In June 2017, the Canadian government released draft regulations relating to "bail-in instruments" issued by Canadian domestically systemically important banks ("D-SIBs"). The proposed regulations are a key part of Canada's new bank recapitalization plan; under the plan, certain bank instruments, including many debt securities, may convert into the issuer's equity securities if an issuer becomes non-viable. In addition to the bail-in regulations, Canada's Office of the Superintendent of Financial Institutions ("OSFI") also published for comment its draft Total Loss Absorbing Capacity ("TLAC") guideline.
Once finalized, these regulations will have a significant impact on how Canadian banks issue debt securities around the world. We discuss in this article the principal impact of the proposed regulations on Canadian banks that issue structured notes into the U.S. market.1
Timing of Effectiveness and New Issuances
Under the draft regulations, D-SIBs would have 180 days following the publication of the final versions of the bail-in regulations (the "effective date") to prepare for their initial issuances of bail-in-able instruments. (The final versions of the regulations are currently expected to be published before the end of 2017.) Thereafter, each D-SIB will be required to maintain a minimum capacity to absorb losses, consisting of regulatory capital and debt that is subject to the possibility of conversion, effective the first fiscal quarter of 2022. (See the section below, "Canadian TLAC.")
Notes and other instruments that are issued before the effective date will not be subject to the bail-in rules except in limited circumstances, such as if they are amended or extended in a certain manner.
Instruments That Are Subject to the Rules
Securities and other instruments would be subject to the bail-in provisions if they satisfy all of the following criteria:
- they must have an initial term to maturity greater than 400 days;
- they must be unsecured and unsubordinated; and
- they must be assigned a CUSIP or ISIN (or similar security identification) number in order to facilitate their trading.
If a conversion of the bail-in debt occurs, the holders of the bail-in debt must receive more common shares per dollar of claim than the holders of the issuer's subordinated debt and preferred shares.2
Structured Notes and Other Exclusions from the Bail-in Regime
Covered bonds, other secured debt, derivatives, structured notes and certain other liabilities are explicitly excluded from the bail-in regime. Deposits (other than deposit notes3) with a D-SIB will also be outside the scope of the bail-in regime. As is the case in connection with the U.S. TLAC regulations, the definition of "structured note" is significant. The proposed regulations would define "structured note" as:
"...a debt obligation that (a) specifies that the obligation's stated term to maturity, or a payment to be made by its issuer, is determined in whole or in part by reference to an index or reference points, including (i) the performance or value of an entity or asset, (ii) the market price of a security, commodity, investment fund or financial instrument, (iii) an interest rate, and (iv) the exchange rate between two currencies; or (b) contains any other type of embedded derivative or similar feature.
However, the following debt obligations are not structured notes [emphasis added]: (a) a debt obligation in respect of which the stated term to maturity, or a payment to be made by its issuer, is determined in whole or principally by reference to the performance of a security of that issuer; and (b) a debt obligation that (i) specifies that the return on the debt obligation is determined by a fixed or floating interest rate or a fixed spread above or below a fixed or floating interest rate, regardless of whether the return is subject to a minimum interest rate or whether the interest rate changes between fixed and floating, (ii) has no other terms affecting the stated term to maturity or the return on the debt obligation, with the exception of the right of the issuer to redeem the debt obligation or the right of the holder or issuer to extend its term to maturity, and (iii) is payable in cash."
Under this definition, typical equity, commodity linked and currency linked structured notes and ETNs linked to a reference asset will be outside of the bail-in regime. However, as in the U.S. context, market participants need to understand how this definition applies to simpler rate-linked notes (which are sometimes referred to as "lightly structured notes" or "lightly structured rate-linked notes"4):
- Floating rate linked notes linked to CMS5: the second paragraph of the definition above would appear to remove these instruments from the definition of "structured note," as CMS is an "interest rate." Accordingly, notes of this kind would be subject to the bail-in regime.
- Fixed to floating rate notes6 appear not to be "structured notes" by virtue of the second paragraph above.
- Floating rate notes with a capped interest rate and/or a floor: the second paragraph appears to remove those notes with a minimum interest rate from the definition; however, it is silent as to the impact of a maximum rate. It would be helpful for the regulator to clarify this distinction in the final rules.
- Step up callable notes: these appear not to be "structured notes" by virtue of the second paragraph above. This result would be consistent with the discussion below relating to TLAC, in which the proposed rules appear to contemplate that step-up callable notes could be eligible for TLAC.7
- Inflation-linked structured notes:8 the first paragraph of the definition would appear to include this instrument in the "structured note" definition due to its embedded derivative. Since inflation rates are not "interest rates," the second paragraph would not seem to remove them from the definition. Accordingly, these instruments would probably not be subject to the bail-in regime.
