Since 1 April 2020, UK banks issuing new shares and entities applying for banking licences must provide the Prudential Regulation Authority (PRA) with a legal opinion. We have experience of drafting these, and of other rule changes made by the PRA on the same date.
In June 2019, certain parts of "CRR II", an EU regulation amending parts of CRR, came into force. These amended the rules in CRR setting out the criteria for what counts as Common Equity Tier 1 (CET 1), the best form of regulatory capital. They also altered the scope of the requirement in CRR to obtain approval from the regulator to count particular instruments as CET 1.
In terms of capital instruments, only equity instruments have ever been able to qualify as CET 1, and the typical example is plain vanilla ordinary voting shares. Any instrument has always had to meet several criteria to count as CET 1, and this list has been amended by CRR II – for instance, there is now an explicit requirement for the instrument to be fully paid up and not funded directly or indirectly by the firm.
The CRR II changes that came into effect in June 2019 led to some temporary amendments to the PRA's capital rules applicable to UK banks, building societies and the eight PRA-designated investment firms. However, on 1 April 2020, permanent amendments came into force for those firms. They go beyond the requirements of CRR II (including as onshored in the UK since the expiry of the Brexit transitional period), because the PRA unilaterally wanted to tighten the rules on CET 1 further. The changes, relating to a pre-issuance notification regime, are contained in a new Chapter 7A of the Definition of Capital Part of the PRA Rulebook. The PRA has also updated its Supervisory Statement on the Definition of Capital; Pre/post-Issuance Notification form for CRR firms; and CET 1 compliance template. The UK has preserved these changes in its onshored post-Brexit legislation.
When preparing to issue or vary the terms of an existing CET instrument is a requirement (not contained in CRR II), firms must now obtain a "properly reasoned draft legal opinion" from an external law firm confirming that newly issued instruments that a firm is seeking to classify as CET 1 meet the relevant criteria. The opinion must be filed with the PRA as part of a firm's application for the instruments to be approved as CET 1. The requirement also applies where a firm is varying the terms of an existing CET 1 instrument.
Under CRR II, subsequent issuances only require approval and (under the amended PRA rules) an accompanying draft legal opinion, where they are not on "substantially the same terms" as a previous issuance for which the firm has already received approval (whether before or after 1 April 2020).
The PRA has provided guidance on when an issuance will not normally be considered substantially the same as a previous issuance (and so triggering the need for a new legal opinion). This includes, for example, where there any change to voting rights, subordination or distributions, or where the transactions involve new side agreements or material amendments to an existing side agreement.
Previously, further regulatory approval was always required for a new issuance of a CET 1 instrument except where it was on "identical terms" to a previously approved issuance. The fact that CRR II provides that approval is not required for issuances on "substantially the same terms", and associated PRA guidance, will generally be a welcome development for firms.
The other two key changes made by the PRA in relation to CET 1 are:
As noted above, a draft legal opinion on the eligibility of instruments to count as CET 1 ought to be more straightforward than an opinion on AT 1 or Tier 2 instruments, where an in-depth and sometimes complex analysis of the terms of the issuance is needed. However, even with 'vanilla' ordinary shares, there are a number of issues which firms will need to consider on a CET 1 issuance or variation which are not addressed in PRA guidance on:
CRR, including the CRR II changes discussed in this Briefing, has been onshored into UK law following the end of the Brexit transitional period at the end of last year. We think that it is unlikely that the requirements covered here will change in the short-medium term, especially given that many of them, including the legal opinion requirement, constituted gold-plating by the PRA.
Only banks and the eight PRA-designated investment firms that have so far been designated by the PRA are subject to the amended PRA rules. (Solvency II insurance firms are already subject to separate capital rules, which include a requirement to provide a legal opinion in certain circumstances.)
The changes under CRR II, including in particular the strengthening of the criteria for eligibility for CET 1 status, are applicable to all investment firms within scope of CRR – a much wider group, which includes many investment banks, asset managers, brokers and wealth managers. However, the FCA has not amended its rules applicable to these firms in line with the PRA's changes, nor indicated any intention (for example as part of the implementation of the Investment Firms Prudential Regime, due to come into force on 1 January 2022) to do so.
We have considerable experience in preparing legal opinions in support of applications and notifications relating the eligibility of instruments for regulatory capital purposes; these include opinions on AT 1 and Tier 2 instruments, and most recently, on CET 1 instruments as required by the amended PRA rules.
