The following frequently asked questions (FAQs) provide further information to assist regulated entities in the interpretation of Prudential Standard APS 111 Capital Adequacy: Measurement of Capital (APS 111), GPS 112 Capital Adequacy: Measurement of Capital (GPS 112), and LPS 112 Capital Adequacy: Measurement of Capital (LPS 112) (the relevant prudential standards) with respect to the requirements for Additional Tier 1 Capital and Tier 2 Capital instruments.
These FAQs do not provide an exhaustive list of examples and regulated entities are encouraged to contact APRA where they have questions regarding the interpretation of the relevant prudential standards.
Section 1: Information relevant for APRA’s assessment of the eligibility of capital instruments
Section 2: Minority Interests
Section 3: Conversion requirements for Additional Tier 1 and Tier 2 Capital instruments
Section 4: Cross-default provisions in relation to Additional Tier 1 and Tier 2 Capital instruments
Section 5: Incentives to redeem Additional Tier 1 and Tier 2 Capital instruments
Section 6: Optional Redemption of Additional Tier 1 and Tier 2 Capital instruments
Section 7: Distributions on Additional Tier 1 Capital instruments
Section 8: Marketing of Additional Tier 1 and Tier 2 Capital instruments
Section 9: Use of laws of a foreign jurisdiction in Additional Tier 1 and Tier 2 Capital instruments
Section 10: Default and Winding-up in relation to Tier 2 Capital instruments
Section 11: Mutual Equity Interests
Note: These FAQs are published for information purposes only. The content of these FAQs is not legal advice. Users are encouraged to obtain professional advice about the application of any legislation or prudential standard to their particular circumstances.
Users should exercise their own skill and care when relying on any material contained in the FAQs. APRA disclaims any liability for any loss or damage arising out of any use of or reliance on these FAQs.
1.1: What information will facilitate APRA’s assessment of Additional Tier 1 and Tier 2 capital instruments?
In assessing the eligibility of an existing or proposed capital instrument, APRA will wish to review a complete set of relevant documents for that capital instrument. This includes:
- a statement of compliance (refer to 1.2);
- the prospectus or information memorandum;
- the terms and conditions;
- the term sheet and/or pricing supplement;
- relevant opinions (e.g. accounting, tax and legal – refer to 1.4), rulings, advices and waivers; and
- any ancillary and supporting agreements (e.g. agency agreement, dealer agreement) (refer to 1.8).
APRA’s assessment will be facilitated if all documentation for a proposed capital instrument is in the form of well-developed and consistent drafts. Where amendments have been made to a base document over time, it will assist if APRA is provided with a consolidated copy of the current draft document, with new clauses/content identified. In addition, an explanation of the rationale behind the insertion of new clauses/content or innovative features and how they are consistent with the prudential requirements will facilitate APRA’s assessment.
Drafting errors in the documentation or lack of an adequate explanation of the rationale behind inclusion of new clauses/content or innovative features will inevitably lead to delays in APRA’s assessment process as the errors will need to be rectified and the documents resubmitted and an explanation for the changes provided.
1.2: What information is sought in a statement of compliance?
To assist APRA’s assessment of a capital instrument, the statement of compliance is expected to:
- address each required capital eligibility criterion set out in the relevant prudential standards;
- clearly set out references to supporting transaction documents and opinions; and
- relate to the final issue documents or at least well-developed draft versions.
A senior executive of the regulated entity should sign the statement of compliance, acknowledging responsibility for the assessment.
1.3: What additional information may be sought when APRA is assessing an Additional Tier 1 or Tier 2 capital instrument?
Where there are multiple entities involved in the instrument (including at conversion or write-off), diagrams depicting the interactions between entities in various scenarios and accompanying accounting entries may assist APRA’s assessment.
If the instrument is to be issued by a subsidiary within an ADI Level 2 group, the regulated entity will need to determine the impact on Regulatory Capital of the minority interest restrictions. Provision of the full calculation will facilitate APRA’s review - refer also to 2.1. (The minority interest restrictions on Additional Tier 1 and Tier 2 capital instruments do not apply to other industries.)
1.4: What opinions are needed to facilitate APRA’s assessment of an Additional Tier 1 or Tier 2 capital instrument?
For any new or revised capital instrument APRA expects provision of opinions from independent experts on the:
- accounting treatment;
- tax treatment; and
- legal status of the instrument in all relevant jurisdictions.
