The Government has recently announced a package of proposals designed to provide financial support to the banking industry. Under these proposals the Government has agreed to make available:
- £50 billion to eligible institutions under a new recapitalisation scheme
- at least £200 billion to banks under its Special Liquidity Scheme (and has agreed, until the market stabilises, to continue to conduct auctions to lend sterling for three months, and US dollars for one week, against extended collateral)
- for an interim period, an expected £250 billion guarantee (available to those eligible institutions that have raised Tier 1 capital by an amount and in a form the Government considers appropriate) of new short and medium term debt issuance to assist eligible institutions in the refinancing of their wholesale funding obligations as they fall due
The Government has also announced that the Bank of England will bring forward its plans for a permanent regime underpinning banking system liquidity, including a Discount Window facility. This note summarises some of the key considerations arising out of the £50 billion recapitalisation scheme. The Recapitalisation Scheme
What is the recapitalisation scheme?
The detail of the £50 billion recapitalisation scheme is set out in the Government’s 8 October press release 08/10/2008 100/08 Financial support to the banking industry (the 8 October press release) and 13 October press release 13/10/2008 105/08 Treasury statement on financial support to the banking industry (the 13 October press release).
Under the recapitalisation scheme, the Government will make available an aggregate of £25 billion to Abbey, Barclays, HBOS, HSBC, Lloyds TSB, Nationwide, The Royal Bank of Scotland and Standard Chartered (Tranche 1) and an incremental minimum of £25 billion further support to “eligible institutions” (Tranche 2).
Who can apply?
Tranche 2 is available to any “eligible institution”. Tranche 1 is available only to Abbey, Barclays, HBOS, HSBC, Lloyds TSB, Nationwide, The Royal Bank of Scotland and Standard Chartered.
“Eligible institutions” are UK incorporated banks (including UK subsidiaries of foreign institutions) which have a “substantial business” in the UK and building societies. UK incorporated banks (including UK subsidiaries of foreign institutions) that do not have a “substantial business” in the UK may also apply for inclusion as an eligible institution. “Eligible institution” would not seem to be sufficiently widely drafted as to include a UK branch of a foreign institution.
Neither the 8 October press release nor the 13 October press release offers any guidance as to what would constitute a “substantial business” or a “foreign institution”. However, in reviewing all applications the Government will give due regard to an institution’s role in the UK banking system and the overall economy.
How much will the Government make available to each eligible institution?
This will be finalised following detailed discussions. However, the Government announced on 13 October that it has already agreed to make capital investments in The Royal Bank of Scotland and, upon shareholder approval of the merger, HBOS and Lloyds TSB, totalling £37 billion. On the face of it, this means that Tranche 1 has been fully committed and that the Government’s remaining commitment in Tranche 2 is for a minimum of £13 billion.
What can the funds be used for?
The facilities are being established to make Tier 1 capital available to eligible institutions. As part of the Government bailout, the Financial Services Authority recommends banks have a Tier 1 capital ratio of at least 9 per cent.
How will the Government invest?
The Government may invest by subscribing for preference shares, by subscribing for permanent interest bearing shares (PIBS), or (at the request of an eligible institution) by providing assistance to an ordinary equity fund-raising.
The FSA rules state that at least 50 per cent. of a bank’s Tier 1 capital should comprise ordinary shares and retained earnings (that is, excluding preference shares). As a result, some eligible institutions will need to raise funds through issuing a combination of preference shares and ordinary shares.
Government conditions of assistance
The Government will provide assistance to eligible institutions under its recapitalisation scheme only on “terms and conditions that appropriately reflect the financial commitment being made by the taxpayer”.
Both the 8 October and the 13 October press releases identify that an eligible institution’s dividend policies may be taken into account in reaching agreement on any capital investment by the Government. Each of The Royal Bank of Scotland, HBOS and Lloyds TSB announced on 13 October that it has agreed not to pay dividends (cash dividends in the case of Lloyds TSB) on ordinary shares while any preference shares issued to the Government remain outstanding. Since these announcements, the Government has clarified that there is no blanket restriction on payment of dividends for five years. However, the precise scope of the restrictions is not yet clear.
The 8 October and 13 October press releases also identify that an eligible institution’s executive compensation practices may be taken into account and changes may be required as a condition to any Government funding.
