- International Context
- Compensation Regime
Where CDIC uses one of its resolution tools to resolve a failing financial institution, it is expected that the creditors and shareholders of the financial institution will be in a better financial position than if the financial institution had simply been liquidated (or wound up).2 This is because the losses incurred in liquidation through the closure of the financial institution would generally far outweigh those that would be incurred as a result of the use of one of CDIC’s resolution tools.
However, if that were not the case, the CDIC Act provides an important safeguard to ensure that creditors and shareholders of the financial institution are compensated where they have been made worse off as a result of CDIC’s actions than they would have been in a liquidation.
This protection is consistent with international standards and best practices.
Canada has been an active participant in the G20’s financial sector reform agenda aimed at addressing the factors that contributed to the global financial crisis that began in 2008. This includes international efforts to address the potential risks to the financial system and broader economy posed by systemically important financial institutions perceived as “too-big-to-fail”.
Following the financial crisis, the Financial Stability Board (FSB) set out the responsibilities and powers that authorities should have in place to resolve large complex financial institutions. These international standards are known as the Key Attributes of Effective Resolution Regimes for Financial Institutions (the “Key Attributes”). The objective of the Key Attributes is to make it possible for authorities to resolve a large, complex financial institution in a manner that protects eligible deposits, maintains the flow of critical financial services, protects the economy, and minimizes risk to taxpayers.
The Key Attributes set out essential features that should be part of the resolution regimes for financial institutions in all jurisdictions. One of these features relates to the safeguards resolution regimes should contain to protect affected creditors of the failed financial institution. This safeguard ensures that creditors of the failed financial institution are not made worse off in resolution than they would have been in liquidation.
Specifically, Key Attribute 5.2 states:
Creditors should have a right to compensation where they do not receive at a minimum what they would have received in a liquidation of the firm under the applicable insolvency regime (“no creditor worse off than in liquidation” safeguard).
The legislative framework for CDIC’s compensation regime is set out in the CDIC Act. The CDIC Act sets out a test for compensation, which entitles creditors and shareholders of the financial institution to compensation should they be left worse off as a result of CDIC’s actions to resolve a failed financial institution than they would have been if the financial institution had been liquidated (the No Creditor Worse Off or NCWO test).
Under the statutory authority of the CDIC Act, the Compensation Regulations set out who may be entitled to compensation, provide further details on the test for determining whether a creditor or shareholder of the failed financial institution is entitled to compensation, and outlines procedural requirements.
Who might be entitled to compensation?
A creditor or shareholder may be entitled to compensation if he or she held shares or certain liabilities of the failed financial institution at the time the financial institution entered into resolution (which is the date the Governor-in-Council (GIC) order was issued).
Under the Compensation Regulations, the following persons may be entitled to compensation:
- Holders of bail-in debt whose debt has been converted into common shares pursuant to the bail-in power;
- Holders of non-viability contingent capital (NVCC) instruments whose instruments3 have been converted into common shares pursuant to their contractual terms;
- Debtholders whose subordinated debt has been transferred to CDIC (see FIRP);
- Shareholders of the financial institution;
- Holders of any liability of the financial institution, if the financial institution was liquidated (or wound up) at the end of the resolution process; and
- Holders of any liability of the financial institution that was assumed by either a CDIC-owned workout company4or a bridge institution, which was subsequently liquidated or wound up.
Who is not entitled to compensation?
The compensation regime is designed to protect the persons who have been affected by CDIC’s actions. Persons who have not been affected by the resolution will not be entitled to any compensation. For example, persons whose liabilities have been assigned to a third party (for example, a bridge institution), or persons whose claims had been paid in full (i.e., were ‘made whole’) during the resolution will not be entitled to compensation.
Persons who may be entitled to compensation cannot transfer their right to compensation to other persons. Any transfer of the right to compensation will not be recognized for purposes of the compensation process.
How will compensation be calculated?
No Creditor Worse Off Test
The test for determining whether a person is entitled to compensation is: Compensation = Liquidation Value – Resolution Value5 where
- Liquidation Value = an estimate of what a person would have received if the entire financial institution had been liquidated. Liquidation Value will be estimated as of the date the financial institution entered resolution (i.e., the date of the GIC order).