Opinions need to be able to be relied upon by APRA to its satisfaction. For this reason, opinions ideally will be addressed to APRA. Alternatively, where opinions are addressed to the entity, APRA expects the opinion will include a statement that the advice may be relied upon by APRA for the purpose of assessing capital eligibility under the relevant prudential standards.
1.5: What matters will APRA look for in the accounting opinion?
To facilitate assessment of whether the instrument will meet the requirements of the relevant prudential standards, the accounting opinion will need to address whether:
- the instrument constitutes equity or is a liability for accounting purposes;
- conversion of the instrument will generate an unequivocal increase in Common Equity Tier 1 (CET 1) Capital under Australian Accounting Standards on a Level 1 and Level 2 basis (if relevant);
- write-off of the instrument will generate an unequivocal increase in CET 1 Capital under Australian Accounting Standards on a Level 1 and Level 2 basis; and
- an approval from APRA for any capital reserve generated by the accounting treatment is required.
1.6: What matters will APRA look for in the tax opinion?
To facilitate assessment of whether the instrument will meet the requirements of the relevant prudential standards, the tax opinion, at a minimum, will need to address any adverse tax consequences (including potential tax liabilities and tax offsets) which may arise as a result of conversion or write-off of the instrument, as well as any other relevant issues.
If the opinion concludes that there are potential tax implications arising from the primary means of loss absorption (whether conversion or write-off) including reductions in deferred tax assets, increases in deferred tax liabilities, or other offsets arising from conversion or write-off, the regulated entity will need to determine its best estimate of the offset value and consequently the net amount of CET 1 Capital that will be generated by full conversion or write-off of the instrument. This estimate can take account of the fact that net deferred tax assets are already deducted from CET 1 Capital. This analysis will typically involve scenario analysis demonstrating the potential impact of the conversion or write-off. The regulated entity will also need to determine how this best estimate will be updated during the life of the instrument. APRA will wish to review this information.
1.7: What matters will APRA look for in the legal opinion?
To facilitate assessment of whether the instrument will meet the requirements of the relevant prudential standards, the legal opinion will need to address whether:
- the issue of the instrument is legally permitted and in compliance with applicable law, including the issuer’s constitution;
- the issuer has obtained all approvals and authorisations required in relation to the issue of the instrument and the performance of the terms of the instrument;
- the instrument will constitute valid and legally binding obligations of the issuer, enforceable in accordance with the terms of the instrument, including subordination;
- the conversion/write-off arrangements are legally effective and there are no legal impediments to those arrangements operating in accordance with their terms; and
- the laws of any foreign jurisdiction applying to the instrument could prevent it from satisfying the qualifying criteria for Additional Tier 1 or Tier 2 capital under the relevant prudential standards. See also 9.1.
For mutual ADIs, additional opinions in respect of instruments that convert to Mutual Equity Interests (MEIs) will typically be sought. (See 11.1 below.)
1.8: What is the relevance of ancillary agreements (including agency agreements, agreements with dealers etc.) to assessing the eligibility of a capital instrument?
In its assessment of the eligibility of a capital instrument, APRA will wish to consider whether there are provisions in any documents related to an instrument that may hinder recapitalisation of the regulated entity or any other members of the group to which the issuer belongs.
In addition, APRA will wish to assess whether ancillary documentation is consistent with, and appropriately supports, the operation of the instrument in accordance with its terms.
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2.1: How is the eligible Regulatory Capital of an ADI or general insurer attributable to third parties/minority interests calculated?
Under the relevant prudential standards, eligible Regulatory Capital issued by a fully consolidated subsidiary of an ADI or general insurer to third parties may be included in Regulatory Capital at Level 2, subject to the deduction of any surplus capital amount above the minimum regulatory requirements.
For general insurers, the minority interest restrictions only apply to CET1 capital. However, for ADIs, minority interest restrictions apply to CET1, Additional Tier 1 and Tier 2 capital. Where applicable, the ADI or general insurer will need to undertake an analysis of the implications for the amount of eligible capital under the relevant prudential standards and verify the calculation. If a minority interest calculation is required for an ADI, the calculation needs to be completed at each tier of capital, regardless of the tier of capital of the minority interests.
