Toronto Seminar Series Presentation Materials › documents › 171120-toronto-seminar-series.pdfToronto Seminar Series Monday, November 20, 2017 10:30 a.m. – 2:00 p.m. The Fairmont

Toronto Seminar Series

Monday, November 20, 2017

10:30 a.m. – 2:00 p.m. The Fairmont Royal York

100 Front Street West Toronto, ON M5J 1E3 Canada

Session 1: Debt Capital Markets, Regulatory Developments & Market Outlook 10:30 a.m. – 12:00 p.m.

Overview of the debt capital markets;

Issuance levels and trends;

What to expect in the months ahead;

U.S. regulatory developments;

Canadian regulatory developments;

NVCC issuances; and

Modifying issuance programs for the bail-in regime.

Speakers:

Tom Connell Managing Director, Standard & Poor’s

Bryan Farris Associate Director, UBS Investment Bank

Peter Hamilton Partner, Stikeman Elliott LLP

Ahmet Yetis Americas Head of Capital Solutions, UBS Investment Bank

Oliver Ireland Partner, Morrison & Foerster LLP

Anna Pinedo Partner, Morrison & Foerster LLP

Lunch: 12:00 p.m. – 12:30 p.m.

Session 2: Blocked? Navigating the U.S. Regulatory and Tax Regimes Applicable to Blockchain 12:30 p.m. – 2:00 p.m.

What is blockchain and how does it work?;

Which laws apply?;

Timing, finality, and enforceability;

System accountability and responsibility;

Use cases;

Digital tokens, token sales, and U.S. regulation;

IRS Notice 2014-21;

Case study: Department of Justice Coinbase summons; and

Interesting issues relating to taxation of financial instruments and crypto.

Speakers:

Shiukay Hung Associate, Morrison & Foerster LLP

Oliver Ireland Partner, Morrison & Foerster LLP

https://www.mofo.com/resources/events/171120-toronto-seminar-series.html

https://www.mofo.com/people/oliver-ireland.html

https://www.mofo.com/people/anna-pinedo.html

https://www.mofo.com/people/shiukay-hung.html

https://www.mofo.com/people/oliver-ireland.html

Canadian Bail-in and TLAC

November 20, 2017

• Three pieces that work together:

• Legislation: Amendments to Bank Act and Canada Deposit Insurance Corporation Act were enacted in 2016 to provide for bail-in debt. However, details were left to the regulations to these statutes.

• Regulations: In June 2017, draft regulations were published for comments by the Canadian Department of Finance.

• TLAC Guidance: Concurrently with the regulations, the Canadian federal financial regulator, the Office of Superintendent of Financial Institutions (OSFI), published the TLAC Guidance.

• Not retroactive: Applicable only to instruments issued after regulations come into effect, or are amended to increase their principal amount or to extend their term after the regulations come into effect (provided they otherwise meet the criteria).

• Timeline: Final regulations expected in fall of 2017 or early 2018; will be effective 180 days from final publication.

Canadian Legislative Background

Which Banks Are Covered by Canada’s

Bail-in Regime?

• “Bail-in” regime (and TLAC Guidance) applies only to “domestic systemically important banks” (D-SIBs).

• OSFI has designated six Canadian institutions as D-SIBs:

• Bank of Montreal;

• Bank of Nova Scotia;

• Canadian Imperial Bank of Commerce;

• National Bank of Canada;

• Royal Bank of Canada; and

• Toronto-Dominion Bank of Canada.

• Any debt obligation (other than subordinated debt) that meets the following three requirements could be converted:

• Debt is perpetual or has a maturity of more than 400 days (including through the exercise of an explicit or embedded option by the issuer or a holder);

• Debt is unsecured or only partially secured at the time of issuance (in the case of partial secured debt, debt that exceeds the value of collateral is covered by the bail-in regime); and

• Debt is tradable and transferable (if it has a CUSIP or other similar identification).

• Any share or subordinated debt that is neither common share nor non-viability contingent capital (NVCC).

What Debt Obligations Could Be Converted

under Canada’s Bail-in Regime?

• Canada uses a narrower approach (compared to the EU), and whatever is not expressly “covered” is considered “excluded”. For example, banks’ normal course deposits would not be covered.

• In particular, the following types of debt obligations are expressly excluded:

• Covered bonds;

• Eligible financial contracts;

• Structured notes (covered later in the presentation);

• Any conversion or exchange privilege that is convertible at any time into shares;

• Any option or right to acquire shares or any privilege referred to above; and

• Any share of a series created before January 1, 2013, and issued as a result of the exercise of a conversion privilege under the terms attached to another series of shares created before January 1, 2013 (this exception is meant to exclude rate reset preferred shares created before January 1, 2013, which contained terms allowing for conversion into a separate series of fixed or floating rate shares).

What Debt Obligations Are Excluded

from Canada’s Bail-in Regime?

• Determination by Superintendent: A determination by the Superintendent of Financial Institutions (the “Superintendent”) that the bank has ceased, or is about to cease, to be viable.

• The Superintendent has discretion to make this recommendation and may consider a number of factors, including the bank’s reliance on debt to sustain its operations, the bank’s loss of confidence of depositors and public, the bank’s level of regulatory capital, and the bank’s expected inability to pay its obligations as they become due.

• Governor in Council approval: Governor in Council approval, on the recommendation of the Minister of Finance, for the CDIC to take temporary control or ownership of the non-viable bank and carry out a bail-in conversion.

What Would Trigger a “Bail-in”

Resolution?

• No Conversion Multiplier: Unlike the NVCC instruments, the bail-in debt will not have a fixed conversion multiplier.

• CDIC Discretion: The CDIC has discretion to determine the conversion. This discretion provides flexibility to set appropriate conversion terms. This approach is consistent with other jurisdictions.

What Is the Conversion Formula?

• Parameters on CDIC Discretion:

• Adequate recapitalization – CDIC must take into consideration the requirement in the Bank Act for banks to maintain adequate capital;

• Order of conversion – bail-in eligible instruments can be converted only after all subordinate ranking bail-in eligible instruments and NVCC instruments have been converted;

• Treatment of equally ranking instruments – equally ranking bail-in eligible instruments must be converted in the same proportion (pro rata) and receive the same number of common shares per dollar of the claim that is converted;

• Relative creditor hierarchy – holders of bail-in eligible instruments must receive more common shares per dollar of the claim that is converted than holders of subordinate ranking bail-in eligible instruments and NVCC that have been converted.

What Is the Conversion

Formula?, cont’d.

• As per guidance from regulators, senior bail-in debt holders would be better off than legacy instruments (i.e., those that are not NVCC and that would not be eligible for conversion under the bail-in power). These instruments could incur losses after they are vested in CDIC as part of the bail-in process.

What Is the Conversion

Formula?, cont’d.

• Effective November 1, 2021 (i.e., fiscal Q1 2022), D-SIBs will need to meet two minimum standards: (i) the risk-based TLAC Ratio of at least 21.5%; and (ii) the TLAC Leverage Ratio of at least 6.75%.

• TLAC Ratio = TLAC Measure/Risk-weighted Assets

• TLAC Leverage Ratio = TLAC Measure/Exposure Measure

TLAC Guideline

• The following are eligible to be recognized as TLAC:

• Tier 1 capital, consisting of:

• Common Equity Tier 1 capital; and

• Additional Tier 1 capital;

• Tier 2 capital; and

• Prescribed shares and liabilities (Other TLAC Instruments) (e.g., senior bail-in debt) that are subject to conversion – in whole or in part – into common shares under the CDIC Act and that meet all of the eligibility criteria set out in this guideline.

TLAC – Composition of TLAC

• The criteria for the capital elements comprising Tier 1 and Tier 2 capital, as well as the various limits, restrictions, and regulatory adjustments to which they are subject, are described in OSFI’s CAR guideline.

TLAC – Eligibility Criteria for

Tier 1 and Tier 2

• The criteria for Other TLAC Instruments to qualify as TLAC include the following:

• Permanent conversion (where the instrument is governed by foreign laws, the D-SIB should provide evidence that there are no impediments to the application of Canadian statutory bail-in powers under the foreign law or within the terms of the instrument);

• Instrument is directly issued by the Canadian parent bank (indirect issuances by subsidiaries or through special-purpose vehicles will not be eligible as TLAC);

• Instrument satisfies all of the requirements set out in the bail-in regulations discussed above;

• Instrument must be issued and paid for in cash or, with the prior approval of the Superintendent, in property;

• Neither the institution nor a related party over which the institution exercises control or significant influence can have purchased the instrument, nor can the institution directly or indirectly have funded the purchase of the instrument;

TLAC – Eligibility Criteria for Other TLAC

Instruments

• The instrument is neither fully secured at the time of issuance nor covered by a guarantee of the issuer or related party or other arrangement that legally or economically enhances the seniority of the claim vis-à-vis the institution’s depositors and/or other general creditors;

• The instrument is not subject to set-off or netting rights;

• Except as provided below, the instrument must not provide the holder with rights to accelerate repayment of principal or interest payments outside of bankruptcy, insolvency, wind-up, or liquidation;

• Events of default relating to the non-payment of scheduled principal and/or interest payments will be permitted where they are subject to a cure period of no less than 30 business days and clearly disclose to investors that:

• Acceleration is only permitted where an order has not been made under subsection 39.13(1) of the CDIC Act in respect of the institution; and

• Notwithstanding any acceleration, the instrument continues to be subject to bail-in prior to its repayment;


Other TLAC Instruments, cont’d.

• The instrument is perpetual or has a residual maturity in excess of 365 days (where the instrument has a step-up or other incentive to redeem, the instrument is deemed to mature on the date on which the incentive to redeem becomes effective. For such instruments, the residual maturity would be measured with reference to the effective date of the incentive to redeem rather than the contractual maturity date);

• The instrument can be called or purchased for cancellation at the initiative of the issuer only and, where the redemption or purchase would lead to a breach of the D-SIB’s minimum TLAC requirements, with the prior approval of the Superintendent;

• The instrument does not have credit-sensitive dividend or coupon features that are reset periodically based in whole or in part on the institution’s credit standing; and

• Where an amendment or variance of the instrument’s terms and conditions would affect its recognition as TLAC, such amendment or variance will only be permitted with the prior approval of the Superintendent.


Other TLAC Instruments, cont’d.

November 2017

UBS FIG Debt Capital Markets and Solutions

MoFo Toronto Seminar Series

DCM and Capital Update

1

US$1,250,000,000 4.650% PerpNC5

Baa3/BBB- AT1 Capital

UBS Investment Bank Global Coordinator,

Structuring Agent, Joint Bookrunner

October 4, 2017

US$1,400,000,000 FRN due 2022

2.450% due 2022 A1/A+ Senior Notes

UBS Investment Bank

Joint Bookrunner September 14, 2017

$1,250,000,000 FRN due 2020

2.200% due 2020 A1/A Senior Notes

UBS Investment Bank

Joint Bookrunner October 30, 2017

US$1,500,000,000 FRN due 2020

2.250% due 2020 Aa2/A+ Senior Notes

UBS Investment Bank


US$2,000,000,000 FRN due 2019

1.900% due 2019 Aa2/AA- Senior Notes

UBS Investment Bank


£350,000,000 1.375% due 2021

A1/A+ Senior Notes

UBS Investment Bank Joint Bookrunner October 3, 2017

€1,000,000,000 FRN due 2021

A1/A+ Senior Notes

UBS Investment Bank Joint Bookrunner

September 21, 2017

UBS Momentum in the Canadian Bank Sector 2017 YTD Successes and Momentum

• UBS has established itself as the premier underwriter of Canadian bank debt in 2017, leading the highest profile offerings of the year and serving as a true global provider – lead bookrunning deals in four different currencies and across the product suite

• UBS has climbed to #2 in Canadian bank league tables across all currencies

Rank Manager Vol

(mm) Issues

Δ vs. 2016

1 3,843.33 16 4

2 3,786.55 16 5

3 3,647.50 19 2

4 3,121.91 13 1

5 2,725.00 10 5

US$1,750,000,000 2.350% due 2022 Aaa/AAA Covereds

UBS Investment Bank

Joint Bookrunner July 20th, 2017

2017 YTD League Table Key Messages

£400,000,000 1.25% due 2022

A1/A+ Senior Notes

UBS Investment Bank Joint Bookrunner

June 1, 2017

€1,250,000,000 0.125% due 2022 Aaa/AAA Covereds

UBS Investment Bank

Joint Bookrunner January 9, 2017

A$800,000,000 FRN due 2022


UBS Investment Bank

Joint Bookrunner September 27, 2017

A$1,000,000,000 FRN due 2022


UBS Investment Bank

Joint Bookrunner August 30, 2017

$300,000,000 FRN due 2020

A1/A Senior Notes

UBS Investment Bank Sole Bookrunner January 12,2017

€750,000,000 0.375% due 2022

A1/A+ Senior Notes

UBS Investment Bank Joint Bookrunner March 30, 2017

Source: Dealogic

http://www.google.com/url?sa=i&source=imgres&cd=&cad=rja&uact=8&ved=0CAwQjRwwAGoVChMI09W76N-IxgIVSjOMCh2s6gAt&url=http://en.wikipedia.org/wiki/File:Scotiabank_Logo.svg&ei=kBN6VdPNO8rmsASs1YPoAg&psig=AFQjCNF33yL7ay6BHSo4fV_TuXbP1eonBQ&ust=1434150161100909


https://www.google.com/url?sa=i&rct=j&q=&esrc=s&source=images&cd=&cad=rja&uact=8&ved=0ahUKEwixxoz5oM_JAhVGbj4KHQy7C6QQjRwIBw&url=https://commons.wikimedia.org/wiki/File:Toronto-Dominion_Bank_logo.svg&bvm=bv.109395566,d.dmo&psig=AFQjCNGRh_REneEm5B3Wjm3UY9BdBiy91Q&ust=1449766843480404

http://www.google.pl/url?sa=i&rct=j&q=&esrc=s&source=images&cd=&ved=0ahUKEwir4uCf_7XWAhXMJlAKHexOANwQjRwIBw&url=http://www.hillcrestmall.ca/store/bank-montreal&psig=AFQjCNGrqbWxjbtWIr9WoffH9p2Tt9pAEQ&ust=1506073525280841







2

Issuer: The Bank of Nova Scotia

Instrument: Fixed to Floating Rate Non-Cumulative Subordinated Additional Tier 1 Capital Notes

Issue Ratings: Baa3 / BBB- (Moody's / S&P)

