On April 18, the Government of Canada published final regulations under the Canada Deposit Insurance Corporation Act (CDIC Act) and the Bank Act. These regulations provide details of the bank recapitalization (bail-in) conversion, issuance and compensation regime relating to bail-in instruments issued by domestic systemically important banks (D-SIBs) (collectively referred to as the Bail-In Regulations). Our earlier bulletin "Government of Canada Publishes Bail-In Regulations" provides a more detailed discussion of the substance of the Bail-In Regulations.1
What You Need To Know
- The Issuance Regulations were revised to add a new section prohibiting advertising or otherwise promoting bail-in eligible liabilities to purchasers in Canada as deposits.
- The Conversion Regulations were revised to clarify that any bail-in eligible liabilities that remain outstanding or unpaid at the time of the D-SIB's entry into resolution would be eligible for conversion.
- Technical and clarifying changes were made to the Compensation Regulations.
- In our view, bail-in debt would not be considered to be convertible into common shares of D-SIBs for purposes of investment requirements that preclude or limit investment by an investment manager or similar person in debt instruments that are convertible into common shares.
The Bail-In Regulations represent the final step in the implementation of the bail-in regime that will allow for the expedient conversion of certain bank instruments into regulatory capital in the highly unlikely event that a D-SIB becomes non-viable.
The Bank Recapitalization (Bail-in) Conversion Regulations under the CDIC Act (Conversion Regulations) and the Bank Recapitalization (Bail-in) Issuance Regulations under the Bank Act (Issuance Regulations) will come into force on September 23—180 days after the date on which the Bail-In Regulations were formally registered on March 27. The Compensation Regulations under the CDIC Act (Compensation Regulations) were brought into force immediately upon registration on March 27.
In conjunction with the publication of the Bail-In Regulations, the Office of the Superintendent of Financial Institutions also published its final Total Loss Absorbing Capacity (TLAC) Guideline (which will come into effect on September 23), as well as revisions to its Capital Adequacy Requirements (CAR) Guideline. The TLAC Guideline requires D-SIBs to maintain sufficient loss absorbing capacity to support their recapitalization in the unlikely event of a failure so that they can remain open and operating without requiring public funds or threatening financial stability. As provided for in the Bank Act, the Superintendent is expected to issue orders setting the minimum TLAC levels applicable to each D-SIB in the near future. D-SIBs must fully meet their minimum TLAC requirements by November 1, 2021 and public disclosure and regulatory reporting relating to TLAC will commence in first fiscal quarter of 2019 (i.e., the fiscal quarter commencing on November 1, 2018). The revisions to the CAR Guideline implement the prudential treatment for holdings of Other TLAC Instruments (as defined in the TLAC Guideline), and applies to all D-SIBs effective the first fiscal quarter of 2019.
Bank Recapitalization (Bail-in) Issuance Regulations (Bank Act)
The Issuance Regulations were revised to add a new Section 5, which prohibits advertising or otherwise promoting bail-in eligible liabilities (including in their name) to purchasers in Canada as deposits.
Bank Recapitalization (Bail-in) Conversion Regulations (CDIC Act)
The Conversion Regulations were revised in Section 2(2) to clarify that any bail-in eligible liabilities that remain outstanding or unpaid at the time of the D-SIB's entry into resolution would be eligible for conversion. Specifically, this change clarifies that bail-in eligible liabilities that mature after entry of the D-SIB into resolution, but before CDIC, has executed the bail-in conversion, would be subject to conversion as opposed to paid out at maturity.
Compensation Regulations (CDIC Act)
Section 2(5) of the Compensation Regulations has been revised to adjust the definition of "intermediary" to ensure that it captures entities generally performing the functions of an intermediary, regardless of their legal structure. The draft version of the Compensation Regulations excluded partnerships from being considered as intermediaries, which would have served to potentially exclude important intermediaries.
Section 3(8) of the Compensation Regulations has been revised to clarify that in the case of preferred shares, CDIC must make the same offer of compensation to prescribed persons in proportion to the liquidation entitlement of their preferred shares (rather than the number of shares). The draft version of the Compensation Regulations would have required CDIC to make the same offer of compensation to holders of preferred shares of the same class in proportion to the number of shares they held. However, as with liabilities, otherwise identical preferred shares can be issued with different par values.