The minority interest provisions relating to Additional Tier 1 and Tier 2 capital instruments for ADIs only apply to complying Basel III instruments. APRA notified ADIs in the Response to Submissions II: Implementing Basel III Capital Reforms in Australia (http://www.apra.gov.au/adi/PrudentialFramework/Pages/Implementing-Basel-III-capital-reforms-in-Australia-September-2012.aspx) that capital instruments issued by subsidiaries of an ADI to third parties which are subject to the transition requirements would not be subject to the minority interests haircut as they were already subject to transition haircuts. However, these instruments are a component of capital of the subsidiary and need to be included in the total of the relevant tier of capital of the subsidiary when calculating the percentage of capital which is attributable to third parties (i.e. included in the denominator of this calculation). The amount to be included is the current transitional amount as approved by the home regulator.
For capital instruments issued by a subsidiary of an ADI, the ADI will also need to consider the implications under Prudential Standard APS 111 Attachment D (Regulatory adjustments) and Prudential Standard APS 222 (Associations with Related Entities) in the event of conversion/write-off.
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3.1: How does the conversion formula need to operate for determining the number of Common Equity Tier 1 Capital instruments issued on conversion of an Additional Tier 1 or Tier 2 Capital instrument?
Under the relevant prudential standards the conversion formula must be fixed in the issue documentation.
To ensure that conversion can occur immediately when required, the conversion formula needs to ensure that the number of shares to be received upon conversion is capable of being ascertained immediately, objectively and without further steps.
In cases where the issuer of ordinary shares is not listed, and a traded share price is not available, it will be necessary to refer to the book value of ordinary shares as reported in the most recently available reports. Proposals for the directors or a third party to determine the valuation following the occurrence of a relevant trigger event will not be acceptable.
If it is possible for the book value of ordinary shares to be equal to or less than zero, the terms would usually state that a maximum number of shares to be received upon conversion will apply in such cases.
For instruments which are, or may be, issued in foreign currency the method for determining the exchange rate at relevant times needs to be clear. In addition, issuers need to ensure that the exchange rate used is (a) the prevailing exchange rate for calculating the conversion number, and (b) the issue date exchange rate for calculating the maximum conversion number.
Issuers need to ensure that there is a method for determining the exchange rate at the time of a trigger event if markets are closed at the intended time of conversion and that any calculations for the adjustment of the conversion formula are also fixed in the issue documentation. See also 3.2.
In the case of MEIs, refer to 11.1.
3.2: Under what circumstances can the ordinary share price at time of issue be adjusted when calculating the maximum number of ordinary shares to be received upon conversion of an Additional Tier 1 or Tier 2 Capital instrument?
Under the relevant prudential standards, the formula for determining the maximum number of ordinary shares received upon conversion must be set out in the issue documentation, based on the ordinary share price at the time of issue. The maximum number of ordinary shares received upon conversion needs to be capable of being ascertained immediately, objectively and without further steps.
The allowable adjustments to the ordinary share price at the time of issue, as set out in the relevant prudential standards, are designed to reflect transactions that change the number of shares on issue without involving any exchange of value and have no impact on the capital base. Transactions involving cash payments or other compensation to or by holders of ordinary shares, or to or by the issuer of ordinary shares, are excluded. For example, rights issues, off-market buy-backs, return of capital and payments of special dividends must not give rise to any adjustment.
3.3: What happens if the issuer is acquired by a third party and any future conversion of an Additional Tier 1 or Tier 2 Capital instrument is to be into ordinary shares of the acquirer?
If an issuer wishes to enable an acquirer to issue shares upon conversion of a capital instrument following an acquisition event (instead of converting the instrument prior to that event), the terms of the instrument need to provide for all amendments required to issue the shares in compliance with the relevant prudential standards, including amendments to trigger events, maximum conversion numbers etc., and for recapitalisation of the regulated entity.
3.4: What is considered immediate conversion or write-off of an Additional Tier 1 or Tier 2 Capital instrument for the purposes of the relevant prudential standards?
Under the relevant prudential standards, immediate conversion or write-off must occur when the regulated entity reaches a loss absorption trigger point or when the regulated entity is notified that APRA considers it would become non-viable.
The instrument must enable conversion or write-off to occur at any time of the day and on a day that is not a business day.
If conversion has not been fully effected, for any reason, within 5 business days of the relevant trigger event, the terms need to unambiguously provide for write-off (including termination of the right to receive ordinary shares, principal and interest) as at the time of the relevant trigger event.
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4.1: What is required of an issuer in relation to the cross-default clauses requirement contained in the relevant prudential standards?
