House of Representatives

Explanatory Memorandum

(Circulated by authority of the Treasurer, the Hon Scott Morrison MP)

Chapter 5 - Conversion and write-off of capital instruments

Outline of chapter

5.1 Schedules 1-3 and 7 to this Bill amend the Industry Acts and the Corporations Act to provide certainty that capital instruments can be converted or written off as provided for in APRA's prudential standards.

Context of amendments

5.2 APRA's prudential standards require regulated entities to maintain minimum levels of regulatory capital. The prudential standards currently establish three categories of regulatory capital - 'Common Equity Tier 1' (CET1), 'Additional Tier 1' (AT1), and 'Tier 2' (T2) capital. AT1 and T2 capital instruments comprise securities (preference shares and subordinated notes, for example) that satisfy the eligibility criteria for AT1 and T2 capital set out in APRA's prudential standards.

5.3 In relation to AT1 and T2 capital, the prudential standards include particular requirements on the capacity of an instrument to 'absorb' losses experienced by a regulated entity through the conversion or write-off of these instruments in certain circumstances.

5.4 Under APRA's current prudential standards, the terms of AT1 and T2 instruments must provide that they absorb losses in the event of a 'non-viability trigger event'. ^[3]

5.5 Further, in order for AT1 instruments that are accounted for as liabilities to be considered as regulatory capital of an ADI, they must also convert or be written off where the ADI holds CET1 capital equal to or less than 5.125 per cent of its risk weighted assets (as calculated using the relevant capital requirements set by APRA's prudential standards).

5.6 APRA's prudential framework provides for two mechanisms by which AT1 and T2 capital instruments may absorb losses: conversion of those instruments into ordinary shares (or equivalent for mutually-owned ADIs); or the write-off of the instruments.

5.7 While such provisions in AT1 and T2 capital instruments are expected to function in accordance with their terms, APRA and market participants have identified some potential legal impediments to the effective operation of conversion or write-off provisions in AT1 and T2 capital instruments in certain circumstances.

5.8 It is important that contractual conversion and write-off provisions in AT1 and T2 capital instruments operate as intended in the event that the circumstances of a regulated entity meet the relevant conditions.

5.9 In June 2014, the Government released a consultation paper on proposals to make certain the effective operation of contractual loss absorption provisions in regulatory capital instruments. The amendments described in this chapter follow from that consultation.

5.10 The amendments are applied to capital instruments other than those issued as AT1 or T2 capital to provide flexibility in the event of future changes to the regulatory capital framework. In order for the amendments to apply, any such instrument will need to be issued with terms included for the purposes of conversion and write-off provisions in APRA's prudential standards at the time.

Summary of new law

5.11 The Bill amends the Industry Acts to provide increased certainty in relation to the conversion and write-off of capital instruments, including amendments to provide that:

•

conversion or write-off can happen despite any impediment there may be in:

•

any domestic or foreign law (other than, for conversion, any laws specified in the amendments or regulations made for that purpose, including laws applying to holdings in companies under Chapter 6 of the Corporations Act or under the Financial Sector (Shareholdings) Act 1998);

•

the constitution of the entity that has issued the instrument or of an entity that is a party to the instrument and (for conversion) the constitution of the entity into whose shares the instrument converts (if different);

•

any contract or arrangement to which the issuing entity, or an entity that is a party to the instrument, is a party, and (for conversion) to which the entity into whose shares the instrument converts (if different) is a party; and

•

any listing rules or operating rules of a financial market in whose official list the issuing entity, an entity that is a party to the instrument, or (for conversion), an entity into whose shares the instrument converts (if different), is included; and

•

any operating rules of a clearing and settlement facility through which the instrument is traded.

•

a stay provision applies to contractual close-out rights that may arise as a result of the conversion or write-off of a capital instrument or the making of a determination by APRA that results in a requirement for the conversion or write-off of a capital instrument.

Comparison of key features of new law and current law

Detailed explanation of new law

Conversion and write-off of capital instruments

Definitions

5.12 The Bill amends the Industry Acts to incorporate several new definitions for the purpose of the amendments to provide certainty for the conversion and write-off of capital instruments.

5.13 The new term 'clearing and settlement facility' refers to a clearing and settlement facility as defined by section 761A of the Corporations Act. The provisions of this Bill use this definition to ensure that instruments may be converted or written off despite the operating rules of a clearing and settlement facility through which the instrument is traded. [Schedule 1, item 31, section 11CAA of the Banking Act; Schedule 2, item 17, section 36A of the Insurance Act; Schedule 3, item 64, section 230AAB of the Life Insurance Act]

5.14 The new term 'conversion and write-off provisions' refers to the provisions in APRA's prudential standards that require certain capital instruments to be converted into ordinary shares or mutual equity interests, or to be written off, in certain circumstances described in the prudential standards. [Schedule 1, item 31, section 11CAA of the Banking Act; Schedule 2, item 17, section 36A of the Insurance Act; Schedule 3, item 64, section 230AAB of the Life Insurance Act]

5.15 The provisions in the prudential standards that set these requirements are currently referred to as the 'loss absorption requirements' and requirements for 'loss absorption at the point of non-viability'. ^[4] The term 'conversion and write-off provisions' is intended to refer to these provisions. However, the amendments leave room for future changes to APRA's prudential standards, including changes that might refer to instruments that are not currently considered capital under the prudential standards.