The 13 October press release states that the commitments regarding executive compensation entered into by banks to date cover “senior” executive remuneration both for 2008 (when the Government expects no cash bonuses to be paid to board members) and thereafter (when incentive schemes will be reviewed and linked to long-term value creation, taking account of risk, and restricting the potential for “rewards for failure”). The Royal Bank of Scotland announced on 13 October that no bonuses would be awarded to any board member in 2008 and that any bonuses earned in 2009 would be paid in shares, while HBOS has announced that there will be no cash bonus for 2008. Lloyds TSB announced that although they would be entitled to take cash as an alternative, executive directors would be asked to receive their 2008 bonus entitlement in Lloyds TSB shares.
It will be interesting to see how far “down the chain” eligible institutions are expected to look when reviewing executive compensation policy. Policies on board remuneration will affect relatively few individuals and it is to be expected that in the long term a much wider group of senior employees will be affected.
Eligible institutions being asked to review short and long term remuneration policies as a condition to Government funding will have to give careful consideration to whether the proposed commitments conflict with existing compensation arrangements and practices. In particular, an eligible institution which agrees restrictions in this regard without first obtaining the consent of the senior executives affected by the commitment runs the risk of future claims from those senior executives.
Linked to this is the requirement for institutions to restrict the potential for so-called “rewards for failure”. Outgoing directors may be asked to waive their potential entitlement to pay-outs on termination (as has been reported in the press) and this may lead to tighter contractual control over future termination entitlements.
On 13 October Hector Sants, the FSA chief executive, issued a letter to the CEOs of a number of banks and building societies concerning their remuneration policies, stating that the FSA wants to ensure that firms follow remuneration policies which are aligned with sound risk management systems and controls, and with the firm’s stated risk appetite. The letter sets out the FSA’s ‘initial thoughts’ on a number of criteria for good and bad remuneration policies, with an emphasis on deferred compensation, recognising that such performance-adjusted, deferred compensation arrangements are complex to design. However, the FSA expects firms to be considering actively how to put in place these structures.
Appointment of non-executive directors
The 13 October press release states that the range of commitments entered into by banks to date includes “the right for the Government to agree with boards the appointment of new independent non-executive directors”.
Lloyds TSB announced on 13 October that the Government will work with the board of Lloyds TSB on its appointment of two new independent directors, but that should the Government’s holding in the combined entity fall below 25 per cent. the Government would only expect to be consulted on the appointment of one independent director. The Royal Bank of Scotland’s 13 October announcement also confirms that the Government will work with its board on the appointment of up to three new independent non-executive directors, “who will bring relevant commercial experience and participate as appropriate in the principal committees of the board”. It is not clear how this these arrangements have been documented between the Government and eligible institutions, although the Government is likely to have sought an undertaking that its nominee(s) will be recommended to shareholders when they become eligible for re-election by shareholders.
It will be interesting to see whether any Government appointees seek to change bank policy through their board representation, for example with respect to overdraft fees.
Commitment to support lending to small businesses and home buyers
Both the 8 October and the 13 October press releases also identify that an eligible institution’s commitment to support lending to small businesses and home buyers may be taken into account and changes may be required as a condition to any Government funding. The announcements released by The Royal Bank of Scotland, Lloyds TSB and HBOS on 13 October all set out certain commitments in relation to mortgage and SME lending. The Royal Bank of Scotland, HBOS and Lloyds TSB have agreed to immediately restore and maintain their mortgage and SME lending availability to at least 2007 levels with the active marketing of competitively priced loan products. This does not appear to constitute an agreement to price loan products to 2007 levels, although a commitment to price competitively and to restore availability to 2007 levels will of course in itself guide the future pricing of the product.
This commitment is particularly notable in the context of an expected recession and a falling housing market. Eligible institutions will therefore need to carefully consider the scope of any commitment they give as to the volume and terms of their future mortgage and SME lending.
Commercial terms of the recapitalisation scheme
The Royal Bank of Scotland, HBOS and Lloyds TSB have announced that they will raise £5 billion, £3 billion and £1 billion respectively from the Government by issuing preference shares with an annual coupon of 12 per cent. The HBOS and Lloyds TSB announcements indicate that the preference shares will be redeemable after five years, and the HBOS announcement states that after the first five years the annual coupon will change to three month LIBOR plus 700bps. No other terms of the preference share issues have been disclosed to date.