- Resolution Value = an estimate of the aggregate value that a person retained or received (or will receive) through the resolution process. For example, in a bail-in scenario, this would include both the:
- Value that the person retained through the resolution (for example, any common shares that are not transferred to CDIC and are retained by pre-existing shareholders); and
- Value that the person received during the resolution process, from CDIC, the financial institution or a liquidator (for example, common shares that bail-in debtholders received as a result of the bail-in conversion; or any other cash or securities received in the context of the resolution process). Resolution Value will be estimated as of the date that CDIC is no longer in control or ownership of the failed financial institution (for example, when the financial institution is returned to private sector control or when the financial institution is liquidated). If a person who is entitled to compensation sells their share or liability before this date, CDIC will estimate the Resolution Value as if the person had not sold their share or liability.
The test will be calculated for each class of shares or liabilities that a creditor or shareholder held at the time the financial institution entered into resolution (i.e., the date of the GIC order).
In determining the amount of compensation to which a creditor or shareholder might be entitled, CDIC is not permitted to compare them against how other creditors or shareholders did in resolution (for example, a creditor will not be owed compensation solely because lower ranking shareholders or creditors retained or received shares or liabilities with some value in resolution).
Compensation will only be payable by CDIC where the Liquidation Value is greater than the Resolution Value – no compensation is payable when a person’s Resolution Value is greater than (or the same as) their Liquidation Value.
CDIC is required to make certain assumptions when determining the offer of compensation. For example, in estimating the Liquidation Value, CDIC is required to assume that the financial institution would not have received any financial assistance or support from CDIC, the Bank of Canada, the Government of Canada or a province as part of the liquidation.
How will the compensation process work?
The compensation process begins when CDIC is no longer in control or ownership of the failed financial institution (for example, when the financial institution is returned to private sector control or when the financial institution is liquidated).
To implement the compensation process, CDIC will:
- Identify persons who might be entitled to compensation (Identified Persons).
- Determine the value of each Identified Person’s share or liability at the time the financial institution entered into resolution.
- Determine whether any compensation is owed to Identified Persons by calculating Liquidation Value and Resolution Value. CDIC (or a valuator engaged by CDIC) will have a reasonable amount of time to conduct the necessary valuations.
- Provide notices. CDIC must provide each Identified Person with an offer of compensation or must notify them that no offer of compensation is being made. CDIC must make the same offer of compensation to Identified Persons who held shares or liabilities of the same class in proportion to the value of their claim. Shares or liabilities will be considered to be in the same class if they would rank equally in the event of a liquidation of the financial institution and received equivalent treatment in the resolution.
- Publish a summary of the offer of compensation (for each class) in the Canada Gazette and on the website of the financial institution.
- Collect any objections to CDIC’s offer (or lack of offer) of compensation (for purposes of appointing an assessor). Identified Persons will have 45 days from the date of publication in the
Canada Gazette to notify CDIC if they accept or reject CDIC’s offer of compensation. If an Identified Person does not notify CDIC within the 45 days, they are deemed to have accepted the offer. If an Identified Person accepts CDIC’s offer, or fails to respond to the offer, they will no longer have any claim against CDIC or the financial institution.
- Distribute any compensation.
CDIC may retain professionals (i.e., qualified persons or firms who have experience administering claims processes, such as Licensed Insolvency Trustees) to help it administer the compensation regime and complete the steps outlined above.
What if persons disagree with the Notice of Compensation?
Identified Persons who disagree with CDIC’s offer of compensation must notify CDIC within 45 days from the date of publication in the Canada Gazette that they reject CDIC’s offer of compensation.
If Identified Persons who held 10% of the value of the debt of a given class, or 10% of the shares of a given class6, object to CDIC’s offer of compensation, the GIC is required to appoint a judge (an “assessor”) to review CDIC’s determination of compensation.
Only the Identified Persons who object to CDIC’s offer and are part of a class that meets the 10% threshold will have their compensation determined by the assessor. Those who accept CDIC’s offer, fail to respond to the offer, or who rejected CDIC’s offer but the 10% threshold was not reached, will receive the amount set out in the offer.
