News News Bulletin August August 15, 2008 15, 2008 4 Defining Hybrid Capital Hybrid Capital In the In the current current environment of bank of bank recapitalisations, has it has never never been been more more important important for banks for banks to know to know what what capital-raising tools tools are are at their at their disposal. disposal. However, despite despite the the implementation of Basel of Basel II in II Europe in Europe by the by the introduction of the of the Capital Capital Requirements Directive Directive ( CRD ), ("CRD"), a common a common approach approach to the to definition the defnition and and treatment treatment of eligible of eligible hybrid hybrid capital capital has has eluded eluded European European member member state state regulators. This This in turn in turn means means that that a level a level playing playing field field for for European banks banks as they as they compete compete for new for new capital capital is some is some way way off. off. One One of the of the main main purposes purposes of the of the European Commission s Commission's recent recent Public Public Consultation on possible possible changes changes to the to the CRD CRD is to is provide to provide clarity clarity and and uniformity as to as the to the treatment treatment of hybrid of hybrid capital. capital. It builds It builds on on the the 1998 1998 public public statement statement on hybrid on hybrid Tier Tier 1 capital 1 capital by by the the Basel Basel Committee on on Banking Supervision, known known as as the the Sydney Sydney Press Press Release, Release, and follows and follows on from on from the Proposal the "Proposal for a for common a common EU definition EU definition of Tier of Tier 1 hybrids 1 hybrids" published published in April in April 2008 2008 by the by the Committee of of European Banking Supervisors ( CEBS ), ("CEBS"), which which was was commissioned by the by the European Commission on this on this subject. subject. The The proposed proposed changes changes to the to CRD the CRD are to are introduce to introduce criteria criteria that that need need to be to fulfilled be fulfilled by hybrid by hybrid capital capital instruments in order in order for these for these instruments to be to eligible be eligible as Tier as Tier 1 capital 1 capital of credit of credit institutions. The The criteria criteria focus focus on three on three main main eligibility eligibility criteria criteria of hybrid of hybrid capital capital instruments - - permanence, flexibility fexibility in in payments and and loss loss absorption. In addition In addition to to establishing these these criteria, criteria, the the proposed changes changes also also set quantitative set quantitative limits limits on the on the use use of different of different types types of hybrid of hybrid capital capital instruments towards towards satisfying satisfying a credit a credit institution s institution's Tier Tier 1 capital 1 capital requirements. The The proposed proposed changes changes also also provide provide for a for grandfathering a "grandfathering" clause clause with with regard regard to to instruments already already issued issued and and prescribe prescribe a a transitional period period before before compliance with with the the amended CRD CRD provisions will will be be mandatory for for European European credit credit institutions. Tier Tier 1 Eligibility 1 Eligibility Criteria Criteria The The proposed proposed Tier Tier 1 eligibility 1 eligibility criteria criteria are: are: (a) (a) As to As to permanence: (i) the (i) the instrument must must be be undated, or or have have a a maturity of at of least at least 30 30 years years (the (the CEBS CEBS Proposal Proposal recommended that that only only undated undated instruments should should be eligible); be eligible); (ii) (ii) the the instrument may may include a call a call option option at the at the issuer s issuer's sole sole discretion, but but this this may may not not be be exercisable earlier earlier than than 5 years 5 years from from the the issue issue date; date; 1 Attorney Attorney Advertisement 1
(iii) (iii) the the instrument may may include a moderate a "moderate" incentive (such (such as a as step-up a step-up in interest interest rate) rate) for the for the issuer issuer to redeem to redeem the the instrument, but but such such incentive incentive may may not not become become operative operative earlier earlier than than 10 years io years from from the the issue issue date. date. There There is no is guidance no guidance on what on what a moderate a moderate incentive incentive is in is this in this context, context, despite despite the the CEBS CEBS Proposal Proposal having having recommended that that moderate "moderate" in this in this context context means means no greater no greater than than (i) 100 (i) ioo basis basis points points or (ii) or 50% (ii) 50% of the of the initial initial credit credit spread, in each in each case case less less the the swap swap spread spread between between the initial the initial index index basis basis and and the the stepped-up index index basis. basis. Instead, Instead, the European the European Commission Consultation states states that that the the competent authorities will will determine whether whether an incentive an incentive exists exists and and whether whether it is it moderate, is "moderate," the the implication being being that that if they if they determine that that it is it more is more than than moderate, they they should should not not allow allow such such an an instrument to count to count towards towards the the institution s institution's Tier Tier 1 capital, 1 capital, although although this this not is not expressly expressly stated. stated. It also It also does does not expressly not expressly limit limit the the hybrid hybrid instrument to one to one coupon coupon step-up, as as recommended in the in the CEBS CEBS Proposal; (iv) (iv) the the instrument may may be be redeemed only only with with prior prior permission of the of the competent authorities, who who may may grant grant such such permission subject subject to certain to certain conditions, such such as that as that the financial the financial condition condition or solvency or solvency of the of the issuer issuer not is affected not affected and and that that the the instrument is replaced is replaced by by instruments which which are are at least at least equity-like as "equity-like" as the as the instrument being being redeemed; (v) (v) the the instrument may may not not be be redeemed for so for long so long as the as issuer the issuer not is in not compliance in compliance with with its minimum its minimum capital capital requirements set out set out in Article in Article 75 of 75 the of the CRD; CRD; and and (vi) (vi) the the competent authority may may permit permit early early redemption of the of the instrument the in the event event of a of change a change in in national national tax tax treatment or regulatory classification classifcation which which was was unforeseen at the at the issue issue date date of the of the instrument. (b) (b) As to As to flexibility of of ongoing payments: (i) the (i) the issuer issuer must must be allowed be allowed (whether (whether by the by terms the terms of the of the instruments or by or any by any relevant relevant statutory statutory provisions) to cancel, to cancel, when when necessary, necessary, the payment the payment of interest of interest and dividends and dividends for an for unlimited an unlimited period period of of time, time, on a on a non-cumulative basis; basis; (ii) (ii) the the issuer issuer shall shall be obliged be obliged to cancel to cancel such such payments payments if it does if it does not comply not comply with with its capital its capital requirements in Article in Article 75 of 75 the of the CRD; CRD; (iii) (iii) the the competent authorities may may require the the cancellation of of such such payments based based on the on the issuer s issuer's financial financial condition and and solvency; solvency; and and (iv) (iv) any any such such cancellation does does not preclude not preclude the payment the payment of interest of interest or dividend or dividend in the in form the form of common of common stock, stock, provided provided that that any any such such mechanism allows allows the the issuer issuer to preserve to preserve financial fnancial resources, and and such such a a scrip scrip payment payment may may be subject be subject to specific to specifc conditions conditions imposed imposed by the by competent the competent authorities. This This an is an important clarification clarifcation for for issuers issuers which which are are tax-resident in the in UK. the UK. In the In the order order for them for them to obtain to obtain tax tax deductions coupons on coupons paid paid on hybrid on hybrid instruments, the the instrument must must not constitute not constitute a results-driven a "results-driven" instrument, i.e. i.e. under under the the terms terms of the of the instrument payments of coupon of coupon must must not not be be dependent upon upon the the issuer s issuer's financial financial results results or or condition. Therefore, the the concept concept of of cancellation of coupons of coupons is a is problem a problem for for UK tax UK resident tax resident issuers, issuers, unless unless the coupon the coupon is replaced is replaced with with an an alternative payment, payment, such such as under as under an an Alternative Coupon Coupon Satisfaction Mechanism. These These have have been been common common features features of UK of hybrid UK hybrid instruments to date to date and and it appears it appears that that these these mechanisms will will be able be able to continue to continue being being used. used. (c) As (c) to As loss to loss absorption: (i) in (i) the in the event event of the of the bankruptcy or or liquidation of the of the issuer, issuer, the the instrument shall shall rank rank after after claims claims of of subordinated creditors creditors and and cumulative preferential shares, shares, i.e. it i.e. will it rank will rank immediately ahead ahead of ordinary of ordinary share share capital; capital; and and (ii) (ii) the the statutory or contractual provisions governing the the instrument must must provide provide for principal, for principal, unpaid unpaid interest interest and and dividends to be to such be such as to as absorb to absorb losses, losses, and to and not to hinder not hinder recapitalisation of the of the issuer. issuer. 2 Attorney Attorney Advertisement 2