Legal Format: SEC Registered

Size: $1.25bn

Pricing Date: October 4, 2017

Issue Date: T+5 (October 12, 2017)

Term / Call: PerpNC5

Reoffer Price 100%

Initial Interest Rate: 4.650%

Reset Interest Rate: 3mL + 264.8bps

PONV*: a) OSFI announces the institution has ceased, or is about to cease, to be viable and that, amongst other things, conversion of all contingent capital will likely restore viability; or b) The institution has accepted, or agreed to accept, a capital injection or equivalent support from the government without which it would be non-viable

Loss Absorption: Variable Conversion x 1.25 ($CAD 5.00 floor)

UBS Role: Global Coordinator, Structuring Agent, Joint Bookrunner

The transaction represents the inaugural Basel III compliant AT1 security issued by a Canadian Bank outside of their domestic CAD market

A strong market backdrop, investor friendly structural features and BNS's strong credit profile allowed BNS to price at 4.65% - the third lowest Tier 1 capital coupon ever in the US$ market

The transaction featured a very high quality and diversified orderbook with ~US$8bn of interest from over 330 orders at the peak

BNS 4.65% PerpNC5 Inaugural US$ AT1 On October 4, 2017, UBS acted as a Global Coordinator, Structuring Agent, and Joint Book Runner on the inaugural US$1.25bn PerpNC5 SEC Registered AT1 transaction for The Bank of Nova Scotia

Highlights

Rationale and marketing

A non-CAD deal offered the opportunity to diversify the issuer's sources of Additional Tier 1 capital, having issued so far exclusively in CAD

BNS wanted to optimize its capital structure, and contribute more to its AT1 "bucket" under Basel III

This offering will lead to the establishment and continued support of a liquid secondary market for Canadian Bank AT1 in USD

A global marketing process commenced with a mandate announcement on Thursday, September 28

In the week following, Bank of Nova Scotia conducted a global investor roadshow with key players in London and New York. These meetings were conducted consecutively over two days across the centers, in anticipation of transaction announcement following their conclusion

The marketing effort was highly successful. BNS met with investors via a series of one-on-one, group meetings and conference calls across the two days, with strong investor engagement across all key centers. The company also received over 660 views on its Net Roadshow, with a significant percentage coming from Asian investors

After receiving incoming interest from investors of ~$3bn, the issuer and bookrunners elected to launch the transaction after the second day of the roadshow into the Asian Market open

The announcement was targeted in to take advantage of the opportunistic issuance window characterised by an accommodative market backdrop and limited competing supply

October 4, 2017

Global Coordinator Structuring Agent Joint Bookrunner

Note: * Point of non-viability

3

Structural Comparison: USD AT1

Issue Size / Coupon USD 1.250bn 4.650%, S/A

USD 1.25bn 5.000%, S/A

USD 1.257.5bn 4.625%, S/A

Launch Date Oct-2017 Sep-2017 Oct-2017

Term / Call Perpetual / 2022 (PerpNC5) Perpetual / 2027 (PerpNC10) Perpetual / 2022 (PerpNC5)

Subordination Senior to Local AT1 Pari Passu to Local AT1 n/a

Call Frequency (post Call Date) Quarterly Every 5yrs Quarterly

Format SEC Registered SEC Registered SEC Registered

Hold-Co vs. OpCo Op-Co Op-Co Hold-Co

Coupon Discretionary, Non-cumulative

Discretionary, Non-cumulative

Discretionary, Non-cumulative

Dividend Stopper Yes1

Yes1

Yes1

Reset Interest Rate $L + 264.8 MS+289 $L + 258

Instrument Ratings (M/S/F)

Baa3 / BBB- / NR

Baa2 / BB+ / BBB Baa3 / NR / BBB-

Issuer Ratings

A1 / A+ / AA- Aa3 / AA- / AA- A3 / A- / A+

Capital Ratios

CET1: 11.30% Tier 1: 12.60% Total: 14.80% CET1: 10.56% Tier1: 12.66% Total: 14.82% CET1: 12.60% Tier 1 14.30% Total: 16.10%

ADI/MDA4

$37bn / $11bn (10% / 3% RWA) $12bn / $8bn (3% / 2% RWA) $258bn / $74bn (17% / 5% RWA)

Loss Absorption

Contractual CET1 Trigger n/a3

5.125% n/a

PONV Contractual Contractual Statutory

Primary Loss Absorption Mechanism

Variable Conversion x 1.25 ($CAD 5.00 Floor)

Variable Conversion x 1.01 (20% Floor)

Not Specified

Conversion Sequence NVCC event triggers conversion of all NVCC instruments concurrently. Subordination is achieved via using different multipliers, 1.0x for CAD AT1, 1.25x for USD AT1, 1.5x for T2

PONV triggers AT1 and T2 sequentially, i.e. first AT1 converts, if insufficient to recapitalize, T2 converts

Not Specified

Floor/conversion price to share price at issuance date

6%2

20% n/a

Source: company filings, SNL (1) Additional capital restrictions apply if payments on AT1 coupons are not made, including restrictions on buy-backs. (2) Versus C$83.18 closing price as of November 10, 2017 (3) PONV Trigger Event, as determined by OSFI: (a) OSFI announces the institution has ceased, or is about to cease, to be viable and that, amongst other things, conversion of all contingent capital will likely restore

viability; or (b) the institution has accepted, or agreed to accept, a capital injection or equivalent support from the government without which it would be non-viable (4) UBS estimates, as of issuance date, (excludes Pillar 2 requirements which are not publically disclosed)

4

Structural Comparison: USD Tier 2

Source: company filings, SNL (1) Additional capital restrictions apply if payments on AT1 coupons are not made, including restrictions on buy-backs. (2) Versus C$72.81 closing price as of November 13, 2017 (3) Trigger Event, as determined by OSFI: (a) OSFI announces the institution has ceased, or is about to cease, to be viable and that, amongst other things, conversion of all contingent capital will likely restore viability;

or (b) the institution has accepted, or agreed to accept, a capital injection or equivalent support from the government without which it would be non-viable

Issue Size / Coupon USD 1.500bn 3.625%, S/A

USD 1.500bn 4.322%, S/A

USD 1,100bn 3.625%, S/A

Launch Date Sep-2016 Nov-2016 Nov-2016

Term / Call Sep-2031 / Sep-2026 (15NC10) Nov-2031 / Nov-2026 (15NC10) Dec-2027/ Dec-2026 (11NC10)

Call Frequency (post Call Date) One time call One time call One time call

Format SEC Registered SEC Registered SEC Registered

Hold-Co vs. OpCo Op-Co Op-Co Hold-Co

Coupon S/A, in arrears S/A, in arrears S/A, in arrears

Reset Interest Rate USSW5 + 220.5 bps USISDA05 + 224 bps --

Instrument Ratings (M/S/F)

A3 / A- / NR Baa1 / BBB / A+ Baa1 / BBB+ / A

Issuer Ratings

Aa2 / AA- / AA- Aa3 / AA- / AA- A3 / A- / A+

Capital Ratios

CET1: 11.00% Tier 1: 12.80% Total: 15.60% CET1: 10.56% Tier1: 12.66% Total: 14.82% CET1: 12.60% Tier 1 14.30% Total: 16.10%

Loss Absorption

PONV Contractual Contractual Statutory

Primary Loss Absorption Mechanism

Variable Conversion x 1.5 ($CAD 5.00 Floor)

Variable Conversion x 1.01 (20% Floor)

Not Specified

Conversion Sequence NVCC event triggers conversion of all NVCC instruments concurrently. Subordination is achieved via using multipliers, 1.0x for CAD AT1, [1.25x for USD AT1], 1.5x for T2

PONV triggers AT1 and T2 sequentially, i.e. first AT1 converts, if insufficient to recapitalize, T2 converts

Not Specified

Write-down Not allowed If conversion within 5-days is not allowed/possible, full or partial write0down

Not Specified

Floor/conversion price to share price at issuance date

7%2

20% n/a

US Bank AT1 Supply has Diminished

Bank AT1 Capital is Globally Undersupplied

2017 AT1 capital supply is down by 20% since 2016 and 60% since 2015, while the remaining AT1 funding need is only 16% of what has been issued globally over the past four years

17

EMEA Bank AT1 Supply has Diminished

U.S. Financial Institutions AT11 Need

($bn) European Financial Institutions

AT11 Need ($bn)2

Wells Fargo & Company 4.0 HSBC 5.0

Citigroup Inc. 3.1 BNP Paribas 4.5

SunTrust Banks, Inc. 1.0 UBS 4.3

Bank of America Corporation 1.2 Santander 2.1

PNC Financial Services Group, Inc. 0.9 UniCredit 2.6

Regions Financial Corporation 0.8 Intesa Sanpaolo 1.5

Discover Financial Services 0.2 ING 1.4

Fifth Third Bancorp 0.5 Credit Suisse 1.4

American Express Company 0.5 Royal Bank of Scotland 0.5

Northern Trust Corporation 0.3 Erste Bank 0.4

Total Remaining AT1 Funding: $12.5 Total Remaining AT1 Funding: $23.7

Source: Bloomberg, Company Filings 1) AT1 as reported (post deductions) using 2016 Q4 data and pro forma AT1 issuance since reporting date, shows top ten banks with highest need 2) European AT1 shortfalls converted to USD-equivalent as of 11/8/2017 Note: *2017 CCAR results imply $8.5bn of net new issuance from Q3 2017 – Q1 2019

32

27

16

10

0

10

20

30

40

50

60

2014 2015 2016 2017

Issu

an

ce (

$b

n)

NC5 Fixed-to-Float NC10 Fixed-to-Float Fixed-for-Life

44

33

28 27

0

10

20

30

40

50

60

2014 2015 2016 2017

Issu

ance

(€bn)

PerpNC5 PerpNC6 PerpNC7 PerpNC8 PerpNC9 PerpNC10+

Remaining AT1 Need

6

Yankee AT1 Performance to Date Comparable Yankee AT1 issuers have experienced record levels of spread compression over the past two years and are seeing the lowest secondary trading levels since reoffer

Yankee AT1 G-Spreads: Historical Spread Movement

Yankee AT1 G-Spreads: Min-Max-Current

0

200

400

600

800

1000

1200

1400

Historical Max

Historical Min

Current

0

200

400

600

800

1000

1200

1400

Nov-14 May-15 Nov-15 May-16 Nov-16 May-17 Nov-17

SANTAN 6.375 Perp

DANBNK 6.125 Perp

NDASS 5.25 Perp

ANZ 6.75 Perp

DB 7.5 Perp

BNP 6.75 Perp

ACAFP 8.125 Perp

SOCGEN 8 Perp

BACR 7.875 Perp

HSBC 6 Perp

RBS 8 Perp

7

Swap Spreads Remain Attractive Credit Continues to Attract New Money Even as USTs Sell Off

Recent High Quality Bank Supply has Performed

New Issue Markets Are Extremely Attractive

Credit has performed and is trading at attractive levels

Total Fund Inflows YTD: $90bn

50

60

70

1.00

1.25

1.50

1.75

2.00

2.25

2.50

May-17 Jun-17 Jul-17 Aug-17 Sep-17 Oct-17

5yr

IG C

DS

5yr

UST Y

ield

Fund Flows 5yr UST Yield 5yr IG CDS

18.00

6.44

-10

-5

0

5

10

15

20

25

30

35

Nov-13 Nov-14 Nov-15 Nov-16 Nov-17

Sp

read

(b

ps)

3yr Swap 5yr Swap

35 42 43 49 55 56 60 63

-17 -20 -17

-6 -2 -11

-10 -7

52

62 60

55 57

67 70 70

-15

5

25

45

65

85

105

TD 3yr BMO 3yr BNS 3yr CIBC 3yr PNC 5yrBank

KEY 5yrBank

BMO 5yr BNS 5yr

G S

pre

ad

(b

ps)

Current G Reoffer Spread

Canadian US$ Benchmarks in 20171

Source: UBS CCS Analysis, Bloomberg

1. Public Benchmark Issuance Only, >2yrs, ex-CDs

1.75 1.75 1.75

7.85 4 4.5

4.9

3.25

1.25

0

1

2

3

4

5

6

7

8

9

RBC TD BMO BNS CIBC

$b

n

Covered Senior AT1

8

Disclaimer & Contact Information These materials have been prepared by UBS AG and/or a subsidiary and/or an affiliate thereof ("UBS") for the exclusive use of the party to whom UBS delivers these materials (together with its subsidiaries and affiliates, the “Client”) using information provided by the Client and other publicly available information. UBS has not independently verified the information contained herein, nor does UBS make any representation or warranty, either express or implied, as to the accuracy, completeness or reliability of the information contained in these materials. Any estimates or projections as to events that may occur in the future (including projections of revenue, expense, net income and stock performance) are based upon the best judgment of UBS from the information provided by the Client and other publicly available information as of the date of these materials. There is no guarantee that any of these estimates or projections will be achieved. Actual results will vary from the projections and such variations may be material. Nothing contained herein is, or shall be relied upon as, a promise or representation as to the past or future. UBS expressly disclaims any and all liability relating or resulting from the use of these materials.

These materials have been prepared solely for informational purposes and are not to be construed as a solicitation or an offer to buy or sell any securities or related financial instruments. The Client should not construe the contents of these materials as legal, tax, accounting or investment advice or a recommendation. The Client should consult its own counsel, tax and financial advisors as to legal and related matters concerning any transaction described herein. These materials do not purport to be all-inclusive or to contain all of the information that the Client may require. These materials do not express an opinion as to whether any Client should enter into any swap or swap trading strategy that has been described herein by UBS. UBS is not undertaking to act in the best interests of the Client or to act as the advisor to any Client that is a Special Entity as defined under Section 23.440(a) of the Commodity Exchange Act. No investment, divestment or other financial decisions or actions should be based solely on the information in these materials.

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www.ubs.com

Canadian BankRegulatory Developments and Ratings Outlook

Morrison & Foerster Toronto Seminar20 November 2017

Copyright © 2017 by S&P Global. All rights reserved.

Thomas ConnellSenior Credit OfficerS&P Global Ratings

• Overview of Bank Criteria Framework• Rating Implications of Canadian Bail-in Framework

2

Agenda

Bank Criteria Framework Overview

3

ALACSupport

Source: S&P Criteria‐ Bank Ratings Methodology and Assumptions

*

* Proposed Resolution Counterparty Rating criteria would also be applied at this stage.