Under the relevant prudential standards, the issuer needs to ensure that there are no cross-default clauses in the documentation of any debt instrument or other capital instruments of the issuer that link performance of the issuer’s obligations under a capital instrument to default by the issuer, or another party, under any of its other obligations.
It is not sufficient to simply state that there are no cross-default clauses contained in the capital instrument being assessed as this statement does not cover clauses in other instruments. Difficulties arising with performance of any obligations under a capital instrument must not lead to default on other debt or capital obligations. For purposes of APRA’s assessment of the eligibility of a capital instrument, confirmation of this can be provided by the issuer as part of the statement of compliance referred to in 1.2 above.
For ADIs, these provisions on cross default clauses are in addition to the general prohibition on cross default clauses involving related entities set out in Prudential Standard APS 222 Associations with Related Entities.
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5.1: What is considered an incentive to redeem under the relevant prudential standards?
Under the relevant prudential standards, Additional Tier 1 and Tier 2 Capital instruments cannot contain step-ups in interest rates or other incentives to redeem. APRA considers the following provisions as examples of incentives to redeem, in addition to those specifically identified in the standards. For example:
- Mandatory conversions and options for investors to require a conversion (other than in relation to unanticipated changes of control) are considered incentives to redeem, except for conversions where there is a minimum of 2 years from the date the issuer may call the instrument to the date the conversion may be exercised. APRA has concerns that an impending exercise of such options may trigger a pre-emptive redemption, repayment or repurchase by the issuer.
- In certain circumstances minimum and maximum interest rates can act as a step-up and therefore are considered to be incentives to redeem.
- An option to redeem (as opposed to automatic conversion) following a change of control event is also considered an incentive to redeem.
5.2: When is a change in basis in the rate of distribution not regarded as an incentive to redeem?
A change in the rate of distribution from a fixed to a floating rate (or a different fixed rate basis) on an Additional Tier 1 or Tier 2 Capital instrument may not be regarded as an incentive to redeem in certain situations. For this to be acceptable, issuers need to ensure that the manner in which the margin over the reference rate will be determined does not constitute a step-up or other incentive to redeem.
A sufficient condition for a change to be acceptable is if the margin associated with the initial rate at the time the instrument is priced and the margin applying during the subsequent new rate period are the same. In each case, the margin needs to be measured relative to a current reference rate with the same tenor as the period for which the rate is being set, and assuming no change in the basis.
The type of credit risk underlying the reference rate also must not change e.g. it must always be a relevant bank swap rate, or always a government bond/note rate.
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6.1: What criteria apply to a call in respect of a tax event or a regulatory event?
Under the relevant prudential standards, an Additional Tier 1 or Tier 2 Capital instrument may only provide for a call within the first five years of issuance as a result of a tax or regulatory event. APRA expects a tax event or a regulatory event, after which an instrument may be called, to be:
- confined to changes in law (and related judicial and administrative actions);
- confined to changes that have occurred or will occur, as opposed to changes that may occur;
- related only to changes in tax or regulation;
- related to the specific instrument;
- related only to jurisdictions relevant to the specific instrument; and
- not expected at the time of issue.
Approval to redeem early will not be granted if APRA considers the regulated entity was in a position to anticipate the event when the instrument was issued.
6.2: Can a call notice in an Additional Tier 1 Capital or Tier 2 Capital instrument be irrevocable in all circumstances?
The documentation needs to be clear that when a loss absorption trigger point is reached or a non-viability trigger event occurs, the loss absorption provisions will operate without regard to any notification of early redemption.
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7.1: Are there any restrictions on the dividend stopper provisions that may be contained in an Additional Tier 1 Capital instrument?
The relevant prudential standards limit the use of dividend stoppers within Additional Tier 1 Capital instruments. In implementing these, issuers need to ensure that any restriction on the payment of distributions to holders of CET 1 Capital instruments is subject to an exception for any distributions or other payments which it is legally obliged to make as at the time the restriction comes into force.
Regulated entities also need to ensure that any restriction on the payment of these distributions, or any restriction on redemptions or buybacks of CET 1 Capital instruments, does not apply to (1) any existing holding company of the issuer, or (2) any potential future holding company of the issuer, where the holding company does not undertake the role of issuer of the instrument.
This includes situations where a future holding company is substituted as the issuer of ordinary shares on conversion, but not as the issuer of the instrument.
