adequacy requirements, any NVCC issued by the DTI must be convertible into common shares of the DTI or, subject to the prior consent of OSFI, common shares of the DTI's parent or affiliate.⁵ The trigger events in a DTI's NVCC instruments must not include triggers that are at the discretion of a foreign regulator or are based upon events applicable to an affiliate.
   
10. For DTIs that have subsidiaries in foreign jurisdictions that are subject to the Basel III capital adequacy requirements, the DTI may, to the extent permitted by the Basel III rules, include the NVCC issued by foreign subsidiaries in the DTI's consolidated regulatory capital provided certain criteria relating to the foreign subsidiary's NVCC are satisfied, including that such NVCC include triggers equivalent to those specified in 3 above. This is important for Canada's major Schedule I banks. OSFI would only activate triggers in this context after consultation with the host authority where: (1) the subsidiary is non-viable, as determined by the host authority, and (2) the parent DTI is, or would be, non-viable, as determined by OSFI, as a result of providing or committing to provide a capital injection or similar support to the subsidiary.

Confirming the Quality of NVCC Instruments

The Advisory strongly encourages DTIs to seek confirmations of capital quality from OSFI's Capital Division prior to issuing NVCC instruments. The Advisory sets out extensive information requirements in connection with such requests, including the following:

• An external legal opinion addressed to OSFI confirming that the contingent conversion feature is enforceable, that the issuance has been duly authorized and is in compliance with applicable law and, importantly, that there are no impediments to the automatic conversion of the NVCC instrument into common shares upon a trigger event.
• Where the terms of the instrument include a redemption or similar feature upon a tax event (e.g., where a deduction is no longer available to the issuer), an external tax opinion confirming the original availability of such deduction in respect of interest or distributions payable on the instrument for income tax purposes. The Advisory states that OSFI reserves the right to require a Canada Revenue Agency advance tax ruling to confirm such tax opinion if the tax consequences are subject to material uncertainty. This would obviously add considerable time and expense.
• An accounting opinion (which OSFI may require be from an external firm if the accounting consequences are subject to material uncertainty) describing the proposed treatment and disclosure of the NVCC instrument in the DTI's financial statements.
• Where the initial interest or coupon rate payable on the instrument resets periodically or the basis of the interest rate changes from fixed to floating, or vice versa, at a pre-determined future date, calculations demonstrating that no incentive to redeem, or step-up, will arise upon the change in the initial rate.
• Where the terms of the instrument provide for triggers in addition to the two mandatory triggers discussed above, the rationale for the additional triggers and a detailed analysis of the possible market implications. The Advisory does not discuss the type of additional triggers OSFI has in mind.⁶
• A detailed description outlining the rationale for the specified conversion method, including computations of the indicative level of dilution of the DTI's common shares that would occur upon a trigger event, the indicative relative allocation of common shares between original capital providers following the most probable trigger event scenario and an explanation of why such conversion methodology complies with these principles and would enhance the viability of an otherwise non-viable DTI. Neither "indicative" (which replaces the term "expected" used the draft Advisory) nor "most probable" are defined.
• Capital projections that demonstrate that the DTI will be in compliance with the DTI's internal target capital ratios, the DTI's authorized assets-to-capital multiple, applicable Basel III capital and leverage ratios, and any capital composition requirements at the end of the quarter in which the NVCC instrument is expected to be issued and during the transition to full compliance with Basel III.
• An assessment of the features of the proposed capital instrument against Basel III requirements and the principles in the Advisory. This assessment would be required for an initial issuance or precedent and not subsequent issuances.

Issuance of Capital Instruments Prior to January 1, 2013

The Advisory states that DTIs may continue to issue capital instruments that do not comply with the NVCC requirement, but otherwise meet the Basel III criteria for inclusion as Additional Tier 1 or Tier 2 capital, until January 1, 2013. As of that date, all outstanding capital instruments that do not meet the NVCC requirement will be considered non-qualifying capital instruments and will be phased out beginning January 1, 2013 at the rate of 10% each year for 10 years.⁷

DTIs wishing to issue NVCC compliant Tier 1 and Tier 2 instruments prior to January 1, 2013 may do so. DTIs may also amend existing capital instruments that do not comply with the NVCC requirement to achieve compliance or take other action (e.g., exchange offers) to mitigate the effects of non-compliance. In this regard, it is noteworthy that CIBC announced on August 17, 2011 – one day after the release of the Advisory – that it has received confirmation from OSFI that its non-cumulative Class A preferred shares, Series 26, 27 and 29 will be treated as NVCC for the purposes of determining regulatory capital under Basel III. One of the actions CIBC took in connection with receiving this confirmation was to provide an undertaking to OSFI that CIBC will immediately exercise its rights to convert each of the preferred shares into common shares upon the occurrence of a trigger event.