Large Canadian Banks: Rating Components

5

Bank Name Anchor Business Position

Capital & Earnings

Risk Position

Funding&

LiquiditySACP Systemic

ImportanceGov’t

Support ICR

Royal Bank of Canada a‐ Strong Adequate Strong Avg. & Adeq. a+ High +1AA‐/A‐1+

Negative

Toronto‐Dominion Bank a‐ Strong Adequate Strong Avg. & Adeq. a+ High +1AA‐/A‐1+

Stable

National Bank of Canada a‐ Adequate Adequate Adequate Avg. & Adeq. a‐ Moderate +1A/A‐1

Stable

Bank of Montreal a‐ Adequate Adequate Adequate Avg. & Adeq. a‐ High +2A+/A‐1

Stable

Bank of Nova Scotia bbb+ Strong Adequate Strong Avg. & Adeq. a High +1A+/A‐1

Stable

Canadian Imperial Bankof Commerce a‐ Adequate Adequate Adequate Avg. & Adeq. a‐ High +2

A+/A‐1

Stable

*Data as of October 23, 2017

6

Evolving Policy Implications for Bank Credit Risk1. Regulatory Emphasis on Loss-Absorbing Capacity

• Basel III emphasis on loss-absorption of capital instruments• Bail-in frameworks such as the Dodd Frank Orderly Liquidation Authority, and the

European Bank Recovery & Resolution Directive • FSB TLAC

2. Declining Expectations of Extraordinary Government Support in Some Jurisdictions

• Policy goals of avoiding bail-outs, reducing moral hazard, activating market discipline, and addressing too-big-to-fail

• Emphasis on resolution and bail-in makes potential extraordinary government support less predictable

These themes are reflected in recent criteria changes (hybrids, ALAC), andby rating and outlook changes relating to extraordinary government support expectations in some countries.

7

ALAC Criteria Address Bail-in Frameworks

ALAC: Additional Loss‐Absorbing Capacity

• A sufficient cushion of ALAC can lead to uplift of issuer credit rating (ICR) above stand‐alone credit profile (SACP).

• Primarily consisting of hybrid capital instruments subject to conversion or write‐down at a bank’s entry into resolution – can include instruments not in regulatory Tier 1 or Tier 2 capital.

• To raise an issuer’s ICR, must be able to absorb losses without triggering a default of the issuer’s senior unsecured obligations (noting that our definition of default is not the same as a legal event of default).

• For an operating bank, may also include financial obligations issued by a non‐operating holding company (NOHC).

Proposed Resolution Counterparty Rating (RCR) methodology may provide additional component of uplift for liabilities excluded from bail‐in.

Illustrative Bank Rating Transition through Resolution

8

T0 Normal operating conditions

T1 Operating environment begins to deteriorate

T2 Stress escalates

T3 Recovery plan activated

T4 Immediately after the bail-in resolution

T5 About one year after the resolution

Rating Implications of Canadian Bail-in Policy

9

10

Proposed Cdn Bail-in Regime Gradually Taking Shape• The Taxpayer Protection and Bank Recapitalization Regime consultation paper was issued by the Canadian

government on August 1st, 2014.

• We forthwith applied Negative outlooks to six Canadian banks potentially subject to the proposed bail‐in regime, reflecting the possibility of reduction or removal of uplift for the likelihood of extraordinary government support currently incorporated in ratings.

• In December, 2015, we reverted to Stable outlooks on the same banks, for reasons including:• Extended timeframe (we expect implementation from 2018; likely not effective for another year or more);• Regime won’t apply retroactively;• Government made no move to exclude bail-out;• ALAC methodology introduced in April, 2015.

• In April, 2016, the government introduced framework legislation for the regime, but no bail‐in specific details.

• In June, 2017, officials released draft bail‐in regulations and related regulatory guidance for public comment. These were broadly in line with the Aug., 2014 paper and our expectations, so we took no rating action in response. We also do not believe this release changes the near‐term likelihood of extraordinary government support to a DSIB.

• We will review our government support assessment, ALAC‐focused ‘effectiveness’ of the resolution regime, and related opinions, as relevant policy details are finalised and implemented.

11

Bail-inable Debt Issue Ratings – Some Relevant Factors

• Final bail‐in regime elements

• Bank‐specific strategies to meet HLA requirement

• Terms of bail‐inable instruments

• TLAC maturity composition

• Government posture re: direct support

• Expected treatment of subsidiaries

• Expected treatment of legacy subordinated instruments

• Buy‐side response to instrument features

12

IssuerRatings

Issue Ratings

AA-

A+ Senior Debt

A

A-

BBB+ Legacy Sub Debt

BBB NVCC Sub Debt

BBB- Legacy Prefs

BB+ NVCC Prefs

BB

Nonpayment Risk ( 2 notches)

Conversion ( 1 notch)

Representative Canadian Bank Issue Rating Relativities

• In this example: ICR of ‘A+’ includes uplift of two notches for the likelihood of extraordinary government support

SACP

ICR

Support ( 2 notches)

Subordination ( 1 notch)

ICR: Issuer Credit Rating SACP: Stand-alone Credit Profile

Start

Stand‐alone credit profiles No direct impact; secondary impact TBD.

Issuer Credit Ratings (ICR) No immediate impact; over time, notching based on ALAC may replace notching for expected extraordinary government support.

NVCC hybrid instruments No expected impact on notching relative to SACP.

Legacy hybrid instruments Limited expected impact, subject to clarification of treatment in resolution process.

Legacy senior liabilities Issue ratings expected to remain aligned with ICR.

Exempt senior liabilities Issue ratings expected to remain aligned with ICR.

Bail‐inable senior unsecured debt Issue level rating is to be determined, likely in reference to SACP.

Possible Implications of Bail-in Framework on Canadian Bank Ratings (Preliminary)

13

Related rating outcomes are subject to our review of final bail‐in regulations, and to related rating committee deliberations. Outcomes do not address application of proposed Resolution Counterparty Rating criteria.

Thank you

Thomas ConnellSenior Criteria OfficerT: [email protected]

14

Appendix:Supplementary Material

15

16

Source: Banking Industry Country Risk Assessment Update: October 2017

17

*Data as of October 23, 2017

Canadian Banking Industry Country Risk Assessment Summary

18

More Information: spratings.com/global-banking

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19

An Illustrative Rating Path For ASystemic Bank In A Bail-In Resolution

Primary Credit Analysts:

Richard Barnes, London (44) 20-7176-7227; [email protected]

Matthew D Pirnie, Johannesburg (27) 11-214-4862; [email protected]

Secondary Contacts:

Giles Edwards, London (44) 20-7176-7014; [email protected]

Gavin J Gunning, Melbourne (61) 3-9631-2092; [email protected]

Stuart Plesser, New York (1) 212-438-6870; [email protected]

Table Of Contents

The Basics Of A Resolution Using The Bail-In Tool

Background To The Illustrative Case Study

The Illustrative Case Study, Step By Step

Summary Of The Rating Transition Through The Case Study

How The Rating Transition Could Differ From The Case Study Outcome

How Our Proposed Resolution Counterparty Ratings Might Transition

Through The Scenario

Related Criteria

Related Research

WWW.STANDARDANDPOORS.COM/RATINGSDIRECT OCTOBER 4, 2017 1

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An Illustrative Rating Path For A Systemic Bank InA Bail-In Resolution

Since the global financial crisis, G-20 countries have introduced a host of laws and regulations to address the concern

that systemically important banks are too big to fail. One of the main objectives is to ensure such banks become

resolvable, meaning that they can be recapitalized or wound down in an orderly manner, with no direct cost to

taxpayers. Resolution legislation has handed authorities a range of intervention powers, the most high profile of which

is the bail-in tool. This tool permits authorities to impose losses on a failing bank's equity and lower-ranking liabilities

to fund a recapitalization and enable the institution to continue its core activities.

In our meetings with market participants, we are often asked about the potential rating path for a systemically

important private sector bank that comes under stress, enters resolution, returns to financial health through a bail-in

process, and reopens to new business in a restructured form. In this article, we use a hypothetical, simplified, and

illustrative case study to present a possible rating transition through a bail-in resolution. Bank failures play out in

different ways depending on the underlying causes, prevailing economic and market conditions, and the responses of

regulatory authorities and the banks' counterparties. Our primary intention with the case study is to explain potential

rating considerations at key points in the lead-up to, and aftermath of, a bail-in process. We suggest that readers do not

dwell on the precise rating levels described at each stage in the case study, and our intention is not to preempt the

actual ratings that we would assign to a bank facing a real-life stress similar to our hypothetical scenario.

For the fictional bank analyzed in our case study, the bail-in is a success and the available loss-absorbing capacity

proves effective in avoiding a default on operating entity senior liabilities. Our issue ratings on its various subordinated

instruments go to 'D' (default) as they absorb losses and finance a recapitalization. If there were a nonoperating holding

company (NOHC), we would also lower the issuer credit rating (ICR) on this entity to 'D' if the resolution authority

bailed in its senior debt. In contrast, the ICR and senior unsecured issue ratings on the operating entity are more

stable, though far from immune to the severe stress scenario. Although the bail-in is likely to produce a bank with

relatively healthy capital ratios, the ICR immediately after resolution would also reflect its funding and liquidity,

strategy and prospects, and any concerns over the complexity of the bank's required restructuring plan, future

profitability, or the strength and stability of its franchise.

Overview

• We present an illustrative case study to indicate a possible rating transition for a systemically important private

sector bank that is subject to a successful bail-in and reopens to new business.

• We assume that contractually, statutorily, and structurally subordinated debt issues absorb losses and prevent

a default on operating entity senior liabilities.

• Following the bail-in, the ratings on the bank would reflect not only its financial position but also its broader

strategy and prospects.

• The case study is not applicable to countries where we believe that governments remain supportive of private

sector banks.


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The June 2017 resolution of Spain's Banco Popular Español S.A. is the only case to date where the new powers have

been used on a systemically important bank. After authorities concluded that it was failing or likely to fail, Popular's

regulatory capital was wiped out and Banco Santander S.A. then acquired the bank for a token amount (see "Eurozone

Bank Resolution Framework Passes The Banco Popular Test, To A Point," published on June 19, 2017). Senior

investors did not incur losses and instead became creditors of Santander. However, S&P Global Ratings does not see

this solution as a routine playbook for future bank resolutions. This is largely because it depended on a stronger

competitor being able and willing to take on the entire balance sheet of the failing institution, including raising new

capital. Our case study instead considers a resolution method that we expect will become more typical once a larger

number of banks have built substantial loss-absorbing capacity. Under this approach, resolution authorities recapitalize

and restructure nonviable banks using existing creditors' resources rather than tapping capital markets or taxpayers,

with eligible bondholders' claims converted into equity as necessary to restore going-concern capital levels.

The case study is not applicable to countries where we believe that governments remain supportive of private sector

banks. Most countries in Asia-Pacific and Latin America, and some in other regions, fall in this category (see table 3 in

"Banking Industry Country Risk Assessment Update: September 2017," published on Sept. 8, 2017). In itself, the

introduction of resolution powers is not sufficient for us to conclude that government support has become uncertain.

Government intent is also an important factor. Some governments might introduce resolution powers to meet their

G-20 commitments but, in our view, still maintain the willingness and ability to support failing banks in the interest of

financial stability.


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An Illustrative Rating Path For A Systemic Bank In A Bail-In Resolution

The Basics Of A Resolution Using The Bail-In Tool

Since the global financial crisis, policymakers have established the bail-in tool as the preferred resolution method if

systemically important banks become nonviable. These institutions provide critical financial infrastructure such as

deposit-taking and payment services that could be interrupted in an insolvency process to the detriment of the

wider economy. The objective of the bail-in tool is to safeguard the continuity of these operations and ensure that

creditors, not taxpayers, foot the bill.

A bail-in is conducted by the relevant resolution authority and does not require the consent of the affected

creditors. The claims of shareholders and relevant unsecured liabilities are converted into equity and/or written

down to absorb incurred losses and fund a recapitalization (see chart 1). The authority is required by law to respect

each instrument's relative ranking in liquidation, and the bail-in therefore begins with equity and then moves up the

creditor hierarchy. The process continues until the resolution authority has raised the required sum, which is

determined by independent balance sheet valuations. Creditors are partially protected by a requirement that they

should not be worse off in resolution than they would have been if the bank had gone into liquidation. Following

the bail-in, the bank is likely to be restructured significantly to address the cause of the failure and establish a viable

business model. This could involve, for example, the divestment or wind-down of some activities.

Chart 1


1925681 | 300001180


For bail-in to be a credible and effective option, banks need buffers of gone-concern loss-absorbing capacity that

can convert into equity without causing a default on the senior liabilities. Accordingly, with effect from January

2019, resolution authorities will require global systemically important banks (G-SIBs) to maintain prescribed

amounts of total loss-absorbing capacity (TLAC) in the form of structurally, contractually, or statutorily

subordinated instruments. A similar concept--the minimum requirement for own funds and eligible liabilities

(MREL)--will apply to a wider group of EU banks, including institutions that are not subject to the TLAC regime. In

our view, the absence of MREL buffers was the main reason why Italian authorities recently provided taxpayer

support to three struggling banks rather than using a resolution tool (see "Italian Bailouts Show EU Authorities

Walk A Tightrope While Banks Transition Toward Bail-ins," published on July 4, 2017).

Under our additional loss-absorbing capacity (ALAC) methodology, we can raise the ICRs and senior unsecured

issue ratings on banks with sizable TLAC/MREL cushions to reflect the lower default probability on senior

liabilities (see "Bank Rating Methodology And Assumptions: Additional Loss-Absorbing Capacity," published on

April 27, 2015).

Background To The Illustrative Case Study

Our case study is a high-level analysis of a bank's potential rating transition through a bail-in resolution process. A

real-life situation is likely to involve many more complexities and uncertainties than we present here. We focus on

broad rating considerations more than the detailed mechanics of the bail-in process, which we have addressed in

previous articles (see related research).

The subject of the case study is a hypothetical G-SIB named Big Group. The group is headed by Big Bank, an operating

entity domiciled in country X (see chart 2). Big Bank has various subsidiaries, of which one is rated: 100%-owned Big

Financial Services, which is a sizable retail-focused bank domiciled in country Y. In common with most rated banks

around the world that we consider highly or moderately systemically important, we have assumed that Big Bank does

not have a NOHC. However, we discuss later in this article how the case study outcome might differ for a NOHC-led

group.


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Chart 2

We consider that countries X and Y both have effective resolution regimes and their governments' tendencies to

support failing private sector banks is uncertain.

