The Office of the Superintendent of Financial Institutions (OSFI) has recently issued a ruling regarding the regulatory treatment of Limited Recourse Capital Notes (LRCNs) which are currently being adopted as new financial instruments by Canadian banks. An LRCN is a subordinated note issued by a federally regulated financial institution (FRFI) that is secured by preferred shares issued by the FRFI to a special purpose vehicle. OSFI provided this guidance given its mandate to routinely assess the quantity and quality of financial instruments that FRFIs issue as regulatory capital and/or total loss absorbing capacity.
OSFI concluded that the LRCNs meet all of the criteria to be recognized as Additional Tier 1 (AT1) regulatory capital by a Canadian bank and other FRFIs. However, recognition of the LRCNs as AT1 capital will be subject to the following limitations:
- Limitations on Investor Base:
The LRCNs can only be issued to institutional investors.
- Limitations on LRCNs’ and Preferred Shares’ Terms and Conditions:
LRCNs and preferred shares must have a minimum par or stated value of $1000 and be traded on institutional desks (i.e. not exchange-listed).
The LRCNs must have an initial term to maturity of at least 60 years.
Unless the instrument has been replaced with an instrument of higher capital quality (i.e. common equity tier 1-qualifying common shares or retained earnings), the issuer will only be permitted to redeem the LRCNs or preferred shares where the carrying cost of the LRCNs or preferred shares exceeds the cost of replacement capital of equivalent quality (i.e. AT1).
- Limit on LRCN Issuances:
LRCN issuances will be subject to a cap of 0.75% of risk-weighted assets (RWA) (i.e. 50% of the AT1 bucket) as measured on the date of issuance.
In calculating this limit, the issuer should compare the aggregate of its outstanding and proposed issuances of LRCNs on the date of issuance to 0.75% of RWA. The limit should consider the issuer’s capital at the last reporting date with adjustments for subsequent transactions including issuances, redemptions, buybacks, and acquisitions.
The disclosure and marketing of the LRCNs to investors must clearly disclose how the LRCNs’ risks are equivalent to the risks of investing in directly issued Tier 1-qualifying Non-Viability Contingent Capital preferred shares.
Should you have questions about any aspect of OSFI’s ruling as summarized above and how it affects you, please do not hesitate to contact the author.
The author would like to thank Breanne Matheson, summer student, for her contribution to this legal update.