The terms of the preference shares will be a matter for negotiation with the Government, although other banks looking to strengthen their balance sheets will need to consider whether the terms of any preference shares meet the requirements to count as Tier 1 capital.
Building societies may be entitled to raise funds from the Government by issuing PIBS. PIBS are fixed interest securities issued by building societies and quoted on the stock market.
PIBS holders are members of the issuing building society and therefore will be entitled to certain rights such as voting rights. However, members of a building society are usually entitled to one vote each, regardless of the size of their holding. On a winding up, PIBS holders are likely to rank behind other lenders, depositors and members holding share accounts.
Neither the 8 October nor the 13 October press release specifies what the terms and conditions would be. However, PIBS typically have a fixed coupon, and are generally irredeemable or only redeemable at the option of the issuer (which may also require the consent of the FSA). There may be restrictions in a building society's rules as to the number of PIBS which can be issued in any one year. If the eligible building society wished to seek Government funding by way of issuing PIBS, consideration should be given to any restrictions in its rules and the process for amending the rules if necessary.
“Assistance to an ordinary equity fund-raising”
The Government may also agree to provide assistance in connection with an ordinary equity fund-raising (broadly, a placing and/or open offer, or a rights issue). The Royal Bank of Scotland, HBOS and Lloyds TSB have all announced that in addition to raising funds by issuing preference shares to the Government, they will also raise £15 billion, £8.5 billion and £4.5 billion respectively by way of a placing and open offer (in each case at a discount of 8.5 per cent. to the 10 October closing share price). These share issues are underwritten by the Government.
Negotiation will focus on the terms of the placing or underwriting agreement, including the scope of the warranties and indemnities, any commission payable to the Government and any rights that the Government may have to terminate (e.g. on the occurrence of a material adverse change). It is to be expected that rights to terminate for a material adverse change will be minimal.
The 13 October announcements of the terms of the recapitalisation scheme resulted in the share prices of Lloyds TSB and HBOS falling to below the price fixed for the placing and open offer. The Government has as a consequence come under pressure to renegotiate the terms of the preference shares, including the 12 per cent. coupon and the restriction on paying dividends on ordinary shares (although, as noted above, there seems to remain some uncertainty as to the precise nature of this restriction).
The timetable for a placing and/or an open offer is generally shorter than for a rights issue (particularly where shareholder approval is required), and this may be a key consideration in structuring the Government’s capital investment. It is worth noting that the FSA is currently considering ways in which to improve the efficiency of the rights issue process and the orderliness of the market during rights issues.
Memorandum and articles of association
An eligible institution will need to ensure that the terms of any fundraising are consistent with its memorandum and articles of association. For example, an eligible institution which proposes to create new preference shares will need to ensure that its memorandum and articles permits the creation of more than one class of shares, and an eligible institution that proposes to pay commission to the Government under the terms of a placing or underwriting agreement will need to make sure that its memorandum and articles are not inconsistent with this.
An eligible institution should also check that any commitments to be entered into by it as a condition to a fundraising do not violate the terms of its memorandum and articles. For example, an eligible institution which is requested by the Government to withhold a dividend should ensure that there is nothing in its memorandum and articles which would prevent it from making such a commitment.
An eligible institution will need to check whether it has sufficient authorised but unissued share capital to effect any share issue. If not, it will have to increase its authorised share capital, which will require an ordinary resolution to be passed on 14 clear days’ notice.
As well as having sufficient authorised but unissued share capital, eligible institutions will need to ensure that the directors have sufficient share allotment authority to enable them to issue the relevant shares. A listed company is likely to have in place a general allotment authority which, in accordance with IPC guidelines, should be limited to one third of its issued ordinary share capital. Again, if there is insufficient authority an ordinary resolution will need to be passed on 14 clear days’ notice.
Even if the directors have sufficient authority to allot shares, where they are allotting ordinary shares, they will need to ensure that they have the authority to disapply the pre-emption rights conferred on shareholders under UK company law. Since under IPC guidelines a general pre-emption right disapplication must not apply to more than 5 per cent. (7.5 per cent. in a 3-year rolling period) of the existing issued ordinary share capital, an additional specific disapplication authority is likely to be needed for a non pre-emptive issue of shares. These considerations in relation to pre-emption may also apply to an issue of preference shares (for example, where the preference shares have uncapped participating rights as to dividend or capital or are convertible into ordinary shares). Unless the articles of the eligible institution require a longer notice period, the special resolution required to disapply pre-emption rights can be passed on 14 clear days’ notice.