At the beginning of the scenario, which we label T0, the long-term ICR on Big Bank is 'BBB+'. It stands two notches

above the 'bbb-' stand-alone credit profile (SACP; our assessment of the group's consolidated stand-alone

creditworthiness) because the group has a sizable ALAC buffer. The ICR on the bank is in line with the group credit

profile (GCP).

As the scenario plays out, we focus on the implications for four classes of debt in Big Bank's capital structure at T0:

• 'BBB+' rated senior unsecured debt (sometimes called senior preferred in Europe).

• 'BB+' rated senior subordinated debt (sometimes known as senior non-preferred in Europe).

• 'BB' rated vanilla nondeferrable Tier 2 subordinated debt.

• 'B+' rated Tier 1 contingent junior subordinated securities that convert to equity if Big Group's common equity Tier

1 (CET1) ratio falls below 5.125%. For this entity, we see this threshold as a gone-concern rather than

going-concern trigger. Therefore, the contingent clause does not directly influence the issue rating.

Big Financial Services is successful in its chosen market but we do not consider its business or geographic focus to be

core to Big Group's strategy. We classify Big Financial Services as strategically important at T0 and the consequent


1925681 | 300001180


parental support positions its 'BBB' ICR three notches above its 'bb' SACP. We believe the group's ALAC buffer

benefits Big Financial Services' senior creditors because the group has a single point of entry (SPE)-based resolution

strategy and part of its ALAC cushion has been downstreamed to Big Financial Services to satisfy local regulatory

requirements in country Y.

The scenario follows Big Group's rating path through a sharp, unexpected downturn in country X's real estate market

that feeds through to the wider economy. Although it is a sector-wide stress event, Big Group's capital position is

affected much more severely than peers' because it carries proportionately larger real estate exposures.

The Illustrative Case Study, Step By Step

In the sections below, we outline the potential rating levels at five points in time during the stress period, which we

label T1 to T5 (see chart 3).

Chart 3

T1: The operating environment begins to deteriorate

Country X's real estate market starts to decline and general economic activity also shows signs of a slowdown.

Reflecting the worsening risk environment, we cut the Banking Industry Country Risk Assessment (BICRA, the starting


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point for bank ratings in each country) and lower Big Group's capital and earnings projections due to our expectation

of higher credit impairments and weaker revenues. At this stage, the tougher operating environment looks set to

squeeze Big Group's profitability but we expect its capital ratios to remain relatively robust.

These actions lead us to lower Big Bank's SACP by one notch to 'bb+' and its GCP to 'bbb', which result in one-notch

downgrades of Big Bank and its senior unsecured debt. These ratings remain two notches above the SACP because it

retains a sizable ALAC buffer. Since the bank's SACP now sits below 'bbb-', we lower the issue ratings on Big Bank's

senior subordinated, Tier 2, and Tier 1 securities by two notches to reflect our standard notching at this level for hybrid

instruments. Big Financial Services' SACP remains 'bb' because its performance and franchise remain robust and

country Y is thus far largely unaffected by country X's stress. However, we lower the ICR on Big Financial Services by

one notch to 'BBB-' because it is capped one notch below the 'bbb' GCP.

Chart 4

T2: Stress escalates

As time goes on, real estate prices continue to fall and the implications for country X's economy and banking system

look more serious than appeared likely at T1. Big Group is likely to be weakly profitable in the current financial year

and we expect its capital ratios to weaken somewhat, but remain above minimum regulatory requirements including

buffers. Big Group has progressively tightened underwriting criteria and sought to reduce its exposure to the


1925681 | 300001180


problematic real estate sector. It is also preserving capital where possible, such as by cutting non-franchise lending and

reducing equity dividends. Its funding and liquidity metrics remain solid.

We revise Big Group's SACP and GCP downward by a further notch to 'bb' and 'bbb-', respectively. This leads to a

one-notch lowering of the ICR on Big Bank and the issue ratings on its senior unsecured, senior subordinated, and Tier

2 debt. The ICR and senior debt ratings on Big Bank are at the lower end of the investment grade spectrum due to the

ongoing ALAC cushion. We lower the issue rating on Big Bank's Tier 1 securities to 'CCC+' because we believe the

issuer is vulnerable and may cancel the discretionary coupon payments unless business conditions improve. We revise

down the SACP on Big Financial Services by a notch due to a modest adverse franchise impact and because spillover

from country X causes country Y's economy to slow. We additionally lower Big Financial Services' group status to

moderately strategic from strategically important because, although the parent insists that it remains committed to this

subsidiary, we see a growing possibility that Big Financial Services might be sold as a capital-raising measure.

Chart 5

T3: The recovery plan is activated

With country X's economy and real estate market showing no signs of stabilizing, Big Group activates measures that

were part of the recovery plan it submitted to regulators before the stress. Among other actions, it discloses that it will

eliminate equity dividends and cancel coupons on the bank's Tier 1 securities. Media speculation suggests it explored


1925681 | 300001180


an equity increase but market conditions made this impossible to achieve. The group announces a hastily agreed

disposal of Big Financial Services on terms that are capital-accretive for Big Group but undervalue the subsidiary's net

worth and reduce the group's diversification.

The resulting rating actions reflect our view that Big Group's actions to strengthen its balance sheet are insufficient to

avert a continued deterioration in its financial prospects amid the challenging operating environment. We revise the

group SACP downward by two notches to 'b+' because we see Big Group as vulnerable and its capacity to meet its

financial commitments could be impaired by a further decline in business conditions. The GCP, ICR, and senior issue

ratings on Big Bank now stand only one notch higher than the SACP--down from two notches previously--because the

group's operating losses are eroding its ALAC buffer (which includes "excess" going-concern capital as well as eligible

gone-concern loss-absorbing instruments). Due to the evolving situation and considerable uncertainty over Big Group's

ultimate losses, it is far from clear that, in the event of a bail-in resolution, Big Group would have sufficient

lower-ranking obligations to ensure that senior unsecured bonds remain fully intact. Therefore, it would not make

sense to maintain the ICR and senior unsecured issue ratings at an investment-grade rating level.

We lower the issue rating on the Tier 1 issue to 'D' because coupons are to be cancelled. We also downgrade the

senior subordinated and Tier 2 debt to 'CCC+' and 'CCC', respectively, because we perceive a greater risk of a

distressed exchange or resolution action. We remove the remaining notch of parental support from the ICR on Big

Financial Services, lowering it to 'BB-'. Once the sale of Big Financial Services is completed, the rating on this entity

will be partly determined by its relationship with its new owner.


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Chart 6

T4: The immediate aftermath of the bail-in resolution

Big Group's mounting losses add further pressure on its capital position and there are market concerns over the

adequacy of its provisioning on nonperforming assets. Wholesale market counterparties and uninsured depositors are

also beginning to pull away. Country X's resolution authority announces that it considers Big Group to be nonviable

and it will resolve the group using the bail-in tool. The authority appoints an independent auditor to revalue Big

Group's balance sheet, including previously unrecognized losses. Reflecting high uncertainty over key variables such as

collateral valuations, the auditor submits a range of possible net asset values. The resolution authority sizes the bail-in

to cover the most conservative estimate plus the amount required to recapitalize the group. For the purpose of this

case study, we assume that Big Group's residual capital and senior subordinated debt are sufficient to cover the

required bail-in.

A bail-in can be an effective tool to restore solvency, but liquidity availability is also critical to a resolved bank's

viability. Indeed, liquidity access is a prerequisite for us to consider a resolution regime effective. In this case study, we

assume that central bank liquidity would be available to support Big Bank's global activities.

As soon as practically possible following the resolution action, we take rating actions on Big Group based on its

post-resolution profile. The ICR on Big Bank and the issue ratings on its senior unsecured debt at T4 balance a range


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of factors. Positively, the resolution authority is likely to ensure that the bail-in delivers strong capital ratios in both

absolute and relative terms. The nonperforming assets that triggered the group's nonviability should be

comprehensively addressed through the revaluation and recapitalization processes. The assumed central bank

backstop should also underpin and reassure market participants over the group's liquidity position. The resolution

authority and regulator are likely to make these facts widely known to reassure creditors about the group's financial

health.

However, information flows may be incomplete or fragmented following a resolution, which could make it harder for

both us and the market to understand the exact position of the bank. Disclosures from the bank and resolution

authority might be constrained amid a time-pressured and rapidly changing situation. Delayed or restricted

information could undermine market confidence in the resolved institution and hinder our rating analysis.

In addition, banks are businesses and not simply balance sheets. On top of Big Group's financial position, the ratings at

T4 take account of the group's post-resolution business position, including the scope of the required restructuring plan

and the expected strength and stability of its franchise. Since failures in Big Group's business model, corporate

governance, and risk management all contributed to its nonviability, the resolution authority would probably need to

undertake a profound restructuring to produce a healthy bank capable of carrying out its systemic functions safely and

sustainably. Part of the restructuring could be completed at the point of resolution but longer-term measures are also

likely, such as cost cutting and the sale or closure of peripheral activities. This could mean that the bank may well be

unprofitable in the first year or more after the resolution. There is likely to be considerable market volatility and

uncertainty around the time of the resolution, and there could be doubts about Big Group's future strategy and

prospects. Customers and counterparties might remain wary of dealing with Big Group, despite its stronger financial

metrics, until there is more clarity around its future plans. This may be particularly true while bail-in resolution remains

an untested and unproven tool.

All in all, it is difficult for us to be specific on the likely positioning of the ratings at T4 because it would depend on the

exact circumstances. We therefore present two possible outcomes--labeled options A and B--in which we assume

material differences in the availability of information.

Option A. This is a relatively positive outcome in which we assume there is clear and sufficient information available

on Big Group's finances and strategy. We are able to conclude that the group has a reasonably successful future as a

continuing business, albeit in a heavily restructured form. In these circumstances, we believe a reasonable estimate is

that the ICR and senior debt ratings could be close to the 'BBB-/BB+' boundary. We assume a 'BB+' ICR on Big Bank

under option A in this case study. A resolved group is unlikely to have material ALAC to support senior liabilities at T4,

but authorities would expect it to rebuild gone-concern loss absorbing capacity over time.


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Chart 7

Option B. Conversely, in this alternative rating outcome, there is insufficient information for us to have a clear view on

Big Group's direction and prospects. In recognition of this uncertainty, we take a relatively cautious approach on the

ICR and senior debt ratings on Big Bank immediately after the resolution. We assume a 'B' ICR under option B in this

case study. Subsequently, the ratings could move higher in the days, weeks, or months following the resolution if a

stabilization of business activity, funding, and risk controls increases our confidence in the group's creditworthiness.

Equally, the ratings would move lower if the group's financial condition and prospects deteriorate.


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Chart 8

Under both options, we lower the issue ratings on the Tier 2 and senior subordinated debt to 'D' at T4 because these

obligations will not be paid in accordance with their terms. Since our issue ratings essentially reflect the prospect of full

and timely payment, any potential recovery on the senior subordinated bonds is not a relevant factor in the rating

decision and would not prevent the issue ratings on those instruments going to 'D'.

T5: About one year after the resolution

About a year has passed since the resolution and Big Bank is rebuilding its franchise and reputation. We assume that it

remains a continuing, significantly restructured business following the resolution action rather than closing to new

business and running down its balance sheet. Under a new management team, it reshapes its balance sheet to focus

solely on core retail and commercial banking activities in country X, and it sells or closes peripheral businesses. It

believes this new business model will satisfy the long-term expectations of regulators, shareholders, and other

stakeholders. The group's earnings are weighed down by restructuring costs but its credit profile remains underpinned

by the conservatively sized recapitalization completed during the resolution. Its funding and liquidity profiles are stable

and it has recently regained capital market access, issuing senior subordinated and Tier 2 debt to rebuild gone-concern

loss-absorbing capacity in line with regulatory requirements.

We position the SACP at 'bb+' because Big Group is performing in line with the prospective rating view that we took at

T4. Its ALAC buffer does not yet exceed our threshold but we expect that it will soon do so as the group continues to

issue senior subordinated debt. We therefore raise the ICR to 'BBB-' and assign 'BB-' and 'B+' ratings to the new senior

subordinated and Tier 2 issuance, respectively.


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Chart 9

Summary Of The Rating Transition Through The Case Study

In our illustrative case study, the bail-in resolution works largely as intended and there is a relatively orderly rating

transition. We assume that the various types of subordinated debt are effective in absorbing losses to protect senior

liabilities including senior unsecured bonds (see chart 10). The senior liabilities are not immune from downgrades

during the stress scenario, however. This is due to inherent uncertainty over whether the resolution will be a success

and whether available ALAC will be sufficient to cover all incurred losses and fund the required recapitalization.


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Chart 10

How The Rating Transition Could Differ From The Case Study Outcome

There are countless permutations to bank failure scenarios and our case study could not consider them all. Other

factors that could come into play are briefly summarized below.

A liquidity run

The case study considered a relatively orderly failure scenario brought on by solvency concerns, and we assumed that

Big Bank's funding and liquidity profiles remained relatively stable. However, the Banco Popular example shows that

authorities could be forced to accelerate a resolution action if a bank faces severe and rapidly moving liquidity

pressure. This could result in swifter rating downgrades prior to the resolution, and potentially a slower recovery in

ratings thereafter if we believe the bank would be particularly challenged in rebuilding its reputation and franchise.

Less comprehensive liquidity support

In our case study, we assumed for simplicity that central bank liquidity would be available to support Big Bank's global

activities, but the reality is that we are not currently certain whether it would be offered comprehensively. Although

depositors and counterparties should take comfort from a resolved bank's strong capital ratios, they may still have

concerns over its ability to honor its commitments if it does not have a strong liquidity backstop. The existence of a


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comprehensive liquidity safety net, secured by a wide range of eligible collateral, should encourage creditors to stay

with the resolved bank (therefore reducing the likelihood that the backstop is actually used).

Central banks are an obvious liquidity source following resolution since, as lenders of last resort, one of their main

functions is to provide temporary collateralized funding to solvent banks experiencing short-term liquidity strains.

However, funding from central banks or other government-related entities is a controversial area, notably in the U.S.,

where the Orderly Liquidation Fund (part of the Orderly Liquidation Authority provision under Title II of Dodd-Frank)

is currently under review (see "What Financial Regulations May Be Affected By The Trump Administration, And How

They Can Affect Ratings," published on March 20, 2017). Rather than allowing banks to assume an ability to draw from

the fund, U.S. regulators require them to estimate and maintain the amount of liquidity that their material operating

entities would need to withstand a failure of the NOHC. In other jurisdictions, collateralized central bank funding may

be available to a resolved bank's domestic activities, but the position of foreign branches and subsidiaries could be less

clear cut.

