On June 16, 2017, Canada’s Department of Finance and the Office of the Superintendent of Financial Institutions (OSFI) published for comments a package of draft regulations and guidelines setting out the final details of Canada’s bail-in framework and related total loss absorbency capacity (TLAC) capital standard for Canada’s six domestic systemically important banks (DSIBs). The bail-in regulations are expected to be finalized in the fall of 2017 and will take effect 180 days later. The Canadian DSIBs will be expected to fully meet the TLAC standard by November 2021. Both the bail-in power and the TLAC capital standard will have a considerable impact on Canadian DSIBs’ funding and capital structures.

The Canadian bail-in framework was first introduced in June 2016 through amendments to the Canada Deposit Insurance Corporation Act (CDIC Act) (for more information about the June 2016 amendments, please see our May 2016 Blakes Bulletin: Amendments to Canada’s Bank Restructuring Legislation: Bail-In and Financial Contract Safe Harbours). Under these amendments, the Canada Deposit Insurance Corporation (CDIC), Canada’s bank resolution authority, was granted the power to convert a distressed Canadian DSIB’s specified liabilities and shares into common shares (Bail-In Conversion) in order to recapitalize the DSIB. The proposed new regulations specify the types of liabilities and shares that would be subject to this Bail-In Conversion power (bail-in instruments) and set out other key elements of the bail-in framework.

The key elements of the bail-in framework and the TLAC capital standard are discussed below.

LEGISLATIVE FRAMEWORK

The Bail-in Conversion power is set out in the CDIC Act and is supplemented with three new draft regulations:

After these regulations are finalized, CDIC is expected to develop bylaws to set out any outstanding administrative aspects related to the Bail-in Conversion and compensation process. The CDIC bylaws have not been published yet.

The requirement for a Canadian DSIB to maintain minimum capacity to absorb losses is set out in the Bank Act, and the details of the new TLAC capital standard are included in OSFI’s draft new TLAC Guideline and draft revised Capital Adequacy Requirements (CAR) Guideline.

The bail-in framework under the CDIC Act and the related TLAC capital standard will apply to Canada’s six large banks, which have been identified by OSFI as DSIBs. Other Canadian banks and financial institutions are exempt from these requirements, except for the “no creditor worse off principle” discussed below, which will apply in respect of all resolution measures under the CDIC Act.

RESOLUTION ORDER

The bail-in power is activated when the federal government, relying on a recommendation from the minister of finance, CDIC and OSFI, makes a resolution order under the CDIC Act in respect of a non-viable or near-viable Canadian DSIB. The resolution order may authorize CDIC to take control or ownership of the DSIB, convert its bail-in instruments into common shares and undertake other necessary restructuring measures to recapitalize the institution. The conditions and timing of the Bail-In Conversion are determined by CDIC, subject to the restrictions set out in the legislation. If CDIC’s resolution measures are successful, the DSIB must be returned to private control within one year (although this period may be extended to a maximum of five years).

BAIL-IN INSTRUMENTS

Under the Conversion Regulation, a debt obligation of a DSIB will be subject to a Bail-In Conversion if it meets all of the following criteria:

  • The debt obligation is issued by the DSIB after the implementation date of the Conversion Regulation. As noted above, the implementation date is 180 days after the date on which the Conversion Regulation is adopted in final form (currently expected in the fall of 2017). Debt obligations issued before the implementation date will not be subject to a Bail-In Conversion unless they are amended after that date to increase the principal amount or to extend the term.
  • The debt obligation has a term to maturity of more than 400 days or is perpetual (specific rules apply in respect of debt obligations with imbedded options).
  • The debt obligation is unsecured at the time of issuance. If the debt obligation is partly secured at the time of issuance, the unsecured portion will be subject to a Bail-In Conversion.
  • The debt obligation has been assigned a CUSIP number, ISIN, or other similar designation that identifies a specific security to facilitate its trading and settlement.

Subordinated liabilities and preferred shares of a Canadian DSIB issued or amended after the implementation date will also be subject to a Bail-In Conversion, but only if they do not qualify as non-viability contingency capital (NVCC) instruments that contractually provide for conversion into common shares based on an OSFI trigger.

Structured notes (with some exceptions), covered bonds and eligible financial contracts (including derivative agreements, securities lending agreements and repos, among others), and certain other instruments are exempted from the Bail-In Conversion power. In addition, the requirement that a bail-in instrument have a CUSIP number, ISIN or a similar identifier effectively limits the Bail-In Conversion power to tradable debt instruments and excludes account-based deposit liabilities.

CONVERSION PROCESS

Bail-in instruments may be converted into common shares fully or partly, which is determined by CDIC. In addition, unlike NVCC instruments, the conversion formula for bail-in instruments will not be specified in the terms of the instrument but will be determined by CDIC in its discretion, subject to the following parameters set out in the Conversion Regulation:

  • Adequate Recapitalization: In carrying out a Bail-In Conversion, CDIC is required to take into consideration the Bank Act requirement that a DSIB maintain adequate capital. As such, adequate recapitalization of the DSIB must be a key consideration in determining the magnitude and rate of the conversion.
  • Order of Conversion: CDIC must “use its best efforts” to ensure that a bail-in instrument is converted into common shares only if all NVCC instruments and subordinate-ranking bail-in instruments have been, or are concurrently being converted into common shares.
  • Equal Treatment: CDIC must also “use its best efforts” to ensure that equally ranking bail-in instruments are converted in the same proportion during the same restructuring period.
  • Relative Creditor Hierarchy: A holder of a bail-in instrument must receive more common shares per dollar of the claim converted than holders of subordinate-ranking bail-in and NVCC instruments that have been converted into common shares during the same restructuring period. In addition, equally ranking bail-in instruments must receive the same number of common shares per dollar of the claim converted during the same restructuring period.

