Regulatory Capital. Adoption of CRD Amendments, Publication of CEBS Consultation Paper and Publication of the UK Government s Report on Reforming financial markets Introduction Contents Incccc Introduction 1 CRD Amendments 2 CEBS Consultation Paper 4 The UK Government s Report 8 On 6 May 2009 the European Parliament adopted a number of amendments (the Amendments ) to the Capital Requirements Directive (the CRD ). The Amendments include new provisions in relation to regulatory capital instruments, including provisions regarding eligibility criteria for hybrid instruments. To see the full text of the Amendments, click here. On 22 June 2009, the Committee of European Banking Supervisors ( CEBS ) published a consultation paper (the CP ) on certain aspects of the Amendments as they relate to hybrid instruments. The CP was issued in response to the requirement in the CRD that CEBS issue guidelines to ensure convergence of supervisory practices in relation to hybrid instruments. Comments are invited by 23 September 2009, with a public hearing to be held on 8 September 2009. To see the full text of the CP, click here. On 8 July 2009, the UK Government published a document entitled Reforming financial markets (the Report ), in which the UK Government declares that it is working with EU partners to agree a common definition and level of high quality regulatory capital and ensure a more consistent adoption of the Basel Standards. To see the full text of the Report, click here, and to see a Linklaters note on it click here. Our previous stop presses on this topic can be accessed here. We summarise below some of the key parts of the Amendments, the CP and the Report (as it relates to capital instruments). These will certainly lead to the need for changes to the terms and conditions of regulatory capital instruments going forward and, in a UK context, may well lead issuers to use indirect issue structures to address tax concerns arising out of the new requirements. 13 July 2009 1
CRD Amendments Member States are to implement the Amendments into national law by 31 October 2010 and apply the Amendments from 31 December 2010. New Provisions relating to Core Tier 1 Capital Preference shares are to be treated as hybrid instruments rather than as non-innovative tier one capital as is the case under current UK rules. Pursuant to the Amendments (recital (3)), core tier 1 capital may now include: instruments which rank pari passu with ordinary shares in a liquidation and fully absorb losses on a going concern basis pari passu with ordinary shares but which give a preferential, non-cumulative right to dividend payments. This would appear to include instruments such as the B shares to be issued by Lloyds and RBS in connection with the UK government s Asset Protection Scheme; and any other instrument under credit institutions statutory terms taking into account the specific constitution of mutuals, co-operative societies and similar institutions and which are deemed equivalent to ordinary shares in terms of their capital qualities in particular as regards loss absorption. This new text appears to be targeted at instruments such as the Profit Participating Deferred Shares to be issued by the West Bromwich Building Society see our stop press for further details. See also The UK Government s Report below. There is an existing requirement in Article 57(a) of the CRD that, to qualify as a core tier 1 security, an instrument must amount to capital within the meaning of Article 22 of the Accounts Directive. Article 22 requires capital to be regarded under national law as equity capital. It is not clear what the benchmark is for an instrument to be regarded as equity capital and whether a preferred dividend ordinary share would satisfy this requirement. Hybrid Eligibility Criteria Article 57 of the CRD has been amended to make clear that core capital comprises only equity capital, claims in respect of which must rank after all other claims in any liquidation. A new Article 63a has been inserted into the CRD to set out the eligibility criteria for hybrids. Hybrids must rank on a winding-up behind upper tier 2 securities and be undated or have an original maturity of at least 30 years. An issuer call after five years is permitted. In the case of undated instruments, a modest incentive to redeem is permitted but only after 10 years and, in the case of dated instruments, no incentive to redeem is permitted. Earlier tax and capital disqualification calls (but not accounting or rating agency calls) may also be permitted by competent authorities. 2 13 July 2009