(d) (d) Generally: (i) only (i) only fully fully paid-up amounts of such of such instruments can can be taken be taken into into account account in determining compliance with with the the issuer s issuer's Article Article 75 minimum 75 minimum capital capital requirements; (ii) (ii) the the instrument may may not not be be redeemed at the at option the option of the of the instrument holder; holder; and and (iii) (iii) the the terms terms of the of the instrument must must provide for for debt debt and and unpaid interest to to be be such such as as to absorb to absorb losses, losses, whilst whilst leaving leaving the the issuer issuer in a in position a position to continue to continue trading. trading. The The proposed proposed quantitative limits limits are are as follows: as follows: (a) (a) hybrid hybrid instruments that that are are convertible in in emergency situations into into a a pre-determined fixed fixed number number of of common common stock stock may may not exceed not exceed 50% 50% of the of issuer s the issuer's total total Tier 1 Tier capital, 1 capital, after after deducting deducting the book the book value value of own of shares own shares held held by the by issuer, the issuer, intangible intangible assets assets and and current current year year losses losses ( Total ("Total Net Net Tier Tier 1 Capital ); 1 Capital"); (b) (b) hybrid hybrid instruments not not falling falling within the the descriptions in in (a) (a) above or or (c) (c) below below may may not not exceed exceed 35% 35% of the of the issuer s issuer's Total Total Net Net Tier Tier 1 Capital; 1 Capital; (c) (c) hybrid hybrid instruments which which are are dated dated and and which, which, by by their their contractual terms terms or the or the statutory provisions governing governing them, them, provide provide for for an an incentive for for the the issuer issuer to redeem to redeem (such (such as a as step-up a step-up coupon) coupon) may may not not exceed exceed 15% 15% of the of issuer s the issuer's Total Total Net Net Tier Tier 1 Capital; 1 Capital; and and (d) (d) the the aggregate amount amount of all of all instruments specified in in paragraphs (a) (a) to (c) to (c) above above may may not not exceed exceed 50% 50% of of the issuer s the issuer's Total Total Net Net Tier Tier 1 Capital. 1 Capital. Existing Existing hybrid hybrid Tier Tier 1 1 instruments that that do not do not meet meet all the all the proposed eligibility eligibility criteria criteria will will nevertheless remain remain eligible eligible as Tier as Tier 1 capital 1 capital for 30 for years 30 years from from the effective the effective date date of the of CRD the CRD amendments, provided provided that after that afer 10 years io years from from the the effective effective date date they they do not, do not, in in aggregate, exceed exceed 20% 20% of Total of Total Net Net Tier Tier 1 Capital, 1 Capital, and and after after 20 years 20 years from from the effective the effective date date they they do not, do not, in in aggregate, exceed exceed 10% io% of Total of Total Net Net Tier Tier 1 Capital. 1 Capital. Important Considerations Responses Responses to the to the consultation which which were were published published by the by the European European Commission raised raised various various issues issues with with the the proposed CRD CRD changes. changes. The The most most common common criticism criticism was was directed directed at the at the requirement that that the the loss loss absorbing provisions of the of the hybrid hybrid instrument should should not"not hinder hinder recapitalisation recapitalisation" of the of the issuer issuer and and should should leave leave the institution the institution in a "in position a position to to continue continue trading. trading." No No guidance has has been been provided provided as to as how to how national national regulators are are to interpret to interpret these these provisions and and it is it thought is thought that that they they are are likely likely to have to have regard regard to the to the more more detailed detailed proposals set set out out in the in the CEBS CEBS Proposal. Proposal. In the In the CEBS CEBS Proposal, Proposal, it was it was stressed stressed that hybrid that hybrid instruments should should be able be able to absorb to absorb losses losses both both in a liquidation in a liquidation (by (by virtue virtue of the of the instrument ranking ranking senior senior only only to ordinary to ordinary share share capital capital in terms in terms of priority of priority of of payment in a in a liquidation), and and also also on on a going a going concern concern basis. basis. The The concept concept of of absorption of losses of losses on on a going a going concern concern basis basis has has so far so proved far proved to be to the be most the most difficult difficult proposed proposed feature feature to define to define clearly. clearly. CEBS CEBS suggested suggested that absorption that absorption of losses of losses on a on going a going concern concern basis basis means means that the that instrument the instrument should should (i) help (i) help to to prevent prevent the the issuer s issuer's insolvency insolvency (which (which the the subordination of the of the instrument on liquidation does does not not achieve), and and (ii) make (ii) make the the recapitalisation of the of the issuer issuer more more likely. likely. As to As helping to helping to prevent to prevent the the issuer s issuer's insolvency, CEBS CEBS recommend recommend that that the following the following conditions should should be met: be met: the the instrument should be be permanent; 3 Attorney Attorney Advertisement 3