- Range accrual notes linked to an interest rate,9 or notes with a single bullet payment at maturity that is tied to the level of an interest rate,10 would appear to be "structured notes" under the first paragraph set forth above.
Required Disclosures and Disclosure Documents
The offering documents for new instruments must disclose whether those instruments are subject to the bail-in regime. We would anticipate that, particularly for notes subject to bail-in, these disclosures would follow the practice of certain European issuers of notes into the U.S. market; that is, the offering documents would include prominent cover page disclosure about the bail-in feature, as well as related risk factor disclosure as to the nature of the bail-in regime.
Required Contractual and Other Terms
To facilitate the enforceability of the bail-in power, and to help ensure that any legal issues would be resolved in a Canadian court, an instrument subject to the bail-in regime will need to include the following in its terms:
- the holder of the instrument is bound by the Canada Deposit Insurance Corporation Act, often called the "CDIC Act" (including the conversion of the liability into common shares and the resulting termination of the instrument), and by the laws of Canada or of a province of Canada in respect of the operation of the CDIC Act;
- the holder of the instrument is subject to the jurisdiction of Canadian courts as to the CDIC Act and those laws; and
- the above two bullets are binding on the holder of the liability despite any other terms of the liability, any other law that governs the liability and any other agreement between the parties.
Issuers of registered notes or bank notes would need to amend their indentures (or paying agency agreements, in the case of unregistered programs) and forms of notes to address these terms.
Steps to Be Taken
If the amendments are adopted in the form proposed, then prior to the effective date, Canadian issuers into the U.S. market will need to take a number of steps as to structured notes, such as "lightly structured notes," that are subject to the rules:
- Amending their existing registration statements (or filing new registration statements) to:
- Add the required bail-in disclosures.
- Amend and supplement their indentures and forms of notes to include the required bail-in provisions discussed above and the required TLAC provisions discussed below.11
- Updating their forms of pricing supplements and product supplements to include the required disclosures.
- Updating any relevant brochures and marketing materials for the relevant notes to explain the bail-in provisions.
- Underwriters and other distributors of these notes may wish to update the forms of underwriting agreements and program agreements to address the issuer's compliance with the new regulations.
As discussed above, many "structured notes" (such as equity-linked notes) will not be subject to the bail-in regime. Depending upon its issuance plans, an issuer may wish to consider whether it useful to maintain two separate issuance programs: one program for use with notes that are subject to the bail-in regime and to continue to use their existing programs for notes that are not subject to the bail-in regime. For example, an issuer could elect to continue to use an existing shelf registration statement exclusively for notes that are not subject to the bail-in regime until that shelf expires and to establish a new shelf for use with notes that need to comply with the new requirements.
In connection with the proposed bail-in regulations, OSFI also published for comment its draft Total Loss Absorbing Capacity Guideline (the "TLAC Guideline"). Similar to U.S. and European regulatory changes, the TLAC Guideline is intended to ensure that D-SIBs have sufficient loss absorbing capacity to support the recapitalization of a non-viable D-SIB.
Beginning in the first fiscal quarter of 2022 (which may start in the fourth calendar quarter of 2021 for many Canadian banks, due to their accounting periods), D-SIBs would be required to maintain a TLAC ratio of at least 21.5% of risk weighed assets and a minimum TLAC leverage ratio of 6.75%. For these calculations, TLAC would consist of eligible capital instruments and eligible bail-in-able debt. Accordingly, a debt instrument, including a "lightly structured note," would need to comply with the standards discussed above in order to qualify as TLAC.
In addition, in order to qualify as TLAC:
- the security must be directly issued by the Canadian parent bank, as opposed to an operating subsidiary or a financing subsidiary;12
- except in limited cases, the security must not provide the holder with acceleration rights as to principal or interest except in the context of a bankruptcy, insolvency, wind-up or liquidation;13
- the security must have a remaining maturity of more than 365 days;14
- if the security can be called at the issuer's discretion, and where that redemption would lead to a breach of the issuer's minimum TLAC requirements, the call would require the prior approval of the Superintendent of Financial Institutions;
- the security may not have credit-sensitive coupon features that changed based on, for example, the issuer's credit rating; and
- if an amendment of the security's terms would affect the security's status as TLAC, that amendment will only be permissible upon receipt of the Superintendent's prior approval.
The final bail-in and TLAC regulations are currently expected to be released before the end of 2017. However, most market participants do not expect significant revisions to be made. Canadian issuers and their underwriters will need to plan for offering these instruments after the effective date.