Competent authorities are required to suspend redemptions of dated instruments if their issuer does not comply with the Pillar 1 capital requirements set out in Article 75 of the CRD and, in a departure from the Commission Proposals, may require the suspension of the redemption of dated instruments on the basis of the financial and solvency situation of credit institutions. Hybrids must contain provisions permitting the issuer when necessary (and requiring the issuer when in breach of the Pillar 1 requirements) to cancel coupons on a non-cumulative basis. Competent authorities may also require cancellation of payments based on the financial and solvency situation of the issuer. Issuers shall, however, be allowed to make interest/dividend payments in the form of core tier 1 instruments (ACSM) - but subject to restrictions set out in the CP and described below. The requirement that the terms of hybrid instruments are such as to absorb losses and to not hinder the recapitalisation of the credit institution is retained. The provision goes on to provide that this shall be accomplished through appropriate mechanisms, as elaborated by [CEBS]. See below for a description of CEBS comments in this regard. Limits on Hybrid Instruments Instruments that (i) must be converted during emergency situations (which CEBS describes as when an issuer makes significant losses and does not comply with the capital requirements of its competent authority) and (ii) may be converted at the initiative of competent authorities at any time based on the financial and solvency situation of the issuer, in both cases into core tier 1 instruments within a pre-determined range are not to exceed 50% of total tier 1 capital. No more than 35% of total tier 1 capital shall be comprised of hybrid instruments other than those referred to in the bullet above. No more than 15% of total tier 1 capital shall be comprised of dated hybrid instruments and hybrid instruments with an incentive to redeem. Grandfathering of Core Capital instruments Issuers which, by 31 December 2010, do not comply with the new limits on capital described above are required to develop strategies and processes to resolve the situation by the dates set out in Article 154(9). Article 154(9) provides that instruments which, until 31 December 2010, were deemed equivalent to core tier 1 instruments but no longer comply with the new rules for core tier 1 instruments or the new rules for hybrid instruments shall be deemed to be hybrid instruments until 31 December 2040, subject to the following limits: they shall not amount to more than 20% of total tier 1 capital between 2020 and 2030 and Regulatory Capital. 3
they shall not amount to more than 10% of total tier 1 capital between 2030 and 2040. CEBS is required to monitor new issues of capital instruments until the end of 2010, presumably to ensure that the grandfathering provisions are not abused. Article 154(9) has been amended since the final draft of the proposed changes to the CRD. Previously it was unclear whether instruments, such as non-cumulative preference shares, which were previously treated as noninnovative tier 1 securities in the UK would be grandfathered as such. It is now clear that they will not, and that they will be treated as hybrid instruments from the time the CRD changes come into force. Further Changes The Amendments make clear (at recital (4) and Article 156) that further changes to the CRD are to be expected to enhance the quality of capital further. The European Commission is to review the CRD as a whole by the end of 2009, and is to report to the European Parliament with further proposals by no later than 31 December 2011. CEBS Consultation Paper The CP focuses on certain areas of hybrid issuance, namely permanence, flexibility of payments, loss absorbency (in liquidation and going concern), limits on issuance and issues by SPVs. Permanence The CP describes incentives to redeem as any feature that, in combination with a call option, leads to an expectation that the instrument will be redeemed at the call date. Interest rate step-ups and principal stock settlements are given as examples. CEBS states that it is not necessary for the call and step-up/other incentive feature to have the same effective date for there to be an incentive to redeem. Details of the permitted level of step-up are set out in paragraph 54 of the CP. There is to be no more than one step-up over the life of an instrument and, once classified as being in the 15% bucket, an instrument with a step-up will remain in that bucket even if not redeemed on the call date. Guidance is given in paragraphs 59-70 of the CP on the procedure to be followed if a hybrid instrument is to be called or redeemed (including redemption of a dated instrument). This includes a requirement to inform the competent authority of the reasons for the call/redemption and to provide solvency data (before and after call/redemption) both on a current basis and looking three to five years ahead. Competent authorities will 4 13 July 2009