the the issuer should have have the the ability ability to to cancel cancel payments of of coupons/dividends; the the instrument would not be be taken into into account for for the the purposes of of determining whether the issuer issuer is insolvent; insolvent; and and the the holder of of the the instrument should not not be be in in a a position to to trigger an an insolvency procedure against against the the issuer issuer (and (and therefore therefore must must have have no right no right to demand to demand redemption of the of the instrument or payment or payment of a of a coupon/dividend). In relation In relation to the to the requirement of the of the instruments not not being being taken taken into into account in a in a determination of of solvency, CEBS CEBS suggested suggested two possible two possible features features that would that would allow allow the instrument the instrument to achieve to achieve this this first - first the ability the ability of the of the issuer issuer to convert to convert the the instrument into into common equity, equity, and and second second the the ability ability of the of the issuer issuer to write-down to "write-down" (whether (whether on a on permanent a permanent or temporary temporary basis) basis) the principal the principal amount amount of the of the instrument. Respondents noted noted that that a hybrid a hybrid instrument that that can can be converted be converted into into common common shares shares at the at issuer s the issuer's option option may may be be unattractive to some to some investors investors and and therefore therefore increase increase the pricing the pricing of the of the instrument for the for the issuer. issuer. Even Even less less attractive attractive for investors for investors is a is a permanent write-down "write-down" of principal, of principal, which which may may put put the the holder holder of the of the hybrid hybrid instrument a in worse a worse position position than than ordinary an ordinary shareholder, since since the the shareholder may may benefit beneft from from future future rises rises in the in the share share price price and and is, therefore, is, therefore, inconsistent with with the general the general principle principle that that a hybrid a hybrid instrument should should rank rank ahead ahead of ordinary of ordinary shares. shares. Other Other problems problems surrounding the the concept concept of of conversion into into ordinary ordinary shares shares and and principal principal write-downs are are the the quantum. quantum. No No suggestions were were made made by the by CEBS the CEBS as to as how to how to determine to determine the appropriate the appropriate amount amount of principal of principal to to be written be written down, down, or or converted into into ordinary shares, especially where where there there are are multiple multiple series series of hybrid of hybrid instruments issue. in issue. For For UK-tax UK-tax resident resident issuers, issuers, the concept the concept of a of a write-down or a or a conversion may may also also create create problems problems for the for issuer the issuer if if the the write write down down or or conversion gives gives rise rise to a to credit a credit in accounting terms, terms, as this as this could could create create an an additional tax tax liability liability for for the the issuer issuer at a at time a time when when it is it in is financial fnancial distress. distress. Conclusions These These attempts attempts to to harmonise the the meaning meaning of hybrid of hybrid Tier Tier 1 capital 1 capital across across Europe Europe are are a major a major step step forward. forward. However, However, the proposed the proposed CRD CRD changes changes still leave still leave open open many many questions questions about about the detailed the detailed interpretation of certain of certain of the of proposals, the proposals, meaning meaning that that there there will still will still be significant be significant scope scope for differing for differing interpretations of the of the provisions by by different different national national regulators and, and, therefore, therefore, will will not not fully fully achieve achieve the the goal goal of a of level a level playing playing field feld for for European credit credit institutions. The The European Commission has stated has stated that it that expects it expects to publish to publish its firm its frm proposals for for changes changes to the to the CRD CRD in in September 2008. 2008. However, the the Basel Basel Committee is also is also currently currently conducting a review a review of capital of capital and and its meaning its meaning and and it would it would seem seem desirable for for the the proposed charges charges to the to CRD the CRD to be to delayed be delayed until until it is it clearer is clearer what what recommendations the Basel the Basel Committee Committee will will suggest, suggest, since since this could this could lead lead to a to further a further round round of changes of changes to the to the CRD. CRD. 4 Attorney 4 Attorney Advertisement
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