On May 11, 2011, the Department of Finance issued a consultation paper dealing with covered bonds. This consultation paper contemplates the adoption of covered bonds legislation and seeks comments with respect to the content of that legislation. The enactment of covered bonds legislation would implement a proposal made by the federal government in the 2010 budget and would respond to requests made by many of the Canadian banks for such legislation. The Consultation Paper is open for comments until June 10, 2011.
A covered bond is a bond issued by an issuer (for our purposes a Canadian bank) and collateralized by a pool of assets that meet certain eligibility criteria. In Europe, this collateralization is often accomplished by designating certain assets as being allocated to a collateral pool. Legislation then provides that the holders of the covered bonds issued in relation to the designated pool have a priority claim upon the assets in the designated pool. In Canada, the assets are actually transferred to an SPV which, in turn, guarantees the covered bonds. The priority afforded by the Canadian structure is the result of the application of ordinary legal principles (much the same principles as are relied upon in the context of a securitization) and not specific legislation. In fact, there are currently no existing legislative or regulatory provisions or other regulatory guidance specifically dealing with covered bonds in Canada other than a letter issued by the Office of the Superintendent of Financial Institutions on June 27, 2007. This letter provided that covered bonds must not, at the time of issuance, make up more than four per cent of the total assets of the bank or other deposit taking institution. OSFI also stated at the time that it expected that the pledging policies of banks and other deposit-taking institutions would be amended to address the issuance of covered bonds. Since covered bonds are in substance a form of secured borrowing, it certainly makes sense that they would be addressed in the pledging policy.
Even in the absence of legislation, covered bonds have been issued by Canadian banks by using the transfer to an SPV, as described above, as a means of providing the assurance of priority provided by legislation in Europe. The Consultation Paper acknowledges that the existing non-legislative approach "provides a high level of disclosure to investors" and provides assurance to investors that "if the issuer defaults, the assets in the cover pool will be used to prevent any disruption of cash flows to investors.” The Consultation Paper also acknowledges that the existing non-legislative approach has proven to be successful in developing a covered bonds market for Canadian issuers.
Why then is legislation being contemplated? The Consultation Paper provides two reasons. Dealing with the second stated reason first, the Consultation Paper notes that some international investors are restricted from purchasing bonds under a non-legislative framework. The creation of a legislative framework would, therefore, enhance market access for Canadian banks. This may well be a most worthwhile policy objective (I leave for others to discuss the theoretical impact on depositors and other unsecured creditors of bank). Unfortunately, there is little or no discussion in the Consultation Paper as to what must be included in covered bonds legislation in order to ensure the ability to access these "international investors".
Meanwhile, the first stated reason is more confusing. Specifically, the Consultation Paper states that "the issuer's assurances in the prospectus that the cover assets will be available for the benefit of covered bond investors are not a substitute for statutory protection". It is unclear, however, whether what is meant by this statement is that the existing legal protections arising from the transfer of assets to an SPV are insufficient, or that the issuer's representation and covenant that adequate and appropriate assets have in fact been transferred is not sufficient. If it is the first rationale, being that the transfer of assets to an SPV is insufficient to confer legal priority, then that rationale is inconsistent with the statement in the Consultation Paper that the existing non-legislative framework provides covered bond investors with assurance of payment. It is also questionable in light of the fact that the Consultation Paper contemplates that the proposed legislation would continue to require a transfer to an SPV (the proposed legislative action in relation to the insolvency of trusts would, however, be useful). In addition, since the transfer approach is essentially the same mechanism as is used in a wide range of securitization transactions, one cannot help but wonder if Finance is really casting doubt upon that mechanism. The second rationale would appear to invoke the risk that a Canadian bank might represent and undertake to do something and then not do it. On this rationale, the legislation would be dealing with the risk that Canadian banks might engage in conduct in relation to the bank’s investors that is, in substance, fraudulent. It is also worthy of note that the risk that inadequate or insufficient assets might be allocated to covered bond investors could arise equally in a designation structure, as in Europe, or a transfer structure, as in Canada.
How then would legislation deal with these issues? As described, the contemplated legislation appears to be directed at three broad areas.
First, certain aspects of the legislation would deal with issues that are prudential in character. These areas would include legislation around eligible issuers, the extent of permitted over-collateralization, record-keeping and the transfer of excess assets to the SPV. Prudential issues of this sort would normally be addressed between OSFI and banks and would not typically require legislation. In practice, such issues would much more commonly be addressed by means of prudential guidance issued by OSFI. In fact, as seen above, the existing four per cent limit was not enacted by way of legislation.
Second, other aspects of the proposed legislation would address the form of the covered bonds transaction. The matters falling into this class would include matters in relation to the permitted legal form of the SPV, eligible assets, whether uninsured mortgages could be used, the manner in which assets in the pool should be valued and whether and how assets could be substituted into the pool. Consistency may well be important. However, market forces usually end up imposing consistency where consistency is important and it is unclear to me how consistency mandated by legislation would represent an improvement. In addition, legislation is an odd way of ensuring that transactions respond to the requirements of an international market. Indeed, in many areas, the contemplated legislation could simply codify existing practice (such as by way of requiring a transfer to an SPV). Weighing in the balance against any legislative prescription of the terms of the transaction is the risk that the legislator will either get it wrong or the market will evolve, with the result in both cases being that the legislation ends up mandating a form of transaction inconsistent with what is required in the international market.
The third area is the most curious of all. It would involve the creation of a Covered Bond Registrar. The responsibilities of this august personage are as yet undefined, but would appear to involve a review of the terms of the transaction and a certification that the transaction meets the requirements of the legislation. This is a role that does not currently exist within Canadian financial institutions law and the assumption of this role would represent a very major departure for any existing Canadian financial institutions regulator. Indeed, it is very hard to imagine that this is a role that OSFI would willingly undertake, not least because of the potential of a conflict with its primary role as a prudential regulator. In addition, it is difficult to see what real comfort such a regulator would, as a practical matter, bring to a transaction beyond that already provided by trustees, underwriters, counsel and rating agencies.
I would not want to be taken as opposing the legislation. Ensuring diverse funding sources is important and if that object requires legislation, then legislation there should be. However, the various elements of the proposed legislation are arguably unnecessary, potentially restrictive and inflexible and may involve structural issues and issues of conflicting roles. What is not considered in the Consultation Paper is whether all of these things must be done in order to achieve the benefit of diverse funding, or whether some more modest approach would equally suffice.