Criteria to be Considered in Triggering Conversion of NVCC

The decision of whether to maintain a DTI as a going concern where it would otherwise become non-viable will be informed by OSFI's interaction with the Financial Institutions Supervisory Committee (FISC), which is comprised of OSFI, the Canada Deposit Insurance Corporation, the Bank of Canada, the Department of Finance, and the Financial Consumer Agency of Canada, and any other relevant agencies the Superintendent determines should be consulted. The Advisory notes that the conversion of NVCC would likely be used along with other public sector intervention, including liquidity assistance, to maintain a DTI as a going concern. The Advisory goes on to state that in assessing whether a DTI has ceased, or is about to cease, to be viable and that, after the conversion of all contingent capital instruments, it is reasonably likely that the viability of the DTI will be restored or maintained, the Superintendent would consider all relevant facts and circumstances, including the criteria outlined in relevant legislation and regulatory guidance.⁸

The Advisory provides the following examples of the criteria that the Superintendent would consider in determining whether to trigger conversion of a NVCC instrument:

• Whether the assets of the DTI are sufficient to provide adequate protection to its depositors and creditors.
• Whether the DTI has lost the confidence of depositors or other creditors and the public.
• Whether the DTI's regulatory capital has reached a level, or is eroding in a manner, that may detrimentally affect its depositors and creditors.
• Whether the DTI failed to, or will not be able to, pay any liability that has or will become due and payable.
• Whether the DTI failed to comply with an order of the Superintendent to increase its capital.
• Whether any other state of affairs exists in respect of the DTI that may be materially prejudicial to the interests of its depositors or creditors or the owners of any assets under the DTI's administration, including where proceedings under a law relating to bankruptcy or insolvency have been commenced in Canada or elsewhere in respect of the holding body corporate of the DTI.
• Whether the DTI is unable to recapitalize on its own through the issuance of common shares or other forms of regulatory capital. In the case of a privately-held DTI, this would mean that the parent firm or entity is unable or unwilling to provide further support to the subsidiary.

Looking Ahead

Now that the final NVCC rules have been promulgated, DTIs will need to sharpen their focus on implementing these rules. There are certain matters that will need to be considered in connection with new issuances of NVCC instruments, including ratings,⁹ design of conversion features, inclusion of these instruments in trading indices, and investor demand for these instruments.¹⁰ While these matters may take some time to sort out, the cut-off date of January 1, 2013 is fast approaching and so we can expect to see, reasonably soon, DTIs issuing new NVCC compliant instruments and taking steps to deal with existing instruments that do not meet the NVCC requirement.

The Advisory states that OSFI is considering the application of Basel III, including NVCC, to cooperative credit associations, insurers, and other federally regulated entities. Accordingly, the Advisory may not be the last word on NVCC in Canada.

Footnotes

1. The draft NVCC Advisory was discussed as part of a broader overview of Basel III and related OSFI initiatives in Fasken Martineau's February 2011 Bulletin Basel III – Implications and OSFI Guidance.

2. As discussed below, these types of assistance and support may also be used to preserve the viability of DTIs and will be relevant in determining whether the Superintendent will trigger conversion of an NVCC instrument.

3. The context in which the Superintendent would exercise her discretion and the criteria to be considered by the Superintendent in further discussed below under the heading "Criteria to be considered in triggering conversion of NVCC".

4. That is, former holders of subordinated debt are to receive economic entitlements more favourable than those provided to former preferred shareholders, and former preferred shareholders are to receive economic entitlements more favourable than those provided to pre-existing common shareholders.

5. Schedule II banks had lobbied strongly for this option of having NVCC convertible into common shares of a parent or affiliate, which, as discussed above, was not contemplated in the draft Advisory.

6. For example, whether "going concern" triggers such as regulatory capital falling below a specified level would be acceptable.

7. As set out in OSFI's Advisory Treatment of Non-Qualifying Capital Instruments released in February 2011.

8. The Advisory specifically refers to OSFI's Guide to Intervention for Federally-Regulated Deposit-Taking Institutions in this regard.

9. Following the release of the Advisory, DBRS stated that subordinated debt NVCC will likely be rated no higher than the standard rating for preferred shares and preferred share NVCC instruments will likely be rated one notch below the standard rating for preferred shares.

10. A concern has been expressed that since DTIs will invest in NVCC instruments issued by other DTIs, any future problems with one or more DTIs will ultimately affect other DTIs. On the other hand, it has been observed that risk of contagion of this sort already exists given the extent of inter-DTI securityholdings.

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