5.16 The new term 'conversion entity' is relevant in circumstances where an instrument includes terms that provide for the instrument, or rights under the instrument, to convert into ordinary shares or mutual equity interests of a different entity. Where such a conversion takes place, the instrument converts, or rights convert, into ordinary shares or mutual equity interests of the conversion entity. [Schedule 1, item 31, section 11CAA of the Banking Act; Schedule 2, item 17, section 36A of the Insurance Act; Schedule 3, item 64, section 230AAB of the Life Insurance Act]

5.17 The new term 'converts' describes any process by which instruments, or rights under instruments, may be converted into ordinary shares or mutual equity interests. This term is broadly defined in order to accommodate current and future contractual approaches to how instruments are converted into ordinary shares or mutual equity interests. [Schedule 1, item 31, section 11CAA of the Banking Act; Schedule 2, item 17, section 36A of the Insurance Act; Schedule 3, item 64 , section 230AAB of the Life Insurance Act]

5.18 The new term 'mutual equity interests' is only incorporated into the Banking Act conversion and write-off provisions, and refers to such interests as defined in APRA's prudential standards. This term is relevant to circumstances where a capital instrument has been issued by a mutually-owned ADI, or by an entity described in existing subsection 11CAB(1) with respect to a mutually-owned ADI. [Schedule 1, item 31, section 11CAA of the Banking Act]

5.19 The new term 'operating rules' refers to operating rules as defined by section 761A of the Corporations Act. The provisions of the Bill use this definition to refer to the operating rules of a financial market or a clearing and settlement facility. [Schedule 1, item 31, section 11CAA of the Banking Act; Schedule 2, item 17, section 36A of the Insurance Act; Schedule 3, item 64, section 230AAB of the Life Insurance Act]

5.20 The term 'related subsidiary' refers to a subsidiary of a holding company of a regulated entity. Note that 'holding company' is now defined in the Industry Acts (see Chapter 10). This term is used to provide for circumstances where a related subsidiary issues capital instruments that count as regulatory capital for a conversion entity. The amendments provide certainty that those instruments will absorb losses despite potential legal impediments. [Schedule 1, item 31, section 11CAA of the Banking Act; Schedule 2, item 17, section 36A of the Insurance Act; Schedule 3, item 64, section 230AAB of the Life Insurance Act]

5.21 The amendments provide that conversion of regulatory capital instruments is effective despite any law except certain specified laws. The term 'specified law' refers to the following:

•

the Financial Sector (Shareholdings) Act 1998;

•

the Foreign Acquisitions and Takeovers Act 1975;

•

Chapter 6 of the Corporations Act 2001 (takeovers).

•

any law prescribed in the regulations for the purposes of this paragraph. [Schedule 1, item 31, section 11CAA of the Banking Act; Schedule 2, item 17, section 36A of the Insurance Act; Schedule 3, item 64, section 230AAB of the Life Insurance Act]

5.22 The Bill also amends the Industry Acts to define the terms 'financial market' and 'listing rules' according to their definition in section 761A of the Corporations Act. [Schedule 1, item 7, subsection 5(1) of the Banking Act; Schedule 2, item 4, subsection 3(1) of the Insurance Act; Schedule 3, item 113, Schedule Dictionary of the Life Insurance Act]

Scope of instruments to which these amendments apply

5.23 The Bill amends the Industry Acts to describe the scope of instruments to which the amendments apply.

5.24 The amendments apply to instruments that include terms for the purposes of the conversion or write-off provisions in the prudential standards. [Schedule 1, item 31, subsection 11CAB(1) of the Banking Act; Schedule 2, item 17, subsection 36B(1) of the Insurance Act; Schedule 3, item 64, subsection 230AAC(1) of the Life Insurance Act]

5.25 The amendments apply to instruments issued by any of the following, or to which any of the following is a party:

•

a regulated entity;

•

a holding company of a regulated entity;

•

a subsidiary or a related subsidiary of a regulated entity (see 5.20 for the definition of a related subsidiary); or

•

an entity prescribed by the regulations for the purposes of these amendments. [Schedule 1, item 31, subsection 11CAB(1) of the Banking Act; Schedule 2, item 17, subsection 36B(1) of the Insurance Act; Schedule 3, item 64, subsection 230AAC(1) of the Life Insurance Act]

5.26 The amendments include a regulation-making power to prescribe other kinds of entities that might issue capital instruments that include terms for conversion or write-off. This is intended to allow flexibility to accommodate potential future capital raising structures.

