As of January 1, 2013 Canadian deposit taking institutions were no longer able to include new issues of preferred shares and subordinated debt in their Tier 1 and Total Capital ratios unless those instruments included a provision that allows the financial institution to either permanently convert these instruments into common shares or fully write-down the instrument, in the event that the institution is no longer viable. Instruments that contain these features are known as non-viability contingent capital ("NVCC"). Existing instruments without the non-viable contingent capital provision, also known as non-qualifying capital, will be gradually phased out of regulatory capital at a rate of 10% per year until 2022, after which they will no longer qualify as regulatory capital.

International financial markets have seen several issuances of early trigger contingent convertible instruments, though there have been few such issuances in Canada. Most issuances have taken the form of debt that automatically converts into additional common shares upon the occurrence of a pre-determined trigger event, rather than debt that includes the principal write-down feature.

We recently advised a financial institution in connection with an application to the Office of the Superintendent of Financial Institutions ("OSFI") for confirmation that several subordinated intercompany term loans qualified as Tier 2 capital of the financial institution, according to OSFI's Capital Adequacy Requirements (CAR) Guideline (the "Guideline"), including the NVCC elements of the Guideline.

This particular request for capital confirmation is noteworthy because it is the first instance in Canada of receiving capital confirmation for NVCC instruments that are fully written-down at the point of non-viability, rather than converted to common shares.

In this case, the instruments are typical subordinated term loans except that they provide that if a pre-determined trigger event occurs, the instrument is immediately and entirely written-down. The Guideline requires a minimum of two trigger events, which are based on the ability of the regulatory authorities to mandate the write-down of the instruments during a crisis that affects the financial institution. The trigger event is earlier of:

  1. the Superintendent of Financial Institutions (the "Superintendent") announcing that the financial institution has been advised, in writing, that the Superintendent is of the opinion that the financial institution has ceased, or is about to cease, to be viable and that, after the conversion of all contingent instruments and taking into account any other factors or circumstances considered relevant or appropriate, it is reasonably likely that the viability of the financial institution would be restored or maintained; or
  2. a federal or provincial government in Canada publicly announces that the financial institution has accepted or agreed to accept a capital injection, or equivalent support, from the federal government or any provincial government or political subdivision or agent or agency thereof without which the financial institution would have been determined by the Superintendent to be non-viable.

OSFI has noted that in order for an instrument with the principal write-down feature to satisfy the NVCC elements of the Guideline, the issuing institution must be privately-held, as in the case of a Schedule II bank, and must not have issued any capital to third parties. Given these requirements, it is expected that the write-down option will generally not be available to the big six Schedule I Canadian banks. The Guideline sets out the NVCC requirements, and OSFI also indicated that the NVCC features and flexibility will be clarified in coming months.

NVCC is intended to provide a buffer for financial institutions during times of stress and to enhance market discipline by ensuring that capital providers bear the risk of loss. As OSFI states in the Guideline, "The NVCC requirements aim to ensure that investors in non-common regulatory capital instruments bear losses before taxpayers where the government determines it is in the public interest to rescue a non-viable bank." OSFI has indicated that the regulatory authorities would only elect to trigger the NVCC provisions where there is a high level of confidence that the conversion plus some additional measures would restore the viability of the financial institution. Where the NVCC provisions are not triggered and the financial institution is liquidated or otherwise resolved, capital providers would be subject to losses according to the statutory hierarchy of claims and the NVCC would not be converted.

To date, only a few financial institutions in Canada have taken steps to have their instruments treated as NVCC, and we have not seen the emergence of a robust market in Canada for NVCC preferred shares and subordinated debt instruments. While it is not mandatory to seek capital confirmation from OSFI, we expect that many institutions will voluntarily do so as a risk mitigant to avoid issuing an instrument that later has to be de-recognized because OSFI subsequently determines the instrument to be non-compliant with the NVCC elements of the Guideline. There are several information requirements that must be satisfied in connection with a request for a confirmation of capital quality from OSFI. There are also various structural and contractual criteria that capital instruments must satisfy in accordance with the NVCC elements of the Guideline.