The next generation of regulatory capital has arrived in Canada

A number of Canadian banks, including Royal Bank, National Bank, Bank of Montreal and CIBC, have recently issued “limited recourse capital notes”, or LRCNs, in public offerings to institutional investors, starting with RBC in July 2020.

Structure of the Limited Recourse Capital Notes

• The LRCN structure consists of two instruments (1) deeply subordinated interest-paying LRCNs, with a term to maturity of at least 60 years, that are issued by the bank directly to investors, and (2) perpetual, non-cumulative preferred shares that are issued by the bank to a trust to satisfy the recourse of LRCN holders upon the occurrence of certain prescribed events.
• The legal form of the LRCN is debt, with a dated maturity. The initial interest rates on the LRCNs have been in the range of 4.30%-4.50%, and the payout resets every five years at the initial credit spread over the prevailing five-year Government of Canada yield. The dividend rate on the preferred shares matches the interest rate on the LRCNs.
• In the event of (i) the non-payment of principal on maturity, (ii) non-payment of interest on an interest payment date, (iii) non-payment of the redemption price, (iv) an event of default or (v) a non-viability trigger event as described in Chapter 2 of OSFI's Capital Adequacy Requirements (CAR) Guideline, the sole recourse against the bank for the claims of LRCN holders will be to the assets held in the trust (i.e., the preferred shares, common shares issued upon a conversion following a non-viability trigger event, cash from the redemption or purchase for cancellation of the preferred shares, or any combination thereof).
• Upon a non-viability trigger event, the preferred shares held by the trust will automatically be converted into common shares of the bank using the same conversion formula as existing Canadian dollar denominated preferred shares ($5.00 floor price and 1.0x multiplier).
• No dividends are expected to be declared on the preferred shares while the preferred shares are held by the trust, although the different transactions employ different mechanics for achieving that result. In the initial transactions, the terms of the preferred shares provided that the trust as holder was not entitled to dividends. In the more recent transactions, the terms of the preferred shares were the same whether held by the trust or the holders of the LRCNs, but instead the trust provided the bank a revocable waiver of its right to receive any and all dividends on the preferred shares.
• Two key features that the LRCN structure had to meet to qualify as an Additional Tier 1 instrument for regulatory capital purposes are that the instrument is perpetual and payments are discretionary and non-cumulative. OSFI considered the structure holistically in a capital ruling for LRCNs published in July 2020¹ (the OSFI Ruling) and concluded that (1) the bank has full discretion to trigger the delivery of preferred shares to LRCN holders in lieu of paying interest, and (2) the recourse of holders of LRCNs is limited to perpetual Tier 1-qualifying instruments—preferred shares or common shares—in all circumstances (and that the LRCN structure is perpetual based on its economic substance).
• Since the LRCNs are debt that constitutes borrowed money and the bank is required to pay interest to holders, the bank is entitled to an interest deduction for Canadian federal income tax purposes provided the bank uses the proceeds of the LRCNs for an eligible income-producing purpose. The fact that in certain events the recourse of holders of the LRCNs is limited to the assets held by the trust does not detract from the lender-borrower relationship between the bank and the holders of the LRCNs or the obligation of the bank to pay interest on the LRCNs. Payments on the LRCNs are also not subject to Canadian non-resident withholding tax where held by non-residents of Canada.
• The LRCNs are treated as equity for accounting purposes.

Beyond the banks

• In the OSFI Ruling, OSFI concluded that the LRCN structure meets all of the criteria to be recognized as Additional Tier 1 regulatory capital by the Bank and other federally regulated financial institutions (FRFIs). OSFI indicated that, if issued, the LRCNs may be recognized as Tier 1 Capital Instruments other than Common Shares in the case of life insurers or Category B capital in the case of property & casualty insurers or mortgage insurers.
• If LRCNS were issued by a non-bank FRFIs, the recourse events would not include the non-viability trigger event.
• LRCNs may also be of interest to issuers that are not FRFIs from the perspective of their accounting treatment and equity weighting by rating agencies (though there are other instruments in the market that can provide analogous benefits).

Practical considerations

• Notwithstanding the OSFI Ruling, we expect individual FRFIs will seek an OSFI capital confirmation in respect of their own LRCN issuances consistent with current market practice.
• FRFIs will want to ensure that their universal shelf prospectus qualifies deeply subordinated debt to offer LRCNs—typically referenced as junior subordinated indebtedness—in addition to conventional subordinated debt. The prospectus supplement for an offering qualifies both the issuance of the LRCNs to the public institutional investors and the issuance of the preferred shares to the trust.
• FRFIs would need to comply with the conditions imposed in the OSFI Ruling, which include the following:
  • Sales are limited to “accredited investors”² who are not individuals (no retail)
  • Minimum par value of $1,000 for the LRCNs and preferred shares (versus the typical $25)
  • LRCNs and preferred shares are not exchange listed
  • LRCN issuances will be subject to a cap of 0.75% of risk-weighted assets (i.e., 50% of the AT1 bucket) as measured on the date of issuance. OSFI will develop limitations for insurers in due course.

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¹ Available here.

² As such term is defined in National Instrument 45-106 – Prospectus Exemptions or section 73.3 of the Securities Act (Ontario), as applicable.