A simultaneous sovereign stress

For simplicity, the case study did not take account of possible stress on sovereign finances at the same time as Big

Group's asset quality downturn. Fundamentally, sovereign pressures can have a direct impact on bank ratings, such as

when they lead to a sharp currency depreciation or an inability to borrow from overseas markets. Under our criteria, it

is possible to rate a bank above its sovereign only if we see an appreciable likelihood that the bank would not default if

the sovereign were to default (see "Ratings Above The Sovereign--Corporate And Government Ratings: Methodology

And Assumptions," published on Nov. 19, 2013). Banks often carry material exposures to their domestic economies in

their loan and securities portfolios, and we therefore very rarely rate banks higher than their sovereigns. Depending on

the circumstances, sovereign ratings could influence how bank ratings transition through a resolution process.

A broader systemic stress

The case study considered a largely institution-specific stress in which a real estate crash hit Big Group much more

than peers due to its outsize exposure. A broader-based stress affecting most or all banks in a system could pose

greater challenges. In itself, the type of stress should not materially affect the rating transition for an individual bank

going through a bail-in process, but there might be a different policy response from governments and regulators in a

systemic crisis. A systemic stress is likely to lead to greater direct pressure on the BICRA than in the scenario

described, which implies that revisions to the anchor would drive rating changes more than changes in our assessment

of bank-specific factors. Post-resolution, a severely weakened operating environment and BICRA would make it

challenging for us to assign an ICR as high as 'BBB-/BB+' to a resolved bank.

Targeted short-term government or central bank support

In our view, regulators' handling of the Banco Popular and Italian stresses reveals a strong reluctance to impose losses

on senior creditors of stressed banks that have not yet built sufficient loss-absorbing capacity. Accordingly, during this

transitional period, and despite the constraints of resolution legislation, it is possible that certain governments may find

a way to ensure continued full and timely payment on banks' senior obligations. Under our criteria, if we were

sufficiently confident that a government would intervene to the benefit of the senior creditors of a systemically

important bank as a specific failure scenario plays out, we could reflect it in the ICR and senior unsecured issue ratings

as additional short-term support (see paragraphs 197-203 of "Banks: Rating Methodology And Assumptions," published


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on Nov. 9, 2011).

Additional short-term support might also be a rating consideration if central banks provide specific funding or liquidity

facilities following a resolution, for example. This backstop could mitigate weaknesses in banks' stand-alone funding

and liquidity profiles.

A breakdown in cooperation between international resolution authorities

Our case study assumed that Big Group operated only in country X at the time of its resolution, and we therefore did

not directly consider cross-border issues. Most G-SIBs have resolution plans that are based on a SPE model in which

intragroup downstreamed TLAC transfers a subsidiary's losses up to the parent company. For G-SIBs with material

cross-border footprints, a successful SPE resolution depends on close cooperation between the relevant international

authorities. Downstreamed TLAC is intended to give comfort to host authorities that the bank and its home resolution

authority will support foreign subsidiaries. Still, host authorities have their own legal responsibilities and could

potentially bail in a subsidiary's downstreamed TLAC before the home authority acts, or alternatively implement a

different resolution tool. This could result in a less orderly resolution and increased uncertainty, which could accelerate

rating actions and produce lower rating outcomes.

A payment moratorium

The European Commission has proposed to amend the EU resolution directive to allow a broad payment moratorium

of five days or more. A similar measure already exists in some EU countries and its broad purpose is to prevent a run

on a bank while authorities implement a resolution. This may have been useful in the Banco Popular resolution to

stabilize its liquidity position. However, we believe a moratorium could have unintended consequences such as

potentially hastening liquidity withdrawals when a bank first comes under stress. It could also put EU banks at a

competitive disadvantage to international peers (for example, by increasing margins payable to central counterparties),

and conflict with existing industry agreements that allow an up to two-day stay on derivative cross-default and

termination rights in the event of resolution.

Under our criteria, a moratorium could have direct rating consequences and lead us to lower the ICR to 'D' in certain

circumstances (see "Methodology: Timeliness Of Payments: Grace Periods, Guarantees, And Use Of 'D' And 'SD'

Ratings," published on Oct. 24, 2013).

The resolved bank has a nonoperating holding company

All G-SIBs in Switzerland, the U.K., and the U.S. are headed by NOHCs and certain other systemically important banks

also have them. The NOHCs' senior unsecured debt is structurally subordinated to their operating subsidiaries' senior

liabilities and these instruments can therefore count toward TLAC/MREL and ALAC. Our rating approach for NOHCs'

senior unsecured debt results in issue ratings that are at the same level as ratings on operating entities' senior

subordinated instruments because they serve the same economic function. Therefore, the rating transition for Big

Bank's senior subordinated debt through the case study shows the likely path for NOHC senior unsecured debt.

We typically rate NOHCs' Tier 1 and Tier 2 issues one notch lower than equivalent operating entity instruments,

reflecting structural subordination. Therefore, if Big Bank had a NOHC that issued regulatory capital, the issue ratings

could be a notch lower at each stage of the case study.


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The stressed bank's Tier 1 securities include a higher contingent trigger

We assumed in the case study that Big Bank's Tier 1 securities had a gone concern contingent trigger set at a 5.125%

CET1 ratio. If the trigger were instead higher, at 7% for example, it is possible that the contingent feature could

activate before the resolution action, although we note that this was not the case with Banco Popular. A trigger breach

would generate equity through a direct conversion or a principal writedown, which could help to mitigate pressures on

the issuer's credit profile, at least temporarily. If the issuer had not already suspended coupon payments, an equity

conversion or principal writedown would lead us to lower the issue rating on a Tier 1 instrument to 'D'.

How Our Proposed Resolution Counterparty Ratings Might Transition ThroughThe Scenario

We published a request for comment earlier this year proposing to introduce resolution counterparty ratings (RCRs;

see "Request For Comment: Methodology For Assigning Financial Institution Resolution Counterparty Ratings,"

published on Jan. 31, 2017). We are currently reviewing the comments received with a view to publishing the final

methodology. As proposed, an RCR is a forward-looking opinion of the relative likelihood of default of certain senior

liabilities whose treatment in a bail-in resolution scenario, in the context of an effective resolution framework, leads to

a distinctly lower default risk than that of the remaining senior unsecured liabilities. The exact instrument types

covered by the RCR would depend on regulatory provisions and authorities' stance in each jurisdiction. In most

jurisdictions with effective resolution regimes, we anticipate that the RCR liabilities would typically include

collateralized debt, certain types of deposits, repurchase obligations, and certain derivative counterparty obligations.

In the request for comment, we proposed that RCR uplift would in most cases be one notch if the ICR is between

'BBB-' and 'A+', or up to two notches if the ICR is between 'B-' and 'BB+'. We also indicated that RCR uplift could

exceed these limits in a stress scenario if a bank approached an expected resolution action and we anticipated

additional short-term support for RCR liabilities. In such a stress, we would likely position the RCR in the lead-up to

the expected resolution action at the level where it would most likely sit immediately after resolution.

Related Criteria

• Request For Comment: Methodology For Assigning Financial Institution Resolution Counterparty Ratings, Jan. 31,

2017

• Bank Rating Methodology And Assumptions: Additional Loss-Absorbing Capacity, April 27, 2015

• Bank Hybrid Capital And Nondeferrable Subordinated Debt Methodology And Assumptions, Jan. 29, 2015

• Principles For Rating Debt Issues Based On Imputed Promises, Dec. 19, 2014

• Group Rating Methodology, Nov. 19, 2013

• Ratings Above The Sovereign--Corporate And Government Ratings: Methodology And Assumptions, Nov. 19, 2013

• Methodology: Timeliness Of Payments: Grace Periods, Guarantees, And Use Of 'D' And 'SD' Ratings, Oct. 24, 2013

• Methodology: Use Of 'C' And 'D' Issue Credit Ratings For Hybrid Capital And Payment-In-Kind Instruments, Oct.

24, 2013

• Criteria For Assigning 'CCC+', 'CCC', 'CCC-', And 'CC' Ratings, Oct. 1, 2012

• Banks: Rating Methodology And Assumptions, Nov. 9, 2011

• Banking Industry Country Risk Assessment Methodology And Assumptions, Nov. 9, 2011


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• Rating Implications Of Exchange Offers And Similar Restructurings, Update, May 12, 2009

Related Research

• Banking Industry Country Risk Assessment Update: September 2017, Sept. 8, 2017

• Italian Bailouts Show EU Authorities Walk A Tightrope While Banks Transition Toward Bail-ins, July 4, 2017

• Eurozone Bank Resolution Framework Passes The Banco Popular Test, To A Point, June 19, 2017

• To Fail Or Not To Fail: The Point Of Nonviability Is Unclear For European Banks, May 31, 2017

• Financial Institutions And Resolution Regimes: Research And Analysis Published By S&P Global Ratings, May 18,

2017

• What Financial Regulations May Be Affected By The Trump Administration, And How They Can Affect Ratings,

March 20, 2017


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Credit FAQ:

A Closer Look At How ProposedBail-in Regulations May AffectCanadian Bank Ratings

Primary Credit Analyst:

Nikola G Swann, CFA, FRM, Toronto (1) 416-507-2582; [email protected]

Secondary Contact:

Devi Aurora, New York (1) 212-438-3055; [email protected]

Financial Institutions Criteria:

Tom Connell, Criteria Officer, Toronto (1) 416-507-2501; [email protected]

Table Of Contents

Frequently Asked Questions

Related Criteria And Research

WWW.STANDARDANDPOORS.COM/RATINGSDIRECT JULY 14, 2017 1

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Credit FAQ:

A Closer Look At How Proposed Bail-inRegulations May Affect Canadian Bank Ratings

On June 16, 2017, the Government of Canada released for public consultation draft bail-in regulations and related

regulatory guidance for Canadian banks. A "bail-in" mechanism is a public policy tool that allows authorities to

recapitalize a bank at or near a state of nonviability through equity conversion or writedown of designated liabilities.

Bail-in mechanisms are being implemented in many jurisdictions to expand the options for governments to deal with

the impending failure of a large financial institution, while avoiding the need for a taxpayer-funded bail-out.

The proposed measures include the following elements:

• Regulations under the Canada Deposit Insurance Corporation Act governing bail-in conversion processes and

related compensation considerations;

• Regulations under the Bank Act relating to the issuance of bail-inable debt; and

• A draft guideline on Total Loss Absorbing Capacity (TLAC) and updated Capital Adequacy Requirements (CAR)

guideline from the Office of the Superintendent of Financial Institutions.

The regulations are subject to a public consultation period running until July 17 (30 days). The government has

indicated it expects to publish final regulations during the fall of 2017 after considering any stakeholder comments.

The draft proposals indicate that the regulations would go into effect 180 days following the publication of the final

regulations.

The federally regulated banks that will be subject to the proposed Canadian regulations are Bank of Montreal, The

Bank of Nova Scotia, Canadian Imperial Bank of Commerce, National Bank of Canada, Royal Bank of Canada, and The

Toronto-Dominion Bank.

(For further information, see "Canadian Systemically Important Banks Ratings And Outlooks Are Unchanged

Following Release Of Draft Bail-In Regulations," published June 19, 2017, on RatingsDirect, and "Credit FAQ: How

Will The Federal Government's Expected Bail-In Framework Affect Our Ratings On Canadian Banks?" published

March 20, 2017.)

S&P Global Ratings believes it will be useful to provide additional context about its views on the framework's expected

rating implications, and the applicability of certain elements of our rating methodologies, with reference to Canadian

banks. Below, we answer questions we've received about key features of the proposed regulations and our view of the

regulations' likely implications for the ratings on Canadian banks, assuming the regulations are implemented without

material changes.

Frequently Asked Questions


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What are the key elements of the proposed regulations?

The regulations are largely consistent with the draft framework that the federal government initially outlined in August

2014. The framework's goals are preservation of financial system stability, avoidance of future taxpayer-funded

bailouts, and mitigation of issues relating to moral hazard and banks that are too big to fail. Specific provisions of the

framework include the following:

• A TLAC requirement of 21.5% of risk-weighted assets (RWAs), with the requirement that banks reach this level by

Nov. 1, 2021.

• Only senior unsecured debt that is tradable and transferable, has an original term to maturity of 400 days or more,

and is issued or renegotiated after the regulations' implementation date would be subject to bail-in conversion to

common shares. Capital instruments would be subject to prior conversion through activation of nonviability

contingent capital triggers or to loss absorption through other Canadian Deposit Insurance Corp. (CDIC) powers.

• The framework doesn't specify a conversion factor applicable to bail-inable senior debt, which would be determined

situationally based on provisions intended to uphold the priority of claims among liabilities of different seniority.

• All other senior liabilities (such as deposits, structured liabilities or secured liabilities, liabilities with original maturity

of less than 400 days, and senior unsecured debt issued prior to the implementation date) would be formally

excluded from bail-in.

• Senior debt subject to bail-in would be positioned as pari passu with other senior unsecured liabilities excluded from

bail-in. The framework allows for compensation based on a "no creditor worse off" provision that compares the

outcome for a particular creditor class under bail-in relative to the outcome for that class under a liquidation

scenario.

• CDIC would use existing powers (other than bail-in) to impose losses on legacy capital instruments (subject to

capital treatment phase-out under Basel III).

• The framework contemplates a unitary class of senior unsecured debt subject to bail-in and doesn't differentiate

between preferred and nonpreferred instruments, as in some other jurisdictions.

• To qualify as TLAC, senior unsecured issues would have to meet certain requirements, including remaining maturity

over 12 months.

Do the proposed regulations include any unexpected elements or significant changes from thepreliminary proposals?

The regulations are closely in line with our expectations and provide some additional detail but don't diverge

materially from the initial proposed framework.

The framework now refers to a bank's required loss-absorbing capacity as TLAC, providing for conceptual alignment

with other jurisdictions implementing the global framework promoted by the Basel Committee on Banking Supervision

and the Financial Stability Board. The initial framework referred to "higher loss-absorbency" liabilities. While we don't

view this as a substantive change, in our view such broad consistency in terminology promotes clarity and

cross-jurisdictional collaboration.

