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DETAIL RESPONSE TO CEBS DRAFT PROPOSAL FOR A COMMON DEFINITION OF TIER 1 HYBRIDS – Summary

1. Introduction

Prudential plc has expressed concerns regarding two key features of the CEBS draft proposal for a common definition of Tier 1 hybrids: mandatory principal writedown or equity conversion, and requirements to allow Alternative Coupon Settlement Mechanism (ACSM). The company believes that achieving the stated objectives of the proposal should be done through principle-based regulation, which allows for flexibility in different regulatory, tax, and legal frameworks across jurisdictions.

2. Principal Write-Down / Equity Conversion

2.1 Improvement of Ability to Absorb Losses

• The ability of hybrid instruments to absorb losses is intended to:

  • Preserve the issuer as a going concern.
  • Provide a "cushion" for senior creditors in insolvency.

• In the UK, current regulations already ensure that Tier 1 hybrid instruments support the issuer’s solvency in a manner similar to preference shares, focusing on desired outcomes:

  • The existence of the instrument should not affect the determination of insolvency.
  • Directors should not be required to consider the instrument for trading while insolvent.
  • Holders or third parties should not be able to petition for winding up based on the issuer’s inability to meet obligations under the hybrid instrument.

• The FSA also mandates an independent legal opinion to confirm compliance with these rules.

2.2 Removal of Obstacle to Re-Capitalisation

• The proposed requirements, especially mandatory principal write-down, are unclear in how they would benefit re-capitalisation.
• A write-down would require the issuer to redeem the instrument at the reduced amount, leading to a cash outflow in a distress situation, which may not be feasible or permitted.
• A conversion into ordinary shares could create new shareholders with conflicting interests, potentially undermining the re-capitalisation process.
• Hybrid instruments often include dividend stoppers to prevent junior capital holders from receiving dividends. These would likely apply during a write-down, making it unattractive for re-capitalisation.

2.3 Negative Consequences

• Tax Position: Automatic write-down or conversion could classify hybrid instruments as "results dependent", which would make periodic payments non-deductible for tax purposes. It may also affect tax grouping.
• Dilution: Equity conversion in a distress situation could lead to massive dilution, which is a major concern for issuers.
• Transfer and Stamp Duty: These could apply to transfers or conversions, increasing costs.
• Corporate Law: Changes in liquidation preferences may require corporate authorisations, complicating the process.
• Holder's Position: Depending on the jurisdiction, the inclusion of write-down or conversion features may lead to re-classification of the instrument, affecting tax treatment and regulatory capital.
• Forced Indirect Issuance: In the UK and similar jurisdictions, such requirements could force indirect issuance, increasing legal and operational risks and costs. Indirect issuance is currently not permitted for insurers.

Prudential plc's Suggestion

• Adopt an outcomes-based approach to ensure hybrid instruments have the appropriate ability to absorb losses.
• Delete the requirement for automatic/mandatory principal write-down.

3. Requirements for allowing ACSM

3.1 Proposed Restrictions on ACSM

• The draft states that ACSMs are acceptable only for tax reasons and only if the issuer has full discretion over coupon or dividend payments.
• Additional conditions include:
  • Shares must be pre-authorized and unissued.
  • Hybrid holders must subscribe for them.
  • Shares must be subscribed immediately to avoid debt accumulation.

3.2 Concerns and Criticisms

• The benefits of these restrictions are unclear.
• The limitations on ACSM use reduce financial flexibility for issuers.
• Even if ACSMs are not needed for tax purposes, they can improve financial flexibility by preserving cash and enabling loss absorption.
• Requiring immediate issuance of shares is undesirable in distress situations and may hinder the ability to defer payments.
• Most hybrid instruments already have suitable mechanisms for settling current coupons through ACSM.

Prudential plc's Suggestion

• Delete the following proposed requirements:
  • ACSM only allowed for tax purposes.
  • Hybrid holders must receive the shares issued under the ACSM.
  • Shares for ACSM must be subscribed immediately.
• A principles-based approach can prevent undesirable liability build-up while allowing deferred payments without affecting the issuer’s going-concern status.

4. Conclusion

Prudential plc advocates for a principle-based regulatory framework that preserves the unique characteristics of hybrid Tier 1 instruments. The proposed mandatory write-down or conversion features and restrictive ACSM requirements could reduce the attractiveness of hybrid instruments for investors, increase costs and complexity, and undermine the loss-absorbing capacity of these instruments without clear benefits to senior creditors.