5.27 Where a regulated entity is a subsidiary of one or more holding companies, the amendments are intended to cover any instrument issued to the market by a holding company of that regulated entity, and any corresponding intra-group instruments or arrangements between the regulated entity, the holding company and any intermediate holding company in order to meet the regulatory capital requirements of the regulated entity. In this case, conversion will occur in accordance with the terms of those instruments or arrangements despite the potential legal impediments listed at 5.28.

Conversion despite other laws etc.

5.28 The Bill amends the Industry Acts to ensure that instruments that are within the scope of these amendments can be converted according to their terms despite any impediments there may be in:

•

any domestic or foreign laws, except for those specified in the amendments and any regulations made for this purpose;

•

the constitution of the entity that has issued the instrument, any entity that is a party to the instrument, or any conversion entity for the instrument;

•

any contract or arrangement to which the issuing entity, any entity that is a party to the instrument, or any conversion entity for the instrument, is a party;

•

any listing rules or operating rules of a financial market in whose official list the issuing entity, any entity that is a party to the instrument, or any conversion entity for the instrument, is included; and

•

any operating rules of a clearing and settlement facility through which the instrument is traded. [Schedule 1, item 31, subsection 11CAB(2) of the Banking Act; Schedule 2, item 17, subsection 36B(2) of the Insurance Act; Schedule 3, item 64, subsection 230AAC(2) of the Life Insurance Act]

Write off despite other laws etc.

5.29 The Bill amends the Industry Acts to ensure that instruments that are within the scope of these amendments can be written off according to their terms despite any impediments there may be in:

•

any domestic or foreign law;

•

the constitution of the entity that has issued the instrument, or any entity that is a party to the instrument;

•

any contract or arrangement to which the issuing entity, or any entity that is a party to the instrument, is a party; and

•

any listing rules or operating rules of a financial market in whose official list the issuing entity, or any entity that is a party to the instrument, is included; and

•

any operating rules of a clearing and settlement facility through which the instrument is traded. [Schedule 1, item 31, subsection 11CAB(3) of the Banking Act; Schedule 2, item 17, subsection 36B(3) of the Insurance Act; Schedule 3, item 64, , subsection 230AAC(3) of the Life Insurance Act]

5.30 The above provisions allow for an instrument to be converted or written off despite the laws of a foreign country or part of a foreign country. This is intended to include laws that are in force in a country or in part of a country despite that law not having been made or otherwise implemented in the foreign country. An example of this would be the self-executing laws of the European Union.

5.31 It should be noted that operating rules of financial markets and clearing and settlement facilities will generally constitute a contract or arrangement to which the entity is party. They have been expressly referred to in these provisions for the avoidance of doubt, including to capture issues that might arise where an instrument converts in the course of a trading and settlement process conducted through a clearing and settlement facility. The explicit inclusion of operating rules of financial markets and clearing and settlement facilities in these provisions is not intended to narrow the meaning of references to contracts and other arrangements in these provisions or similar override provisions elsewhere in the Industry Acts.

Consequential amendments

Definitions of 'financial market' and 'listing rules'

5.32 As the terms 'financial market' and 'listing rules' are now defined terms in the Industry Acts (see 5.22), consequential amendments have been made to the following, to remove duplicate references. [Schedule 1, items 99, 125 and 139, paragraphs 13G(3)(d), 14A(5B)(d), and 14AA(4)(d) of the Banking Act, Schedule 2, items 48, 54 and 107, paragraphs 62Z(4)(d)62ZJ(3)(b)(iv), and 103D(3)(d) of the Insurance Act and Schedule 3, items 43, 49 and 77, paragraphs 168A(4)(d) 176(3)(b)(iv) and 230AD(3)(d) of the Life Insurance Act]

New notes in the Corporations Act

5.33 The Bill amends certain sections of the Corporations Act to include a new note in each of the sections confirming the effect of the amendments. [Schedule 7, items 1 to 3, subsections 256B(1), 437F(8), and 468A(8) of the Corporations Act]

5.34 The note explains that reductions in share capital (in existing subsection 256B of the Corporations Act), or alterations in the status of members of a company made during either the administration of the company or after the commencement of winding up by the Court (in existing subsections 437F(8) and 468A(8) of the Corporations Act, respectively), are effective despite these sections if they result from an instrument being converted or written off for the purposes of the conversion and write-off provisions.

5.35 The inclusion of these notes in certain sections of the Corporations Act is only for the purpose of explaining the effect of conversion and write-off of non-equity capital instruments and is not intended to limit the application of the amendments more widely.

Application and transitional provisions

5.36 The amendments made by the Bill in relation to the conversion and write-off of capital instruments apply in relation to the conversion or writing-off of any instrument on or after the Bill receives Royal Assent, whether the instrument was issued before, at or after that time. [Schedule 1, items 253 and 262; Schedule 2, items 139 and 144; Schedule 3, items 118 and 128]