The regulations substantially clarify the liabilities that are subject to bail-in and those that are excluded. Compared

with many European jurisdictions, there's a narrow specification of instruments subject to bail-in, and this closely

connects to the TLAC definition and requirement with no apparent scope for regulatory discretion concerning the

situational exclusion of certain liabilities from bail-in within a particular resolution process.

The regulations provide some additional clarity on the treatment of legacy capital instruments (that is, Tier 1 and Tier


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Credit FAQ: A Closer Look At How Proposed Bail-in Regulations May Affect Canadian Bank Ratings

2 instruments that don't meet Basel III requirements for nonviability contingent capital [NVCC] features). Under the

proposed regulations, these instruments wouldn't be bailed-in per se, but CDIC would use other resolution-related

powers to impose commensurate losses on legacy capital instruments.

Will S&P Global Ratings consider Canada's resolution regime "sufficiently effective" for the purposesof its additional loss-absorbing capacity methodology once the bail-in regime comes into force?

Our preliminary assessment is that the proposed regulations are generally aligned with the requirements of our ALAC

methodology, while recognizing certain open issues. As part of our ongoing review of this framework, we'll assess

these issues, including:

• Whether there will be any interim enforcement of TLAC requirements or regulatory review of redemption of TLAC

instruments before Nov. 1, 2021, by which time domestic systemically important banks (D-SIBs) must have

accumulated the required TLAC amount (21.5% of RWA);

• Implications of the substantial holdings of Tier 1 capital instruments (both NVCC and legacy instruments) by retail

investors and whether this will inhibit authorities' determination to bail-in or impose losses on such instruments in

an imminent nonviability scenario;

• Confirmation of the sufficiency of arrangements, such as through the Bank of Canada, for interim funding and

liquidity support for an institution subject to a bail-in resolution.

We would likely complete our assessment of the resolution regime's effectiveness for ALAC purposes once we have

addressed these issues, in reference to the final form of the regulations, and have taken into account when the

provisions would formally become effective. We could make this determination soon after the framework's formal

implementation if the relevant conditions are satisfied. This determination wouldn't depend on D-SIBs having made

any specific degree of progress toward meeting the regulatory TLAC requirements (or the relevant ALAC thresholds).

Once S&P Global Ratings has determined that the resolution regime is sufficiently effective, will itthen change its assessment of the likelihood of extraordinary government support?

We won't automatically revise the current ratings uplift that's based on our assessment that the Canadian government

is supportive. Our current view is that the government is committed to establishing a credible and usable bail-in

framework, but because TLAC doesn't include legacy instruments as has been the case in some other jurisdictions,

Canada is likely some time away from the point when a resolution could be effected without some form of support for

a nonviable institution's solvency. This reassessment may happen at a later time, if at all.

Our future assessment of the likelihood of extraordinary government support would be informed by factors such as the

sufficiency of TLAC balances across the industry to support an expectation that bail-in resolution would be a sufficient

response for a bank approaching nonviability, as well as clarity on how authorities would likely balance the policy

goals of preserving financial stability versus avoiding a taxpayer-funded bail-out and related moral hazard concerns.

Will the finalization and implementation of the bail-in framework lead to changes in the issuer creditratings on the D-SIBs?

We haven't revised our outlooks on any of the Canadian banks as a result of the recent announcement of proposed

bail-in regulations and related timing. This indicates that there's no increased potential for rating actions due to the

bail-in framework over the relevant two-year outlook horizon. This is primarily because we'll continue to incorporate

uplift for the likelihood of extraordinary government support in the ratings until we revise our government support

assessment or until equivalent or greater uplift would be achieved based on ALAC. In the meantime, ratings may still


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be subject to change based on various bank-specific and industry factors.

Will the finalization and implementation of the bail-in framework lead to changes in the ratings onspecific securities issued by the D-SIBs?

Our current view is that the ratings on long-term and short-term senior instruments are subject to the same analytical

considerations that are governing the issuer credit ratings (ICRs) on the large Canadian banks (see answer to previous

question). Because legacy senior instruments aren't subject to bail-in, we believe the issue-level ratings on them will

continue to incorporate uplift for any expected extraordinary government support (or ALAC cushion, if that were to

apply). The same approach would apply to other exempt liabilities, such as secured instruments or short-term

instruments with original maturity under 400 days.

Our ratings on NVCC capital instruments won't change due to implementation of the proposed bail-in regulations. We

continue to regard these instruments as loss-absorbing, and the issue ratings on them currently incorporate applicable

notching for subordination and for risks of nonpayment or conversion.

We'll continue to assess the implications of potential loss-absorption that will be imposed on legacy capital

instruments within a bail-in resolution, even though those instruments are not subject to bail-in per se. In conjunction

with the proposed regulations, the government indicated that the CDIC would likely use existing powers to impose

losses on legacy instruments. Generally, we don't believe that this would lead us to equalize the ratings on legacy and

NVCC capital instruments (currently, we rate comparable NVCC instruments one notch lower than legacy

instruments). However, the somewhat-heightened visibility on the likely treatment of legacy instruments in a resolution

scenario could lead to some isolated adjustments to the ratings on specific legacy instruments.

How will S&P Global Ratings determine the ratings on bail-inable senior debt once the regulatoryframework takes effect?

We would take into account the final features of the bail-in framework, the indicated terms and conditions of proposed

new bail-inable instruments, and any relevant considerations arising from an individual bank's strategy for meeting the

framework's requirements.

Other jurisdictions provide reference points as to the potential ratings that would be assigned to senior bail-inable

instruments. In a number of European jurisdictions, the issue-level rating on the senior-most instruments used to meet

a bank's loss-absorbing capacity requirement has been one notch below the issuer's stand-alone credit profile (SACP)

(or unsupported group credit profile). We determine this rating level in reference to our hybrid criteria (see "Bank

Hybrid Capital And Nondeferrable Subordinated Debt Methodology And Assumptions," Jan. 29, 2015), and we include

a one-notch deduction for subordination because an instrument's conversion or write-down would entail effective

subordination, assuming bail-in is the expected response to nonviability. We expect Canadian banks' bail-inable senior

debt will remain legally pari passu with other senior unsecured instruments outside of a conversion scenario.

Will bail-inable senior debt count as ALAC, and does S&P Global Ratings expect that Canadian bankswill have sufficient ALAC to achieve one or two notches of uplift?

Once we determine that the bail-in resolution regime is sufficiently effective, the proposed form of bail-inable senior

debt would potentially be eligible to count as ALAC, subject to conditions set out in our ALAC criteria. The proposed

approach to bail-inable senior liabilities is generally consistent with one of the primary conditions in our ALAC criteria;

that is, that authorities are able to write down or convert the instrument without triggering a default on senior debt that


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is not subject to bail-in.

Beyond this, we would assess whether the framework establishes clear requirements for covered institutions to

accumulate and maintain sufficient quantities of loss-absorbing capacity. Currently, the regulatory requirements

reference a target date of Nov. 1, 2021. This leaves open the question of whether any level of TLAC capacity

accumulated in the meantime will be subject to redemption, without any regulatory constraint.

On an ongoing basis, our assessment of an institution's ALAC capacity would also consider any maturity

concentrations and would exclude any instrument with a remaining life under 12 months. We would also assess the

nature of regulatory constraints on the redemption of instruments for inclusion in ALAC, either on an

instrument-specific or aggregate basis.

We expect that the Canadian banks are capable of meeting the target level of TLAC by Nov. 1, 2021, and that in most

cases they'll achieve this by scheduled refinancing of senior unsecured term instruments coming due in the intervening

period. Eventually, we expect that banks may maintain levels of TLAC well above the stated minimum requirement.

Current levels of unsecured term funding would translate into median TLAC levels approaching 30% of regulatory

RWAs, holding other balance-sheet elements constant.

ALAC uplift is determined relative to RWA calculated within the S&P Global Ratings' risk-adjusted capital framework.

For Canadian banks, the median S&P Global Ratings' RWA value is typically about 50% higher than regulatory RWAs.

Our calculation of ALAC (in contrast to TLAC) is net of an amount representing a bank's core capital requirement. This

translates into expected levels of ALAC as a percentage of S&P Global Ratings' RWA that are below the expected and

minimum TLAC requirements. If we apply these levels to current balance-sheet compositions, we believe the

Canadian banks may accumulate sufficient ALAC for either one or two notches of uplift.

What will the ratings be on senior liabilities exempt from bail-in, including legacy senior debt andsenior debt with original maturity less than 400 days?

We would likely rate exempt senior liabilities in line with the long-term and short-term ICR on the respective banks.

The ICR could incorporate applicable uplift (relative to bank SACPs) based on the likelihood of extraordinary

government support or on the sufficiency of ALAC as applicable.

We typically assign short-term issue-level ratings for instruments with original maturities of up to 365 days and

long-term issue-level ratings for instruments with original maturities greater than 365 days. In some cases, we assign

short-term issue-level ratings to instruments with original maturity above 365 days, depending on market practice. In

any case, we expect that rated institutions will have both long-term and short-term ICRs, regardless of which specific

instruments may be rated.

We recently proposed new criteria for bank resolution counterparty ratings, which allow for incremental uplift above

our ICR on the bank in situations where some bank liabilities benefit from additional protection from default risk,

above the cushion of bail-inable capacity factored into the ICR. We'll comment in more detail on the applicability of

resolution counterparty ratings to Canadian banks once we've published the related criteria.


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How will the proposed framework affect ratings on the large Canadian banks' domestic andcross-border subsidiaries?

Currently, each of the Canadian banks has one or more subsidiaries that we view as "core" to the group, and the

ratings we've assigned to these subsidiaries are typically aligned with the ICRs on the respective parents. This

approach reflects our view that there aren't material restrictions on the group to supporting its core subsidiaries as

needed, taking into account each bank's stand-alone capacity as well as any capacity it might derive from external

support (such as a government bailout).

The proposed framework doesn't, in our view, provide specific reasons to revisit this approach. However, we expect

the evolving domestic resolution framework will interact with the banks' own recovery and resolution plans, which will

also be influenced by regulatory requirements arising from the other jurisdictions in which various Canadian banks

have operations. In aggregate, these ongoing developments may lead to regulatory arrangements that affect our view

of a bank's capacity to support one or more of its subsidiaries, or there may be consequential shifts in how the banks

themselves prioritize their likely support for different operating subsidiaries, as a result of required living will exercises,

for example.

We will also take into account any additional actions the banks take to support resolvability in response to the

framework's finalization. We'll update our views on the status of bank subsidiaries and expectations of intragroup

support as part of our ongoing surveillance and commentary on individual institutions and the overall industry

environment.

Related Criteria And Research

Related Criteria

• Request For Comment: Methodology For Assigning Financial Institution Resolution Counterparty Ratings, Jan. 31,

2017

• Bank Rating Methodology And Assumptions: Additional Loss-Absorbing Capacity, April 27, 2015

• Bank Hybrid Capital And Nondeferrable Subordinated Debt Methodology And Assumptions, Jan. 29, 2015

• Group Rating Methodology, Nov. 19, 2013

• Banks: Rating Methodology And Assumptions, Nov. 9, 2011

Related Research

• Banking Industry Country Risk Assessment Update: July 2017, July 5, 2017

• Italian Bailouts Show EU Authorities Walk A Tightrope While Banks Transition Toward Bail-ins, July 4, 2017

• Eurozone Bank Resolution Framework Passes The Banco Popular Test, To A Point, June 19, 2017

• Canadian Systemically Important Banks Ratings And Outlooks Are Unchanged Following Release Of Draft Bail-In

Regulations, June 19, 2017

• Latin American Governments Remain Reluctant In Reducing Their Role In Bailing Out Large Failing Banks, June 5,

2017

• To Fail Or Not To Fail: The Point Of Nonviability Is Unclear For European Banks, May 31, 2017

• Bank Resolution In Central And Eastern Europe: Many Unanswered Questions, May 26, 2017

• Rating Considerations For Potential Convertible MREL Issues By European Banks, April 25, 2017

• BEA And Some Hong Kong Banks' Subordinated Debt Put On CreditWatch Negative Pending Implementation Of

Resolution Regime, April 25, 2017


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• The Resolution Story For Europe's Banks: A Job Not Yet Half Done, So Plenty More Work To Come, April 5, 2017

• Various Rating Actions Taken On Four Systemically Important German Banks On Improved Loss-Absorbing

Capacity, March 28, 2017

• Credit FAQ: How Will The Federal Government's Expected Bail-In Framework Affect Our Ratings On Canadian

Banks?, March 20, 2017

• Liechtenstein-Based LGT Bank And VP Bank Ratings Affirmed After Review Of Government Support; LGT Off

Watch, March 2, 2017

• Operating Subsidiaries Of Four U.S. Global Systemically Important Banks Upgraded Following Final TLAC Rules,

Dec. 16, 2016

• Credit FAQ: Rating Implications For German Banks Due To Evolving Bank Resolution Regulations, Dec. 15, 2016

• France's New Senior Nonpreferred Notes: An Additional Route To Building Loss-Absorbing Capacity, Dec. 13, 2016

• The Road More Traveled: The Latest EC Proposals Bring EU Banks Closer To Completing A 10-Year Regulatory

Overhaul, Nov. 29, 2016

• ALAC Considerations For Callable TLAC Instruments, Nov. 23, 2016

• Proposals For EU Banks' Bail-in Buffers Could Lead To Broader ALAC Rating Uplift, Aug. 30, 2016

• Comparing Creditor Waterfalls For Swiss, U.K., And U.S. Global Systemically Important Banks, Aug. 17, 2016

• As The Tier 3 Ball Starts To Roll, European Banks Continue To Plot Their Bail-In Buffers, June 6, 2016

• Bulletin: Ratings And Outlooks On Systemically Important Canadian Banks Are Unaffected By Budget 2016 Bail-In

Reference, March 23, 2016

• Outlooks On Systemically Important Canadian Banks Revised To Stable From Negative On Extended Bail-In

Implementation, Dec. 11, 2015

• Outlook On Six Big Canadian Banks Revised To Negative Following Review Of Bail-In Policy Proposal, Aug. 8,

2014

Only a rating committee may determine a rating action and this report does not constitute a rating action.


1884071 | 300001180


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Blocked? Navigating the U.S.