Section 5(d) of the Compensation Regulations has been revised to clarify that in the case of preferred shares, an assessor is to be appointed if prescribed persons who hold 10% of the liquidation entitlement of the preferred shares in a given class (rather than the number of shares) object to CDIC's offer. The draft version of the Compensation Regulations did not differentiate between common shares and preferred shares, such that in either case the threshold for appointment of an assessor would have been if persons who held 10% of the shares of a given class object to CDIC's offer of compensation. As described above, otherwise identical preferred shares can be issued with different par values.
In the lead up to the implementation of the bail-in regime, there has been some speculation in the media about whether senior debt issued by D-SIBs, that would be prescribed liabilities under the Bail-In Regulations, would be considered convertible into common shares of D-SIBs for purposes of investment requirements that preclude or limit investment by an investment manager or similar person in debt instruments that are convertible into common shares (Investment Requirements).
Under the Investment Requirements, investment managers may be precluded from investing in debt instruments that are convertible into common shares. For example, investment managers of funds subject to section 2.18 of National Instrument 81-102—Investment Funds (Money Market Requirements) do not typically invest in convertible debt instruments because if those debt instruments are converted into common shares, such common shares would not meet the Money Market Requirements, including term to maturity requirements and ratings requirements.2 The question then becomes: does the conversion feature of the bail-in debt mean that bail-in debt would not meet the Investment Requirements since it may be converted into common shares by CDIC in the future in specified circumstances?
In our view, bail-in debt would not be considered to be convertible into common shares of D-SIBs for purposes of the Investments Requirements. Given that the bail-in regime has not yet come into effect, there is no relevant jurisprudence in Canada addressing this question. Therefore, our view is based upon common law principles.
First, in a commercial setting, when instruments are considered convertible as a legal matter, it is because either the holder or the issuer has the ability to convert the instrument on specified terms. Bail-in debt, however, is not exchangeable by either the holder or the issuer. It is also not exchangeable at a fixed price. Rather, CDIC is authorized to set the terms and conditions of the conversion, including its timing. Accordingly, bail-in debt does not meet generally understood criteria to be considered a convertible instrument, bail-in debt would not be considered a convertible instrument in legal or commercial terms and a holder of bail-in debt would be considered a creditor of a D-SIB in substance.
Second, there is no clear commercial rationale for bail-in debt to not be considered to meet the Investment Requirements simply because of the possibility of conversion into common shares in the future. Bail-in debt may only be converted in times of severe financial stress of a D-SIB. Consequently, the regime is akin to the insolvency regime applicable to debt of non-D-SIB issuers, where in an insolvency, debt instruments are often converted into common shares.
In general, the mere existence of a regime pursuant to which debt may be converted into equity as a result of future financial distress, or the fact that often creditors are given rights to vote on such a conversion, does not render such debt convertible. If this were the case, it would be impossible for most debt instruments to meet the Investment Requirements since most debt instruments would be subject to the possibility of conversion in an insolvency of the issuer.
Instead, solvency risk would typically be addressed more directly in considering and setting investment requirements and limitations, for example through requirements that debt instruments meet specified ratings. A rating requirement applied to bail-in debt would directly address the risk that is posed by a possible conversion of bail-in debt in the context of an insolvency of a D-SIB.
Finally, to treat the bail-in debt as not meeting the Investment Requirements would run contrary to the very purpose behind the Investment Requirements. The D-SIBs represent some of the strongest and most well-capitalized issuers in the Canadian financial markets, where the risk of insolvency is arguably the lowest, apart from government debt. To interpret the Investment Requirements as excluding all bail-in debt would, however, have the absurd result of leading investment managers to invest in instruments issued by issuers that have a higher risk of insolvency than the D-SIBs.
2 Investment Requirements do not necessarily arise by way of a specific statutory or regulatory provision; they may arise as part of the investment strategy applicable to a particular investment fund, an applicable statement of investment policies, standards and procedures or in order to satisfy more general prudency requirements.
To discuss these issues, please contact the author(s).
This publication is a general discussion of certain legal and related developments and should not be relied upon as legal advice. If you require legal advice, we would be pleased to discuss the issues in this publication with you, in the context of your particular circumstances.
For permission to republish this or any other publication, contact Janelle Weed.
© 2019 by Torys LLP.
All rights reserved.