not permit the call/redemption if it jeopardises the financial and solvency situation of the issuer, or if the issuer will not have adequate capital buffers above the minimum requirements, in the foreseeable future. The process applied to redemptions/calls will also be applied to repurchases. In a change to the current requirements in the UK, CEBS states that this means that repurchases will not be permitted before five years after issue, unless a replacement instrument of at least the same quality has already been issued. Market making/market smoothing activities are exempted, provided an issuer does not hold more than 5% of any of its own issues at any given time. No doubt motivated by recent liability management transactions which have been designed to enhance core tier 1 capital, CEBS indicates that a number of its members believe that repurchases should be permitted within five years of issue even if there is no replacement of the repurchased instrument. CEBS requests feedback from the market in this area. Flexibility of Payments The CP states that deferral (rather than cancellation) of interest/dividend payments because, for example, an issuer has not been able to find investors with whom to place ACSM securities means that the hybrid will not serve to cover losses on a going concern basis. CEBS states that, if an ACSM is included, deferred coupons must therefore be satisfied without delay (which will likely be at a time when the share price is low) by the issue of core tier 1 instruments with a value no greater than the deferred payment, and issuers must have authorised but unissued instruments available for this purpose. An issuer s only obligation must be to issue the core tier 1 securities; it cannot be obliged to find investors for them. If hybrid holders choose to sell the core tier 1 securities and the sale proceeds are less than the deferred payment, the issuer must not be obliged to issue further new instruments to cover the loss incurred by the hybrid holder. Finally, the CP says that an ACSM must not hinder a recapitalisation and that the issuer and competent authority are to be able to cancel the use of the ACSM if required to achieve loss absorbency. Aside from the need to maintain necessary corporate approvals in case it is necessary to operate an ACSM, these requirements may have significant tax consequences in the UK. CEBS provides that payments of coupons or dividends on hybrids can only be paid out of distributable items. In the UK, as a matter of law dividends on (preference or ordinary) shares can only be paid out of distributable reserves. The same is not true of payments on other securities, including hybrid instruments. If CEBS intends to extend this requirement to other securities, something which has not been discussed before, that would be a significant change. Regulatory Capital. 5
Any requirement for coupons to be cancelled, even contingently, or for interest to be funded out of distributable items is likely to have significant UK tax consequences for direct issues by UK resident issuers. This is because, under UK tax law, interest on debt instruments that carry a right to results dependent interest is not deductible (unless the debt instrument is held by another UK corporation tax payer). A requirement to pay interest only out of distributable items could clearly infringe this rule. Moreover, even including a contingency whereby rights to interest are cancelled on solvency grounds could be regarded as a results dependent interest right potentially denying a deduction for any interest on the instrument even if the contingency never occurs. CEBS clarifies that as payments must be cancelled if Pillar 1 requirements are not met, the threshold for any use by a competent authority of its power to require cancellation of payments must by definition come before the issuer fails to meet such requirements. Competent authorities will consider, among other things, solvency data (current and looking three to five years ahead) and the risks facing the issuer in deciding whether or not to require cancellation of payments. Dividend pushers and stoppers are acceptable so long as they do not hinder recapitalisations. Dividend pushers must be waived if (i) an issuer, having paid on a junior security, fails to meet its Pillar 1 requirements before the relevant payment on the hybrid, (ii) the competent authority requires cancellation of payment on the hybrid or (iii) the major part (no guidance as to what this means) of the dividend to shareholders is paid in stock rather than cash. Loss Absorbency The CP discusses loss absorbency both on a liquidation and on a going concern basis. On the latter, in particular in stress situations, the instrument must absorb losses to help the institution to continue operations as a going concern which means..that it should not hinder the recapitalisation of the institution if the recapitalisation is necessary to keep it ongoing and will help the institution to rebuild its financial position. CEBS goes on to state that if investors are to inject new capital to recapitalise an issuer, then that new capital should not be used, directly or indirectly, to benefit existing hybrid holders. CEBS is not prescriptive as to the mechanisms which may be used to achieve the goal of not hindering recapitalisation, but mentions principal write down (permanent or temporary) and conversion into core tier 1 capital as possible mechanisms. On principal write-down, CEBS says that a meaningful write-down mechanism would be pari passu with holders of ordinary shares or other core tier 1 securities it is not at all clear how one would achieve a writedown on this basis. 6 13 July 2009