Regulatory and Tax Regimes

Applicable to Blockchain

November 20, 2017

• U.S. Federal Legislative and Regulatory Landscape

• Introduction to Blockchain/ Smart Contracts/Tokens

• Sample Use Cases

• Key Legal Issues

• Q & A

Agenda

U.S. Federal Legislative and

Regulatory Landscape

• To date, blockchain technology has not received any significant scrutiny from the federal government

• Little legislative action on blockchain has occurred in the current Congress

• On February 9, 2017, Reps. Jared Polis (D-Colo.) and David Schweikert (R-Ariz.) launched the Congressional Blockchain Caucus

• The Caucus is working with MIT and NIST to develop blockchain security standards

• No federal regulatory action has been taken by the banking agencies (FRB, OCC, FDIC), the CFPB, the CFTC, the FTC, or the SEC

• The IRS, however, has been keeping busy!

• Here is what legislators and regulators are saying about blockchain

U.S. Federal Legislative and

Regulatory Landscape

• In its 2016 Annual Report, Treasury’s Financial Stability Oversight Council (FSOC) included a new section on distributed ledger technology (DLT) that outlined some of its potential benefits and risks to financial stability

• FSOC cautioned that market participants and financial regulators will need to monitor the risks and uncertainties posed by distributed ledger systems

• In an October 5, 2016 speech, then-Treasury Deputy Secretary Sarah Bloom Raskin emphasized the importance of building security and resiliency into blockchain systems from the outset as a “core design principle”

• Treasury’s Financial Crimes Enforcement Network (FinCEN) has continued to focus on blockchain as it relates to virtual currency and money transmission

• As an example, on August 14, 2015, FinCEN issued a ruling addressing the application of the Bank Secrecy Act to the on-blockchain transfer of digital certificates representing claims on precious metals

U.S. Department of the Treasury

• In October 7, 2016 remarks, FRB Governor Lael Brainard stated:

• “We are paying close attention to . . . blockchain, recognizing this may represent the most significant development in many years in payments, clearing, and settlement.”

• On December 5, 2016, the Federal Reserve issued a working paper, “Distributed Ledger Technology in Payments, Clearing and Settlement”

• The paper says there may be increased exposure to cyberattacks through the endpoints that validate transactions and write to the blockchain

• Another “key challenge” is identification of appropriate uses for blockchain where the potential reduction in the costs of inefficiencies would justify the costs of the investment and necessary operational changes

• In a March 3, 2017 speech, FRB Governor Jerome Powell said:

• “[F]irms are still grappling with the business case for upgrading and streamlining payment, clearing, settlement, and related functions. . . .”

• “[S]tandardization and interoperability across different versions of DLT will need to be addressed to allow technology integration and avoid market fragmentation.”

U.S. Federal Reserve

• On July 25, 2017, the Securities and Exchange Commission affirmed its role in regulating platforms like those on which blockchain-based instruments are traded by issuing a report finding that digital tokens sold by businesses may constitute unregistered securities offerings

• The SEC also released an investor bulletin on initial coin offerings

• On July 24, 2017, the Commodity Futures Trading Commission announced that, by a unanimous vote, it had issued an order granting LedgerX LLC registration as a derivatives clearing organization under the Commodity Exchange Act

• The order authorizes LedgerX to provide clearing services for fully collateralized digital currency swaps

SEC and CFTC

• In July 2015, the Consumer Financial Protection Bureau released consumer protection principles for the development of new payment systems

• On March 9, 2017, the Federal Trade Commission hosted a Fintech Forum on Artificial Intelligence and Blockchain

• In his opening remarks, Daniel Kaufman, deputy director of the FTC’s Bureau of Consumer Protection, said:

• “The distributed digital ledger behind blockchain . . . has the potential to impact an array of sectors that affect consumer’s everyday lives, from payments to cross-border remittances to real estate and much more, with the promise of making transactions more efficient and secure.”

CFPB and FTC

• On March 25, 2014, the IRS issued Notice 2014-21

• Convertible virtual currencies treated as property

IRS

Q A

• November 2016, crypto exchange firm Coinbase Inc. served with IRS John Doe summonses

• 500,000 account holders

• 807 taxpayers reported

U.S. Tax Enforcement Action

• The IRS has engaged Chainalysis Inc. to track crypto transactions

• 25% of all bitcoin addresses; 50% of network activity

U.S. Tax Enforcement Action,

cont’d.

The New Swiss Bank?

“At some point people will need access to this money, and they are going to have to have a means of coming forward, whether it is through the traditional [Internal Revenue Manual] voluntary disclosure procedure or whether there is a separate project”

― Mark F. Daly, senior litigation counsel at the Justice Department’s Tax Division, November 3, 2017

U.S. Tax Enforcement Action,

cont’d.

• On September 7, 2017, Polis and Schweikert introduced the Cryptocurrency Tax Fairness Act of 2017

• $600 de minimis exception

U.S. Tax Bill

Introduction to Blockchain/

Smart Contracts/Tokens

• An immutable, decentralized ledger

• Key characteristics that differentiate a blockchain from traditional distributed databases:

• Transactions authenticated and tracked via nodes on network

• Cryptographic techniques prevent tampering or manipulating transactions

• Can be public (anyone can participate) or permissioned (only authorized participants)

• Application-agnostic (not limited to digital currencies)

What Is Blockchain?

• Popular blockchains today include the payment network Bitcoin and the smart contracts platform Ethereum, which create and track transactions in bitcoin and ether

What Is Blockchain?, cont’d.

What Is Blockchain?, cont’d.

• An automatically executing computer program that is linked to a distributed ledger

• When triggering variables arise that are coded within the smart contract, the program executes and the resulting transactions are automatically digitally executed

“‘Smart contracts’ are embedded with computer protocols that can automatically verify and execute the terms of the contract without relying on a centralized business logic engine. The proponents of ‘smart contract’ solutions typically envision removing intermediaries through their solutions to achieve greater efficiency while maintaining auditability of the transactions.”

― David Treat, Managing Director, Accenture Capital Markets – Blockchain Lead

Smart Contracts

Smart Contracts Basics

Smart Contract Template – Data

Fields Legal Document

Smart Contract Template – Submission

Smart Contract Template – Confirmed

• What is a token?

• A digital representation of whatever the creators define

• Coins versus tokens

• Examples of types of coins and tokens

• Cryptocurrency coins and tokens (intrinsic, asset-based token, or dApp token)

• Digital representation of the provenance of a physical asset

• Digital asset itself

• Similar technology is used for payment tokenization

• Tokens can represent a record of any kind of asset

• Tokens can be used for a broad range of purposes

Tokens

Sample Use Cases

• Settlement and clearing systems that are globally distributed and comply with reporting requirements

• Trade finance (e.g., letters of credit)

• Asset finance

• International remittances

• Corporate loan syndications

• Post-trade settlement exchanges

• Internet of Things applies across many use cases

• Real time tax reporting and collection

Sample Use Cases

• Financial trades execution upon occurrence of pre-agreed events

• Swaps and derivatives

• KYC/AML checks

• Medical records

• Supply chain and food provenance

• Solar energy sales

• Art sales

• Real estate transactions

• Loans and escrow predefined payment/release events

• Royalty payments to content generators based on usage or downloads

• “Time share” contracts on standard terms

• Insurance payouts

• Many other ambitious use cases have been proposed

Additional Use Cases

Trade Finance: Current-State

Process Depiction

Trade Finance: Future-State

Process Depiction

Key Legal Issues

• Applicable law

• Integrity of and proof of records

• Transaction timing and finality

• Transaction enforceability

• System accountability and responsibility

• Regulatory issues

Key Legal Issues

• Uniform recognition of the system is key

• Choice of law generally will be based on the terms of participation

• Conflict of laws rules will need to honor the choice of law

• The choice of applicable law must bind not only participants but also parties claiming through the participants

• A statutory basis could increase legal certainty

• For example, UCC Article 4A for wire transfers provided that a funds transfer system rule could provide for a choice of law that would bind both participants and would bind remote parties with notice

• Applicable tax law would depend on the tax residence/citizenship of the parties and the sourcing of the crypto assets/instruments

Applicable Law

• Blockchains have the potential to provide secure, reliable, and transparent records on which

• Assets are recorded

• Transactions are tracked and validated

• Discrepancies can be identified by comparison of the transaction against a version of the transaction maintained by another node

• Controlling a majority of the computing power of the network could, however, empower a network participant to alter the ledger

• The proliferation of nodes could create interoperability questions if there are inconsistencies or incompatible protocols

• Questions concerning interoperability can include timing and ownership itself

• Network effects are more limited if there are incompatible protocols

Integrity of and Proof of Records

• Financial transactions recorded on the blockchain are subject to rules set forth in the blockchain protocol as private contracts (e.g., “rule of code”)

• Acceptance of contractual terms, including applicable rule sets, may be incorporated into the underlying code so that use of the system represents agreement to the rule set

• Enforceability is, therefore, subject to the rights and obligations created by the applicable rule set

• Choice of law, as discussed above, will be fundamental to the enforceability of the rule set

• This may work better for some transactions than for others; for example, consumer protection interests in some jurisdictions could override rule set provisions

Transaction Enforceability

• The rule set may also provide for formal dispute resolution rights

• In the distributed ledger context, however, the form and forum of the dispute resolution process is unclear

• In smart contracts, legal review of the code and formal dispute resolution would be critical

Transaction Enforceability,

cont’d.

• Blockchains have the potential to flatten tiers of recordkeeping for transactions, potentially reducing vulnerabilities and increasing the speed of transactions

• At the same time, blockchain applications may introduce new risks relating to the ability to update nodes in a timely manner

• For example, this risk may be greater in a geographically dispersed network of nodes, but may not raise the same concerns in a concentrated, permissioned network

• Inability to update nodes may affect timing of transactions or create differences in records

Transaction Timing and Finality

• The lack of a central administrator complicates accountability

• Access points for the blockchain or the software or protocol publisher, if known, may be held accountable

• What entity has the responsibility to address a system-level breach or systemic fraud?

• The lack of a central administrator would raise questions as to what entity is subject to examination or enforcement

• It also becomes more difficult to ensure that consumers understand what they are agreeing to and what rights they have in the course of the transaction

• Accountability can be less of an issue in a blockchain with an administrator

System Accountability

• Legal risk

• Tax risk

• Operational risk

• Security

• Reliability

• Credit risk

• Liquidity risk

• Compliance risk

• Systemic risk

Regulatory Issues for New Technology

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Client Alert November 7, 2017

House Republicans Release Draft Tax Proposal; Committee Markup Begins

On November 2, 2017, the House Ways and Means Committee unveiled the Tax Cuts and Jobs Act (the “Bill”). The Bill could dramatically alter the U.S. approach to domestic and international taxation. Although the possibility of tax reform has been the subject of much discussion since the election of President Donald Trump, many past proposals have been light on details. The Bill represents the first potential legislative language. House Ways & Means Committee Chairman Kevin Brady (R-Texas) released an amendment to the Bill on November 6, 2017 (the “Amendment”).1 The committee is marking up the Bill this week with a vote expected Thursday. Republican leaders in the House hope for a full vote the week of November 13th.2

The Bill proposes dramatic changes to existing U.S. tax rules. For individuals, the Bill reduces the amount of home mortgage indebtedness on which interest payments are deductible and repeals the itemized deduction for state and local income taxes. For businesses, the Bill permanently reduces the corporate income tax rate to 20% and allows taxpayers to fully and immediately expense 100% of the cost of certain qualified property. For multinational groups, the Bill moves the United States toward a territorial system coupled with anti-base erosion measures intended to shore-up the U.S. tax base. The Bill also proposes a one-time transition tax on currently deferred foreign earnings.

The following is a brief summary of the key provisions in the Bill:

Individual Tax

• Reduces the number of tax brackets from seven to four: 12%, 25%, 35%, and 39.6%. Significantly lowers the taxable income threshold of the 35% bracket and significantly raises the application of the 39.6% bracket; the benefit of the 12% bracket is lost as a taxpayer’s income exceeds $1,200,000 (married filing jointly) or $1,000,000 (single). (The effect of these shifts (without regard to other changes that tend to increase taxable income) is to cause married taxpayers at the top of current 35% bracket ($480,050 of taxable income) to experience the lowest percentage reduction in effective tax rate under the proposed rate revisions (a 0.82% reduction). The percentage reduction thereafter climbs to a maximum percentage reduction of 2.78% at $1,000,000 of taxable income.) The maximum dollar amount of reduction in tax liability is $27,844, reached at $1,000,000 of taxable income (without regard to the new 25% preferential rate discussed below).

• Doubles standard deduction to $24,000 but eliminates personal exemptions. (The effect of the elimination of the personal exemption more than offsets the increased standard deduction for taxpayers claiming

1 Chairman Brady also released a mark-up with some technical changes on Friday, November 3, 2017. 2 On the Senate side, the Senate Finance version will be released later this week.


Client Alert more than two exemptions, but under some circumstances for low-income taxpayers, the net reduction for such taxpayers may be offset by an increase in credits for dependents.)

• Creates a new preferential 25% rate for income from a “business activity.” All of business income from passive activities qualifies for the 25% maximum rate, while the amount of business income from activities in which the taxpayer materially participates depends on a taxpayer’s “capital percentage” for the relevant activity (that is, the portion of the income not considered to be attributable to services provided by the taxpayer). The default capital percentage is 30%, but taxpayers may elect instead to determine their percentage using a formula in the statute. Relies heavily on existing passive/active business activity rules (Section3 469) to determine which income qualifies for the 25% maximum rate and which is subject to ordinary individual income tax rates. The 25% maximum rate does not apply to income from “specified service activities,” which include “any activity involving the performance of services described in Section 1202(e)(3)(A), including investing, trading, or dealing in securities (as defined in Section 475(c)(2)), partnership interests, or commodities (as defined in Section 475(e)(2)).” The 25% maximum rate also does not apply to “investment-related items,” which include capital gain, dividend and dividend-equivalent income, interest income not allocable to a trade or business, and certain other categories of passive income.

• Applies the maximum 25% business activity rate to real estate investment trust (“REIT”) dividends that are currently treated as ordinary income.

• Determines self-employment income from flow-through businesses by reference to a “labor percentage.” The labor percentage is the inverse of the capital percentage computed for that business (discussed above). The exclusion for distributive shares of partnership income allocated to limited partners would be repealed.

• Repeals the so-called “Pease limitation,” which generally limits itemized deductions for high-income taxpayers.

• Reduces the amount of home mortgage indebtedness on which interest payments are deductible. Under current law, taxpayers may deduct interest on up to $1,000,000 in acquisition indebtedness.4 Under the Bill, with respect to debt incurred after November 2, 2017, this would be reduced to $500,000. The $1,000,000 limit would be retained for debt incurred on or before November 2, 2017 (including refinancing of such grandfathered debt), and debt incurred under a binding contract exception. The deduction for interest paid on home equity indebtedness would be eliminated.

