Office of the Superintendent of Financial Institutions
The March 2021 revisions to this ruling clarify the LRCN limitations, including the limits applicable to insurers. The issue, background, facts, considerations and conclusion of the July 2020 ruling remain unchanged.
The issue is whether to recognize Limited Recourse Capital Notes (LRCNs) issued by federally regulated financial institutions (FRFIs) as Additional Tier 1 (AT1) capitalFootnote 1.
A Canadian bank (the Bank) recently issued the LRCNs to third-party investors. The structure consists of two instruments: (1) deeply subordinated interest-bearing LRCNs with a term to maturity of 60 years issued by the Bank directly to investors; and (2) perpetual, non-cumulative preferred shares issued by the Bank to a special purpose vehicle (SPV) for the benefit of LRCN holders.
This figure illustrates the LRCN structure. The structure consists of two instruments: (1) the LRCNs issued by the Bank directly to investors for cash consideration; and (2) preferred shares issued by the Bank to a special purpose vehicle (SPV) for the benefit of LRCN holders.
In the event of the non-payment of principal or interest in cash on any interest payment date, upon an event of defaultFootnote 2, or at maturity, the sole recourse against the Bank for the claims of LRCN holders will be the delivery of the preferred shares held by the SPV. Upon a non-viability trigger event as described in Chapter 2 of OSFI’s
Capital Adequacy Requirements (CAR) Guideline, the LRCNs’ principal, plus accrued and unpaid interest, will become due and payable and, upon non-payment of such principal and interest, LRCN holders will receive common shares of the Bank issued upon conversion of the preferred shares held by the SPV. Redemptions or purchases of the LRCNs or underlying preferred shares by the issuing entity will be subject to prior Superintendent approval.
In its evaluation of regulatory capital instruments, OSFI considers structures holistically. OSFI’s approach to reviewing the quality of instruments, including the LRCN structure, also emphasizes economic substance over legal form. Finally, OSFI’s assessment of instruments considers their potential behaviour and impacts on financial stability, particularly in periods of stress.
Taking into account the foregoing considerations, OSFI assessed the LRCNs and the underlying preferred shares held by the SPV both individually as well as in combination relative to the eligibility criteria set out in Chapter 2 of the CAR Guideline. OSFI’s conclusions on key interpretative questions are summarized below.
Issue # 1: Does the Bank’s obligation to settle coupon payments in cash or through the delivery of the SPV’s underlying preferred shares comply with the CAR Guideline expectation that institutions must have full discretion to cancel payments and such cancelled payments must not be an event of default or otherwise impose restrictions on the issuerFootnote 3?
OSFI concluded that the Bank has full discretion to trigger the delivery of the preferred shares to the LRCN holders in lieu of making interest payments on the LRCNs. Upon doing so, the LRCNs would be cancelled. Foregone interest payments would be cancelled, are non-cumulative and do not result in events of default or other restrictions.
Issue # 2: Given the fixed maturity date of the LRCNs in year 60, do the LRCNs satisfy the CAR Guideline requirement that Additional Tier 1 instruments be perpetualFootnote 4?
LRCN noteholders’ recourse is limited to perpetual Tier 1-qualifying instruments – Bank preferred shares or common shares – in all circumstances, including at maturity of the notes in year 60. OSFI concluded that the LRCN structure is perpetual based on its economic substance and consideration of the structure holistically rather than its component instruments.
Issue # 3: Does the LRCN structure comply with the CAR Guideline requirement that Additional Tier 1 instruments should not embed incentives to redeemFootnote 5?
OSFI concluded the LRCNs do not constitute an incentive to redeem that would be contrary to the CAR Guideline. In addition, the delivery of the preferred shares in exchange for the LRCNs under certain events would not be dilutive to the Bank’s shareholders’ equity, a key consideration in assessing incentives to redeem for instruments with mandatory or holder-initiated conversions to common shares.
OSFI concluded that the LRCN structure meets all of the criteria to be recognized as Additional Tier 1 regulatory capital by the Bank. LRCNs issued by other FRFIs will also be eligible for recognition as regulatory capital as set out below:
Recognition of the LRCNs as Additional Tier 1 capital (or equivalent by insurers) will be subject to the following limitations. OSFI may add to, amend, or delete these limitations at any time. Limitations may also vary by issuer and/or issuance.
Note: For life insurers, the following limitations supplement and are subject to any existing capital composition limits set out in OSFI’s capital guidelines. P&C insurers and mortgage insurers should consult OSFI’s Capital Division in respect of the limitations applicable to any prospective LRCN issuances.
This ruling will also apply to instruments with equivalent terms and conditions that are not characterized as “Limited Recourse Capital Notes”. To ensure the inclusion of prospective instruments as regulatory capital, institutions are encouraged to seek rulings, or capital confirmations, from OSFI prior to issuance. Additional Tier 1 capital is equivalent to Tier 1 Capital Instruments other than Common Shares in the case of life insurers or Category B capital in the case of property & casualty insurers or mortgage insurers.
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The events of default for regulatory capital instruments issued by FRFIs are limited to liquidation, insolvency, wind-up and bankruptcy.
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Refer to criterion # 7 of the Additional Tier 1 eligibility criteria set out in section 22.214.171.124 of the CAR Guideline.
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Refer to criterion # 4 of the Additional Tier 1 eligibility criteria set out in section 126.96.36.199 of the CAR Guideline.
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For clarity, any provision under these conditions applicable to a “preferred share” also applies to any other instrument recognized as Additional Tier 1 capital by OSFI.
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