The CP states that the issuer or the competent authority should be able to operate these mechanisms it is not clear from the CP whether one can elect to have just the issuer operate them. The mechanism used, including the trigger for its use, must be clearly set out in the terms of the hybrid instrument. The CP provides that the trigger points for write-downs/conversion should be when losses lead to a significant reduction of retained earnings and other reserves resulting in a significant deterioration of the solvency level of an issuer (whether expressed by its own funds ratio or otherwise). The detail of how these mechanisms should operate is therefore still far from clear. Depending on the precise terms, both potentially give rise to concerns in relation to the issuer s ability to claim a tax deduction in the UK for the interest it pays. On a principal write-down there is also the question of whether a taxable profit could arise. Unless the issuer has tax losses available to it, a tax charge on write down could be particularly unwelcome in a stress situation. It remains to be seen whether market participants will prefer to communicate this to CEBS, or leave it to their competent authorities to provide more detailed guidance. The Report also refers to conversion of subordinated notes into equity. See The UK Government s Report below. Limits on Issuance Any instrument which is to be eligible as a hybrid instrument beyond the 35% limit cannot be capable of being redeemed in cash. Whether this excludes tax and capital disqualification calls is unclear. Such instruments must be convertible into core tier 1 securities (i) in emergency situations and (ii) at the option of the competent authority at any time based on the financial and solvency condition of the issuer. The trigger for the exercise of the option in (ii) will, like the triggers for approval of calls/redemptions and the trigger for cancellation of dividends/interest payments be based on, among other things, solvency data (current and looking three to five years ahead) and the risks facing the issuer. The instrument must convert into core tier 1 securities within a predetermined range to ensure they share losses pari passu with shareholders since issuance. There is therefore a requirement to determine the maximum number of core tier 1 securities to be delivered based on their market value on issue of the hybrid instrument. Customary adjustment events appear to be permitted. As such, we can expect to see technology from the equity-linked market appearing in some hybrid documentation going forward. The limits on issuance in the CRD can be exceeded on a temporary basis during emergency situations. According to CEBS, mergers and Regulatory Capital. 7
acquisitions generally do not amount to such situations unless their purpose is to reorganise or rescue. Issues by SPVs SPVs may be used to issue hybrid instruments, and will be subject to the same rules as apply to direct issues. On trigger events (which should include the breach or foreseeable breach of an issuer s capital requirements or a serious deterioration in its capital position), the SPV s hybrids should convert into directly issued hybrids or core tier 1 securities or be subject to write-down. The UK Government s Report Quality of Capital The Report states that the government is working with the EU to agree a common definition and level of high quality regulatory capital. The government supports the recommendations of the Turner Review for a fundamental review of capital adequacy requirements. The government clearly views shareholders equity as high quality capital, and subordinated debt as being of a lower quality. It is of the view that the focus should be on requirements for banks to build buffers of high quality capital, and in particular common equity capital. Conversion of debt into equity The Report states that one possible solution to improving banks access to capital during downturns or crises is to make some debt (perhaps the subordinated debt tranche only) convertible into equity in the event of a systemic crisis and on the authority of the financial regulator, thereby immediately injecting new capital into the bank and reducing the need to raise any new equity capital. The Government notes that it is not clear how this would be applied in practice. Building Societies and Profit Participating Deferred Shares In the Report, the Government discusses the decision of the holders of subordinated debt in West Bromwich Building Society to convert their holdings into PPDS. The Report notes the common features which the PPDS share with company equity shares, and that they enable societies to increase their core capital, thereby giving them enhanced resilience to absorb future losses. The Report notes, however, that, given the size of most building societies and the limits both on ownership control that PPDS holders can have and the share of the profits they can expect, it is likely that 8 13 July 2009
retained profits will still play an important role in the core capital base of the majority of societies. If you have any questions on the Amendments, the CP or the Report, please feel free to contact Richard Levy +44 (0)20 7456 5594, Carson Welsh +44 (0)20 7456 4602, Lynne Walkington +44 (0)20 7456 5718, Jonathan Richards +44 (0)20 7456 5695, Jonathan Fried +44(0)20 7456 5008 or any of your other regular contacts at Linklaters. Regulatory Capital. 9
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