Canada: OSFI Releases Final Advisory On Non-Viability Contingent Capital

On August 16, 2011, the Office of the Superintendent of Financial Institutions Canada (OSFI) released the final advisory (Final Advisory) outlining its expectations in respect of issuance of non-viability contingent capital (NVCC) by banks, bank holding companies and federally-regulated trust and loan companies (DTIs). In February 2011, OSFI had released a draft advisory (Draft Advisory) in respect of NVCC. The Final Advisory (full text available here) is largely similar to the Draft Advisory with a few exceptions (blacklined document available here). Below is a summary of the main highlights of the Final Advisory.

Principles Governing NVCC

Effective January 1, 2013 (the Cut-off Date), all non-common Tier 1 and Tier 2 capital instruments issued by DTIs must comply with the following principles to satisfy the NVCC requirement:

• Principle #1: Non-common Tier 1 and Tier 2 capital instruments must have, in their contractual terms and conditions, a clause requiring a full and permanent conversion into common shares of the DTI upon a trigger event. 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.
• Principle #2: All NVCC instruments must also meet all other criteria for inclusion under their respective tiers as specified in Basel III.
• Principle #3: The contractual terms of all Additional Tier 1 and Tier 2 capital instruments must, at a minimum, include the following trigger events:

Additional Tier 1 instruments classified as liabilities for accounting purposes must also include an additional capital trigger pursuant to criterion # 11 of the criteria for inclusion in Additional Tier 1 specified in paragraph 55 of Basel III (which provides that such instruments must have principal loss absorption through either (i) conversion to common shares at an objective pre-specified trigger point or (ii) a write-down mechanism which allocates losses to the instrument at a pre-specified trigger point).

OSFI has now provided more guidance on the term "equivalent support" in the above second trigger. The term "equivalent support" constitutes support for a non-viable DTI that enhances the DTI's risk-based capital ratios or is funding that is provided on terms other than normal terms and conditions. Equivalent support will not include: (i) Emergency Liquidity Assistance provided by the Bank of Canada at or above the Bank Rate; (ii) open bank liquidity assistance provided by CDIC at or above its cost of funds; and (iii) support, including conditional, limited guarantees, provided by CDIC to facilitate a transaction, including an acquisition or amalgamation. In addition, shares of an acquiring DTI paid as non-cash consideration to CDIC in connection with a purchase of a bridge institution would not constitute equivalent support triggering the NVCC instruments of the acquirer as the acquirer would be a viable financial institution.

• Principle #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. The conversion method must also include a limit or cap on the number of shares issued upon a trigger event. This principle was not included in the Draft Advisory.
• Principle #5: The conversion method should take into account the hierarchy of claims in liquidation and result in the significant dilution of pre-existing common shareholders (e.g., former subordinated debt holders should receive economic entitlements that are more favourable than those provided to former preferred shareholders and former preferred shareholders should receive economic entitlements that are more favourable than those provided to pre-existing common shareholders).
• Principle #6: The issuing DTI must ensure that, to the extent that it is within the DTI's control, there are no impediments to the conversion so that conversion will be automatic and immediate. For example, the DTI's by-laws, other relevant constating documents, agreements and terms and conditions of capital instruments must permit the issuance of common shares upon conversion without prior approval of the relevant capital providers or counterparties to agreements. In addition, DTIs should obtain all prior authorizations, including regulatory approvals and listing requirements, to issue the common shares arising upon conversion.
• Principle #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. DTIs 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 them, directly or indirectly, on or after the date of the Final Advisory (August 16, 2011), including senior debt agreements and derivative contracts.
• Principle #8: The terms of the NVCC instrument should include provisions to address NVCC investors that are prohibited, pursuant to the legislation governing the DTI, from acquiring common shares in the DTI upon a trigger event.
• Principle #9: For DTIs, including Schedule II banks, that are subsidiaries of foreign financial institutions that are 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, convertible into common shares of the DTI's parent or affiliate (OSFI expects that such consent would be granted primarily in respect of conversions to common shares of the ultimate parent. OSFI has indicated that it will consider conversions into shares of other affiliates under exceptional circumstances only, including where the shares of an affiliate are listed or where the DTI has no controlling parent). In addition, 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 (such as an event in the home jurisdiction of a DTI's parent).
• Principle #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 that such foreign subsidiary's NVCC complies with the NVCC requirements according to the rules of its host jurisdiction. NVCC instruments issued by foreign subsidiaries must, in their contractual terms, include triggers that are equivalent to the triggers specified in Principle # 3 above. OSFI will only activate such triggers in respect of a foreign subsidiary after consultation with the host authority where (i) the subsidiary is non-viable as determined by the host authority and (ii) 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. This treatment is required irrespective of whether the host jurisdiction has implemented the NVCC requirements on a contractual basis or on a statutory basis.