In reviewing CDIC’s offer of compensation and determining the amount of compensation owed, the assessor is required to consider whether CDIC’s offer was reasonable and consider the same factors as those that CDIC was required to apply when making its initial determination of compensation. The assessor could determine that a different amount of compensation is payable, which could either be higher or lower than the amount offered by CDIC.
The assessor’s determination of compensation owed is final and there are no further opportunities for review or appeal of the assessor’s determination in any court or tribunal.
When will compensation be paid?
Identified Persons will be paid:
- In the case of Identified Persons who accepted CDIC’s offer of compensation, failed to respond to the offer, or who rejected CDIC’s offer but the 10% threshold was not reached, within 90 days of the expiry of CDIC’s offer of compensation; and
- In the case where an assessor was appointed as the 10% threshold was reached, within 90 days of the final determination of the assessor.
Compensation would be paid from CDIC’s funds. CDIC is funded through deposit insurance premiums assessed against its member institutions.
Stylized example – Compensation (Bail-in debtholder)
The following is a simplified example to illustrate how compensation entitlements may be determined. It is based on a hypothetical financial institution, ABC Bank, that is resolved by CDIC through a bail-in resolution. This example calculates the compensation for a bail-in debtholder only. Other persons affected by the resolution could have different entitlements to compensation. The situation would be more complex in actual practice.
- Following a non-viability report on ABC Bank from OSFI, CDIC recommended to the Minister one of its resolution tools, namely that ABC Bank’s shares be vested in CDIC. Subsequently, CDIC took control of ABC Bank in accordance with a GIC order (see EFIRP).
- XYZ Fund, a hypothetical investment fund held bail-in debt (senior debt) issued by ABC Bank with a principal amount of $1000 upon entry to resolution.
- During resolution, XYZ Fund’s debt was converted into common shares by CDIC.
- XYZ Fund received 220 common shares.
Test for determining compensation
Compensation = Liquidation Value – Resolution Value
Estimation of liquidation value
Liquidation Value is an estimate of what a person would have received if the entire financial institution had been liquidated.
After completing a detailed valuation, CDIC estimates that, in a hypothetical liquidation of ABC Bank, holders of senior debt would have received 70 cents for each dollar of senior debt held.
The Liquidation Value of XYZ Fund’s bail-in debt would therefore be: $1,000 x $0.70 = $700.
Estimation of resolution value
Resolution Value is an estimate of the aggregate value that a person retained or received through the resolution process as of the date that CDIC is no longer in control or ownership of the financial institution.
After conducting a detailed valuation, CDIC estimates that the value of each share provided in exchange for the converted debt, determined at the time when CDIC is no longer in control or ownership of ABC Bank, is $5.
The Resolution Value of XYZ Fund’s common shares (received through the resolution process) would therefore be: 220 shares x $5 = $1,100.
Offer of compensation
Compensation is calculated using the following formula:
Compensation = Liquidation Value – Resolution Value
In the case of XYZ Fund, the amount of compensation in respect of its bail-in debt would be zero due to the Liquidation Value being less than the Resolution Value:
Compensation = $700 – $1,100 = –$400.
As a result, CDIC would make an offer of compensation of $0 to XYZ Fund in respect of its bail-in debt.
1 Nothing in this section shall prevent CDIC as resolution authority from fully exercising its powers in accordance with its objects under the CDIC Act.
2 The liquidation would occur under the Winding-Up and Restructuring Act.
3 NVCC includes preferred shares and subordinated debt that, according to the terms of their contracts, convert into common shares if the financial institution becomes non-viable.
4 Workout companies are companies charged with managing or disposing of troubled assets in an orderly manner.
5 The test for holders of NVCC instruments is different than for other persons who may be entitled to compensation. It is as follows: compensation = liquidation value – resolution value – an amount equal to an estimate of losses attributable to contractual conversion. This is to ensure that those persons are compensated only for actions taken by CDIC during the resolution and not for the conversion of their instruments into shares, given they agreed to the conversion risk when purchasing these instruments.
6 The test for common shares is 10% of the number of common shares; and the test for preferred shares is 10% of the liquidation entitlement (amount to which the holder is entitled in liquidation in priority to lower-ranking shares) of the shares of a given class.