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Prudential plc Response to CEBS Draft Proposal on Tier 1 Hybrids

1. Introduction

Prudential plc has expressed concerns regarding two key aspects of the CEBS draft proposal for a common definition of Tier 1 hybrid instruments: 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 would be more effective through principle-based regulation, which can be adapted to the distinct regulatory, tax, and legal frameworks of different jurisdictions.

2. Principal Write-Down/Equity Conversion

2.1 Improvement of Ability to Absorb Losses

Prudential plc acknowledges the aim of enhancing the loss-absorption capacity of hybrid instruments to support the solvency of the issuer and provide a "cushion" for senior creditors in insolvency. They note that the current structure of hybrid Tier 1 instruments in the UK, including perpetual tenor, deep subordination, and solvency conditions, already provides this protection.

However, they argue that mandatory principal writedown or equity conversion would not improve the protection of senior creditors. In fact, such mechanisms may reduce the effectiveness of hybrid instruments in maintaining the issuer's going concern status and could negatively impact the position of senior creditors in liquidation.

2.2 Removal of Obstacle to Re-Capitalisation

Prudential plc is skeptical about how the proposed requirements would facilitate re-capitalisation. They highlight that:

• Principal writedown could result in a cash outflow, which may not be feasible or permitted in a distressed situation.
• Equity conversion would introduce new shareholders with voting rights, which may conflict with the interests of those seeking to re-capitalise the issuer.
• Hybrid instruments often include dividend stoppers, which prevent payments to junior capital holders. These mechanisms would likely remain in place during a writedown, reducing the incentive for re-capitalisation.

2.3 Negative Consequences

Prudential plc outlines several potential negative consequences of the proposed requirements:

• Tax Position: In the UK, automatic principal writedown or conversion may affect the "results dependent" nature of hybrid instruments, potentially disallowing periodic payments as tax-deductible expenses.
• Dilution: Equity conversion in distress could lead to significant dilution, which is a major concern for issuers.
• Transfer and Stamp Duty: These could apply during transfer or conversion, increasing costs.
• Corporate Law: Changes to liquidation preferences might require additional corporate authorizations, complicating the process.
• Position of the Holder: Depending on the jurisdiction, the inclusion of writedown or conversion features could lead to re-classification of the instrument, with implications for tax treatment and regulatory capital.
• Forced Indirect Issuance: The requirement for automatic writedown or conversion could force UK issuers (and those in similar tax regimes) to issue hybrid Tier 1 instruments indirectly, increasing legal and operational risks and costs.

Prudential plc's suggestion: Adopt an outcomes-based approach to ensure hybrid instruments have the appropriate ability to absorb losses, and delete the requirement for automatic/mandatory principal writedown.

3. Requirements for allowing ACSM

3.1 Proposed Restrictions

The draft proposal limits ACSMs to cases where they are used for tax reasons and where the issuer has full discretion over coupon/dividend payments. It also imposes conditions that:

• The shares must be made out of already authorized and unissued shares.
• The hybrid holders must subscribe for the shares.
• The shares must be issued or sold immediately to avoid debt accumulation.

3.2 Concerns with Restrictions

Prudential plc is concerned that these restrictions limit the financial flexibility of issuers and may not be necessary to support the tax analysis of hybrid instruments. They argue that:

• ACSMs can improve financial flexibility by preserving cash and enabling loss absorption.
• The requirement for hybrid holders to receive shares may be unrealistic, as the investor base for hybrids differs from that of equities, and investors may not be willing to accept shares instead of cash.
• Immediate issuance of shares may be undesirable in distress situations, and deferred payments should be allowed to avoid creating liabilities that affect the going concern of the issuer.

3.3 Prudential plc's Suggestion

Prudential plc suggests deleting the following proposed requirements:

• ACSM only allowed for tax purposes.
• Hybrid holders must receive the shares.
• Shares must be subscribed immediately.

They advocate for a principles-based approach that ensures deferred payments do not create liabilities that affect the issuer's going concern, thereby maintaining the flexibility and attractiveness of hybrid instruments.

4. Conclusion

Prudential plc believes that the proposed mandatory features of principal writedown and equity conversion may reduce the attractiveness of hybrid instruments for investors, increase costs and complexity, and fail to achieve the intended objectives. They recommend a principle-based regulation approach that focuses on outcomes rather than specific mechanisms, allowing for greater adaptability across jurisdictions.