Information Requirements to Confirm Quality of NVCC Instruments

OSFI has indicated that DTIs are strongly encouraged to seek confirmations of capital quality from OSFI's Capital Division prior to issuing NVCC instruments (this will avoid the risk of OSFI making a subsequent determination that such instruments do not comply with the principles set out above). The Final Advisory lists a number of informational items that OSFI expects to be provided by DTIs in connection with their request for capital quality confirmation. This list includes draft terms of the NVCC instruments, copies of DTIs' by-laws or other constating documents, legal, tax and accounting opinions, a detailed description outlining the rationale for the specified conversion method, and an assessment of the features of the proposed capital instrument against the minimum criteria for inclusion in Additional Tier 1 capital or Tier 2 capital, as applicable, as set out in Basel III as well as the principles for NVCC instruments set out in the Final Advisory. See the full text of the Final Advisory for a complete list of these items.

Issuance of Capital Instruments prior to the Cut-off Date

• DTIs wishing to issue NVCC compliant Tier 1 and Tier 2 instruments prior to the Cut-off Date may do so following the release of the Final Advisory.
• 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 the Cut-off Date. Such instruments would be subject to phase-out beginning on January 1, 2013 as outlined in OSFI's Advisory Treatment of Non-Qualifying Capital published on February 4, 2011.
• In the Draft Advisory, OSFI indicated that DTIs are encouraged to amend the terms of their existing non-common instruments that do not comply with the NVCC requirement to thereby achieve compliance, or to otherwise take actions, including exchange offers, which would mitigate the effects of such non-compliance. In the Final Advisory, OSFI has indicated that DTIs may consider making such amendments but has deleted the language "encouraging" DTIs to amend their existing non-common instruments.

Criteria to be considered in Triggering Conversion of NVCC

As was stated in the Draft Advisory, OSFI has reiterated in the Final Advisory that the determination of 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, will depend on a number of factors. OSFI has provided the following criteria as a non-exhaustive list of considerations that would be relevant to OSFI's determination:

• Whether the assets of the DTI are, in the opinion of the Superintendent, sufficient to provide adequate protection to the DTI's depositors and creditors.
• Whether the DTI has lost the confidence of depositors or other creditors and the public. This may be characterized by ongoing increased difficulty in obtaining or rolling over short-term funding.
• Whether the DTI's regulatory capital has, in the opinion of the Superintendent, reached a level, or is eroding in a manner, that may detrimentally affect its depositors and creditors.
• Whether the DTI failed to pay any liability that has become due and payable or, in the opinion of the Superintendent, the DTI will not be able to pay its liabilities as they become due and payable.
• Whether the DTI failed to comply with an order of the Superintendent to increase its capital.
• Whether, in the opinion of the Superintendent, any other state of affairs exists in respect of the DTI that may be materially prejudicial to the interests of the DTI's 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. For example, no suitable investor or group of investors exists that is willing or capable of investing in sufficient quantity and on terms that will restore the DTI's viability, nor is there any reasonable prospect of such an investor emerging in the near-term in the absence of conversion of NVCC instruments. Further, in the case of a privately-held DTI, including a Schedule II bank, the parent firm or entity is unable or unwilling to provide further support to the subsidiary.

Stephen Clark's practice focuses on financial institutions and corporate finance. Kashif Zaman is a partner in the Financial Institutions Group. Kashif regularly acts for a number of the major Canadian banks, major non-Canadian financial institutions and investment banks. Victoria Graham's practice focuses on corporate and regulatory issues relating to financial institutions and public and private corporations, including mergers and acquisitions, reorganizations, restructurings and corporate finance

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