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8.1: What information is considered by APRA when assessing whether the marketing of a capital instrument suggests that the instrument does not meet the appropriate capital criteria?
The relevant prudential standards require that Additional Tier 1 and Tier 2 Capital instruments must be marketed in accordance with their prudential treatment. All marketing documentation issued by or on behalf of an issuer is relevant for this purpose.
Material produced by third parties (such as media, dealers, investors) suggesting that an instrument has lesser capital attributes than its prudential classification should be followed up and addressed by the regulated entity to the extent they are aware, and to the extent feasible. This might include, for example, material that:
- suggests Additional Tier 1 Capital instruments are not permanent, such as references to term to maturity or maturity date or that APRA will approve redemption; or
- indicates a ranking or subordination of Additional Tier 1 or Tier 2 Capital instruments that is inconsistent with the relevant prudential standard.
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9.1: What is required to comply with the relevant prudential standards in relation to the laws of foreign jurisdictions?
Where a capital instrument is subject to the laws of a jurisdiction other than Australia or its territories, the relevant prudential standards require a regulated entity to ensure that the instrument still satisfies the qualifying criteria under these standards.
In addition, the loss absorption and non-viability provisions in the instrument must be subject to Australian law. This means that the regulated entity needs to ensure that the laws of the foreign jurisdiction do not override the provisions within the instrument designed to meet the criteria for inclusion in the relevant category of capital.
Acceptable evidence of this would typically include a legal opinion confirming:
- that the laws of the foreign jurisdiction will not override Australian Law in relation to the loss absorption and non-viability provisions;
- whether there are known impediments to the terms of the instrument operating as intended; and
- whether there are any conflicts between the relevant laws of the foreign jurisdiction and the relevant laws of Australia or its territories.
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10.1: What is considered irrevocable winding-up for the purposes of the provisions of the relevant prudential standards permitting acceleration of repayment?
Under the relevant prudential standards, a Tier 2 Capital instrument must confer no rights on holders to accelerate repayment except in bankruptcy (including wind-up) and liquidation. Wind-up must be irrevocable.
For the purposes of its definition within a Tier 2 Capital instrument, APRA considers wind-up to be irrevocable when there has been an effective resolution by shareholders or members for winding-up, or a court order for winding-up has been made and that time for an appeal of the decision has passed.
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11.1: What needs to be considered when a mutual ADI is applying for approval of an instrument that converts to an MEI?
The issue by an ADI of an instrument that converts to MEIs has additional considerations compared to the issue of an instrument that converts to ordinary shares. The ADI needs to ensure that the terms of the instrument, the MEIs and its Constitution align and meet the requirements of APS 111.
If an ADI is planning to issue an instrument that converts to MEIs it will need to provide to APRA full documentation of the instrument, as outlined in 1.1, and of the MEIs, including any proposed amendments to its Constitution, to enable approval of the instrument under Attachment K paragraph 13.
In addition to the opinions listed under 1.4, an ADI issuing an instrument that converts to an MEI will need legal advice to confirm whether or not any amendments to its Constitution, the issue of the capital instrument or the issue of MEIs will trigger provisions under Part 5 of Schedule 4 of the Corporations Act.
For purposes of assessing the eligibility of the capital instrument under the relevant prudential standards, APRA requests that the ADI submit an independent legal opinion on this matter, on which APRA can rely. If the provisions of Part 5 of Schedule 4 of the Corporations Act are triggered, then the ADI will also need to advise APRA if it has requested relief from ASIC and whether ASIC has provided such relief.
11.2: How do the provisions for the distribution of residual assets operate to ensure that MEIs are most subordinated and any surplus is distributed proportionately between the MEIs and members?
Under APS 111 Attachment K paragraphs 4, 5, and 6 any residual assets must be distributed pari passu between member interests and holders of MEIs on a proportionate basis, subject to a cap for holders of MEIs.
The residual assets are those that remain after all senior claims have been repaid and satisfied in full. Senior claims to MEIs include the subscription price for member shares.
In calculating the proportionate basis for distribution of any residual assets, the nominal contribution of the members to the surplus is based on the aggregate nominal value of the members’ interests (whether paid or unpaid) and the nominal value of MEIs is based on the value of the host instrument converted to MEIs.
The residual assets are distributed proportionally between the MEIs and the members’ interests until the aggregate nominal value of the MEIs is distributed to holders of MEIs. Any remaining surplus beyond this point is distributed to the members’ interests.
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