TLAC REQUIREMENT

The TLAC Guideline proposed by OSFI, Canada’s prudential banking regulator, will establish two new minimum capital standards for DSIBs: a risk-based TLAC ratio and a TLAC leverage ratio. The risk-based TLAC ratio is the ratio of a DSIB’s regulatory capital and bail-in instruments, with adjustments (TLAC Measure) to the DSIB’s risk-based assets. The TLAC leverage ratio is the ratio of a DSIB’s TLAC Measure to its non-risk weighted assets. The risk-based TLAC ratio must be at least 21.5 per cent and the TLAC leverage ratio must be at least 6.75 per cent. For comparison, OSFI’s risk-based regulatory capital ratio for DSIBs is at 11.5 per cent (2019 “all-in” minimum) and the minimum leverage ratio is currently at three per cent. The TLAC Guideline notes that DSIBs are expected to hold buffers above the minimum TLAC ratios and that OSFI may vary the minimum requirements for specific DSIBs.

The proposed amendments to the CAR Guideline set out the rules for the regulatory capital treatment of investments by Canadian banks in bail-in instruments issued by other financial institutions, similar to the rules for regulatory capital treatment of investments by Canadian banks in regulatory capital instruments issued by other financial institutions. These rules generally discourage threshold investments by banks in the bail-in and capital instruments of other financial institutions.

BAIL-IN RECOGNITION CLAUSE AND DISCLOSURE STATEMENT

The proposed Issuance Regulation will require a bail-in instrument to expressly indicate in its contractual terms that the holder of the instrument is bound by the provisions of the CDIC Act, including the bail-in power, and that it submits to the jurisdiction of the courts of Canada, despite the governing law of the instrument. This recognition clause will be particularly important for bail-in instruments that are governed by foreign law but must be included in all bail-in instruments.

Additionally, the prospectus or other relevant offering or disclosure documents for a bail-in instrument must expressly state that the instrument is subject to a Bail-In Conversion.

Since a Bail-In Conversion is carried out by operation of the CDIC Act at the direction of CDIC, the failure to include the bail-in recognition clause or the disclosure statement will not exempt the instrument from the Bail-In Conversion power. However, under the TLAC Guideline, OSFI will not recognize a foreign-law governed bail-in instrument towards the TLAC ratios unless the DSIB provides evidence to OSFI that no impediments exist to the application of the Canadian bail-in powers under the foreign law or the terms of the instrument. OSFI has not indicated what it will recognize as evidence of this enforceability (such as a legal opinion from foreign counsel). In addition, it remains to be seen whether OSFI will introduce a process for confirming the quality of a bail-in instrument for TLAC purposes similar to the process currently in place for confirming the quality of NVCC instruments.

RESTRICTIONS ON SETOFF AND ACCELERATION

In order for a bail-in instrument to count towards the TLAC ratios, the instrument must not be subject to set-off or netting rights, according to the draft TLAC Guideline.

Further, the instrument must not provide the holder with rights to accelerate repayment of principal or interest outside of bankruptcy, insolvency, wind-up or liquidation. Events of default relating to the non-payment of scheduled principal and/or interest payments will be permitted if they are subject to at least 30 business days’ cure period and disclose to investors that acceleration is only permitted where a resolution order has not been made under the CDIC Act and that despite any acceleration, the instrument will continue to be subject to a Bail-In Conversion before its repayment.

The draft TLAC Guideline also sets out certain additional eligibility requirements for bail-in instruments.

NO CREDITOR WORSE OFF PRINCIPLE

Consistent with the June 2016 amendments to the CDIC Act, the Compensation Regulation proposes a new framework for providing compensation to a bank’s creditors and shareholders, where they are made worse off as a result of the resolution actions by CDIC than they would have been if the bank was liquidated. The compensation would be payable from CDIC’s deposit insurance fund. It will be based on CDIC’s estimate of the difference between the liquidation value of an instrument (what the holder of the instrument would have received if the bank was wound up without being subject to any resolution measures, such as a Bail-In Conversion) and the resolution value of the instrument (the value received or to be received by the holder through the resolution process). CDIC will have a broad discretion to determine these estimates, subject to the requirements of the Compensation Regulation. The federal government indicated that, in a successful resolution scenario, it expects the estimated resolution value of an instrument to typically exceed its estimated liquidation value such that no or little compensation would be payable. Any right to compensation under the Compensation Regulation would be a personal right and is not transferrable. Compensation offers by CDIC may be appealed to an independent assessor if a threshold number of persons entitled to compensation object to CDIC’s offer.

EFFECTIVE DATE

The bail-in regulations (the Conversion Regulation and the Issuance Regulation) will take effect 180 days after the final versions of the regulations are published, which is currently expected in the fall of 2017, according to the Department of Finance. As such, debt obligations and non-NVCC preferred shares issued after that date (or amended after that date to increase the principal amount or extend the term) will be subject to a Bail-In Conversion if they meet the bail-in eligibility criteria.

Canadian DSIBs will have until November 1, 2021 to meet the TLAC ratios. This will provide approximately four years for Canadian DSIBs to fully meet the TLAC ratios, if the regulations are finalized by the end of this year. However, public disclosure of DSIBs’ TLAC ratios will begin for the fiscal quarter starting on November 1, 2018.

The Compensation Regulation will take effect on January 1, 2018 or at a later adoption date.

Comments on the proposed new regulations and OSFI’s guidelines may be submitted to the Department of Finance and OSFI by July 17, 2017.