Shareholder approval will in any event be required where an eligible institution proposes to create a new class of shares (such as preference shares). Typically, a company with a single class of shares which wishes to create a new class of preference shares will do so by passing a special resolution, both increasing its authorised share capital by the creation of the preference shares and amending its articles to set out the rights attaching to those preference shares.
Shareholder approval may also be needed to disapply the requirement for a general offer under Rule 9 of the City Code on Takeovers and Mergers (i.e. a Rule 9 “whitewash”), as identified in more detail below.
An eligible institution will need to consider the application of the rules of any exchange on which it is listed. For example, a company which is listed on the Official List must notify an RIS as soon as possible after its board has approved any decision to withhold any dividend on its listed securities.
In particular, a listed eligible institution will need to consider, in consultation with its regulator and the Government, the timing of any announcement. It is interesting to note that no announcement was made by The Royal Bank of Scotland, HBOS or Lloyds TSB until the Government’s bailout plan was announced on 8 October, even though the share price of those banks had seen significant volatility prior to that date (in part, as a result of speculation over a possible rescue plan). An eligible institution that is in any doubt as to the timing of an announcement should consult with its regulator at the earliest opportunity.
Generally, a prospectus will be required where an Official List company conducts a rights issue or an open offer, and on a placing where the shares being issued represent 10 per cent. or more of the class of shares already admitted to trading (taking into account other share issues in the previous 12 months) or where the shares are to be offered to the public.
A prospectus would not be required where unlisted preference shares are to be issued by an Official List company to the Government alone.
A prospectus must be approved by the FSA, acting as the competent authority for listing in the UK (the “UK Listing Authority”), or by the regulatory authority in the eligible institution’s “home state” if this is not the UK. In order to seek any shareholder approval required (as described above) a listed company will need to publish a circular to convene a general meeting. In the case of a company listed on the Official List, the circular will need to comply with Chapter 13 of the Listing Rules and to be approved by the UK Listing Authority.
The IPC guidelines contemplate that no shares should be issued under a specific disapplication of pre-emption rights at a discount of more than 5 per cent. or if they represent more than 10 per cent. of the company's issued share capital. In addition, the ABI has verbally indicated that rights issues are preferred to open offers if the increase of share capital is more than 15 per cent. to 18 per cent. or the discount is greater than 7.5 per cent.
In this context, it will be interesting to see how the IPCs react to the proposals of The Royal Bank of Scotland, HBOS and Lloyds TSB to conduct a placing and open offer at a discount of 8.5 per cent to their 10 October closing price.
City Code on Takeovers and Mergers (the “City Code”)
Under Rule 9 of the City Code, if any person, or group of persons acting in concert, which acquires an interest in shares which, when taken together with an interest in shares already held by him or an interest in shares held or acquired by persons acting in concert with him, carry 30 per cent. or more of the voting rights of a company which is subject to the City Code, that person is normally obliged to make a general offer in cash to all shareholders at the highest price paid by him, or any person acting in concert with him, within the preceding 12 months.
Consideration therefore needs to be given as to whether a capital investment by the Government (including an agreement by the Government to underwrite a rights issue or a placing and/or open offer) may result in the Government being interested in 30 per cent. or more of the voting rights of an eligible institution. If it might, any offer will need to be conditional on the disapplication of the requirements for a general offer under Rule 9 of the City Code being approved by the independent shareholders of that eligible institution (i.e. a Rule 9 “whitewash”). For example, Lloyds TSB and HBOS have indicated that they will be seeking independent shareholder approval of the disapplication of Rule 9 as part of the broader merger proposal.
Furthermore, if the board of an eligible institution has reason to believe that a bona fide offer is imminent, consideration should be given to the possibility that seeking Government capital investment could be regarded as a frustrating action under Rule 21 of the City Code. The company should consider consulting the Panel in these circumstances.
If a party is considering making an offer for an eligible institution, careful consideration should be given to the terms of the offer in light of volatile market conditions. The price and certain of the conditions of the Lloyds TSB and HBOS merger announced on 18 September 2008 were subsequently amended on 13 October. It is very rare for the Panel to agree to an amendment to an offer following an initial announcement and this should be taken into account in formulating any offers for eligible institutions in the current climate.