• Limits the exclusion of gains from sale of a principal residence by (i) requiring that the taxpayer have used the residence for 5 of the previous 8 years (instead of 2 of the previous 5 years under current law), (ii) limiting the ability to use the exclusion to once every 5 years (instead of once every 2 years under current

3 References to “Sections” throughout this Client Alert are to the currently effective version of the Internal Revenue Code of 1986, as amended, unless otherwise specified. 4 In addition to “acquisition indebtedness,” current law also permits taxpayers to deduct interest on up to $100,000 of “home equity indebtedness.”


Client Alert law), and (iii) phasing out the exclusion for taxpayers with a 3-year average adjusted gross income exceeding $500,000 (for joint filers), determined without regard to inclusion of gains attributable to the phase-out.

• Repeals the itemized deduction for state and local income taxes. Limits state and local property tax deduction to $10,000.

• Limits gambling deductions to the extent of gambling winnings. Under current law, gambling losses are limited to gambling winnings, but other expenses connected to gambling (when conducted as a trade or business) are not so limited.

• Increases the limitation on charitable contributions to 60% of adjusted gross income (up from 50% under current law).

• Repeals deductions from gross income for alimony payments, moving expenses, and itemized deductions for tax preparation expenses and medical expenses and expenses attributable to the trade or business of being an employee.

• Eliminates the ability of taxpayers to recharacterize IRA contributions as Roth IRA contributions (and vice-versa).

• Increases the exemption from estate, gift, and generation-skipping transfer tax from $5,000,000 to $10,000,000, and beginning 2023, repeals the estate and generation-skipping transfer taxes.

• Repeals the alternative minimum tax (“AMT”) beginning in 2018. Taxpayers may claim a refund for AMT credit carryforwards beginning in 2019.

Business Tax

• Permanently reduces the general corporate tax rate from a maximum graduated rate of 35% to a flat 20%.5 Similarly, reduces the tax rate for qualified personal service corporations6 from a flat 35% to a flat 25%.

• Allows taxpayers to fully and immediately expense 100% of the cost of certain qualified property (e.g., certain tangible personal property, certain computer software, water utility property, etc.). Repeals the current requirement that the original use of the property must begin with the taxpayer taking the depreciation deduction. Instead, under the Bill, a taxpayer is generally eligible for the depreciation deduction if it is such taxpayer’s first use of the property.

• Permits the use of the cash method of accounting for tax purposes by entities taxed as corporations (and partnerships with a corporate partner) whose 3-year average annual gross receipts (determined as of the

5 Currently the rate is 15% for taxable income up to $50,000; 25% for taxable income between $50,000 and $75,000; 34% for taxable income between $75,000 and $10,000,000; and 35% for taxable income above $10,000,000. 6 Section 448(d)(2) generally defines a “personal service corporation” as a corporation that performs services (i.e. health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting). Currently Section 11(b)(2) provides that qualified personal service corporations are subject to a flat rate of 35%.


Client Alert end of the immediately preceding taxable year) did not exceed $25,000,000. Under current law, use of the cash method is limited to corporations whose 3-year average annual gross-receipts did not exceed $5,000,000 for any prior year.

• Restricts business interest expense deduction by providing that no business, regardless of form, may deduct interest expense in excess of 30% of such business’s adjusted taxable income (that is, taxable income allocable to the trade or business without regard to the interest deduction, loss carryovers, and certain other items). Interest deductions by businesses whose 3-year average annual gross receipts for the immediately preceding year did not exceed $25,000,000 would not be subject to this limitation. The provision also would not apply to real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trades or businesses.

• Modifies the rules for carrying back net operating losses (“NOLs”) for corporations by eliminating the existing general 2-year carryback and permitting an unlimited NOL carryforward period (rather than the current maximum of 20 years). In addition, the unused NOL carryforwards will be increased by an interest factor for the period that they remain unused. Similar to the existing alternative minimum tax rules, not more than 90% of the taxpayer’s current year’s taxable income can be offset by otherwise available NOL carryovers.

• Limits like-kind exchange non-recognition treatment to exchange of real property only. Under current law, qualifying personal property may also qualify for preferred like-kind exchange treatment if certain conditions are satisfied.

• Under current law, insured depository institutions may deduct FDIC assessments as a trade or business expense. The Bill phases out these deductions for financial institutions that have consolidated assets between $10,000,000 and $40,000,000.

• Restricts the potential tax benefit of carried interest by limiting the availability of long-term capital gain rates. In general, under new Section 1061, a taxpayer that performs substantial services for an investment business and receives a partnership interest in exchange must use a 3-year holding period to determine long-term capital gain with respect to that partnership interest. Amounts that are disqualified because of the 3-year rule are treated as short-term capital gain. The 3-year rule does not apply where a partnership interest generates a capital loss, rather than capital gain, for a tax year. It also does not apply to partnership interests held directly or indirectly by a corporation or certain capital interests in partnerships.7

International Tax

Territorial Taxation of U.S. Corporations

• Generally moves toward territorial taxation of U.S. corporations, primarily by allowing U.S. corporations to deduct the foreign source portion of any dividends received from a foreign corporation (other than from a

7 If enacted, new Section 1061 could raise potential conflicts between investment managers (such as private equity and venture capital sponsors) on one hand and their investors on the other.


Client Alert passive foreign investment company (“PFIC”) that is not a controlled foreign corporation (“CFC”)) in which the U.S. corporate stockholder owns at least a 10% interest (an “exempt dividend”).

• Prohibits foreign tax credits and deductions for any foreign taxes (including withholding taxes) paid or accrued with respect to any exempt dividend and ignores deductions for expenses properly allocable to an exempt dividend (or stock that gives rise to exempt dividends) for purposes of determining the U.S. corporate shareholder’s foreign-source income.

• Makes other conforming changes to integrate this “participation exemption” into the existing tax rules. For example, the current Subpart F rules relating to CFC investments in U.S. property (Section 956) would no longer apply in the case of a U.S. corporate shareholder. In addition, on the disposition of shares in a 10% owned foreign corporation, basis adjustments would prevent a taxpayer from realizing a loss that corresponded to exempt dividends previously received from that corporation.

• The participation exemption would be effective for dividends paid after December 31, 2017. Certain holding period requirements apply.

One-Time Repatriation Tax

• Imposes a one-time transition tax on all deferred post-1986 foreign earnings, to facilitate the transition to a territorial regime.

• Requires each U.S. shareholder owning at least 10% of most foreign corporations (other than PFICs that are not CFCs and other non-CFCs having no 10% U.S. corporate shareholder) to include as Subpart F income the shareholder’s proportionate share of the foreign corporation’s net post-1986 earnings not previously subjected to U.S. tax.

• Inclusion is determined as of November 2, 2017, or December 31, 2017 (whichever results in a greater amount), and applies for the foreign corporation’s last taxable year beginning before 2018.

• Income inclusion applies to all 10% or more U.S. shareholders, not only U.S. shareholders that are corporations that will be entitled to the participation exemption.

• Tax rate for offshore business earnings held as cash and cash equivalents is 12%; noncash assets are taxed at 5%. Tax would be payable over up to 8 years at the taxpayer’s election. Foreign tax credit carryforwards would be fully available, and foreign tax credits triggered by the deemed repatriation would be partially available, to offset the U.S. tax.8

Anti-Base Erosion Measures

• Tax on high foreign returns. Expands the existing Subpart F regime to require “United States shareholders” of a CFC to include in income 50% of the CFC’s net income that exceeds a routine return (generally, the applicable federal short-term rate plus seven percentage points, times the

8 Although REITs are not the subject of this provision of the Bill, there is no enumerated exception for REITs that have foreign taxable REIT subsidiaries. Currently, it is unclear how this provision would apply in the REIT context.


Client Alert CFC’s adjusted basis in its tangible property used in a trade or business). Income effectively connected with a U.S. trade or business, Subpart F income and certain other specified items of income are excluded from net income subject to this provision, and relevant foreign tax credits are allowed on a limited basis. This provision would make structures in which high-return intellectual property is held in a low-taxed foreign corporation more expensive.9

• Excise tax on related party payments. Imposes an excise tax of 20% on certain payments by a U.S. corporation to a related foreign corporation, unless the foreign corporation elects to treat the payment as effectively connected with a U.S. trade or business (or permanent establishment). The excise tax would apply to most payments that are, with respect to the U.S. corporation, allowable as a deduction or includible in costs of goods sold, inventory or the basis of a depreciable or amortizable asset, but would not apply to payments of interest, for certain securities and commodities, or for certain services charged at cost. This provision would apply only to a U.S. corporation that is a member of an international financial reporting group (which requires, among other things, that U.S. group members have made average annual aggregate payments to foreign members exceeding $100,000,000 over a test period) with respect to payments to a foreign corporation that is a member of the same group.10

• Limitation on U.S. interest deduction. Where a U.S. corporation is a member of an international financial reporting group (which, for these purposes, is a group of entities that includes at least one foreign corporation engaged in a U.S. trade or business or that includes at least one domestic corporation and one foreign corporation, prepares consolidated financials, and has average annual gross receipts over $100,000,000), limits the U.S. corporation’s deduction for net interest expense to the extent that the U.S. corporation’s share of the group’s net interest expense exceeds 110% of the U.S. corporation’s share of the group’s EBITDA. Disallowed interest expense may be carried forward for 5 years. Comparable rules apply to partnerships and to foreign corporations engaged in a U.S. trade or business.

• Limitation on treaty withholding tax reduction. The Bill would have eliminated the potential for treaty-based reduction of U.S. withholding tax on payments that are deductible in the United States (such as royalties) and that are made by any person that is a member of a group of entities controlled by a foreign parent to any person that is a member of the same group, unless the foreign parent would have been entitled to a reduced rate under an applicable treaty if the payment were made directly to the foreign parent. This provision was dropped from the Chairman’s mark, which was released on November 3, 2017.

The wide-ranging and, in some respects, unexpected nature of the proposed tax changes make it difficult to predict the overall impact of the changes, even in the event the changes were enacted into law as currently

9 The Bill also would make narrowly focused changes to the Subpart F rules to bring more taxpayers within their scope and to modify the scope of passive income subject to these rules; and would generally source to the United States income from the sale of inventory property produced within the United States but sold outside the United States. 10 As a practical matter, this unexpected and controversial provision could require foreign payee corporations that have no taxable presence in the United States to elect to file U.S. tax returns and pay U.S. net income tax (and potentially branch profits tax). An election applies for all subsequent years unless the IRS consents to revocation.


Client Alert reflected in the Bill. In particular, Chairman Brady has already indicated that the base erosion measures are up for discussion. Therefore, many aspects of the proposal described above could change materially before any bill is enacted. We will continue to monitor the latest developments in this area.

The Bill also includes numerous other proposed changes that are beyond the scope of this Client Alert. In particular, proposed changes to the tax rules governing employee compensation will be covered in a separate Client Alert.

Contact:

Thomas Humphreys (212) 468-8006 [email protected]

Remmelt Reigersman (415) 268-6259 [email protected]

Shiukay Hung (212) 336-4331 [email protected]

David Goett (212) 336-4337 [email protected]

Joy MacIntyre (415) 268-6270 [email protected]

Jessica Stern (415) 268-6836 [email protected]

Allison Peck (415) 268-6331 [email protected]

Adam Nguyen (415) 268-6278 [email protected]

David Strong (303) 592-2241 [email protected]

John Harper (703) 760-7321 [email protected]

About Morrison & Foerster:

We are Morrison & Foerster—a global firm of exceptional credentials. Our clients include some of the largest financial institutions, investment banks, Fortune 100, technology and life science companies. We’ve been included on The American Lawyer’s A-List for 13 years, and Fortune named us one of the “100 Best Companies to Work For.” Our lawyers are committed to achieving innovative and business-minded results for our clients, while preserving the differences that make us stronger. This is MoFo. Visit us at www.mofo.com.

Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations. Prior results do not guarantee a similar outcome.

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Twice In Two Days: China and Hong Kong Weigh In On Token Sales

Joshua Ashley Klayman

09/06/2017

Financial Transactions

Client Alert

Twice in as many days, powerhouse jurisdictions in Asia have weighed in on token sales. China has halted them altogether,while Hong Kong has, in many ways, followed the path tread recently by the United States, Singapore and Canada,announcing that certain tokens may be securities. [1] Given token sales’ global reach, many, including the author and hercolleagues, have predicted that more and more jurisdictions would provide guidance concerning token sales and that suchguidance may, in some ways, be consistent with the SEC’s statements and acknowledgement that certain tokens may besecurities. [2] The more jurisdictions around the world that weigh in on token sales and provide legal guidance, the fewerand fewer places would-be fraudsters and scam artists will be able to launch deceptive or fraudulent token sales. Fromthat perspective, the Chinese ban on token sales and the announcement this week by Hong Kong may, in some ways, beviewed as a way to clear the path for those issuers that wish to launch legally compliant and responsible token sales. Asnations around the globe weigh in and provide legal guidance concerning token sales, a more legitimate, responsible andsustainable token sale market may emerge.

Below are some thoughts regarding the Chinese and Hong Kong guidance, respectively:

Bull in a China Shop? China Reportedly Halts Token Sales and Will Investigate Prior Chinese Token Launches

This year, token sales have been a big business in China, with Chinese media outlets reportedly stating in July that over US$397 million in the aggregate had been raised from 65 token sales, as reported by CNBC. [3] On September 4, 2017, theChinese government reportedly put a halt to token sales and announced that it will be investigating certain token sales thatlaunched previously. [4]

Over the prior week or so, there had been rumblings on the Internet and elsewhere that Chinese regulators were lookingclosely at token sales and that the National Internet Finance Association of China had expressed concerns regardingfraudulent and misleading sales tactics, as well as sales of tokens that arguably were securities without complying withapplicable securities laws. [5] On August 31, 2016, Duncan Riley reported "China’s Securities and Futures Commission,the China Banking Regulatory Commission and other regulators have held a number of meetings to discuss ‘appropriateregulatory measures.’ Those measures are said to include controls on how much an ICO can raise, regulations pertainingto information disclosure, supervision of ICOs and compulsory investment risk disclosure. The report adds that if ICOs arefound to be considered too risky across the board, they make [sic] consider banning all ICOs outright until the concernswere addressed." [6] Reports earlier this week that the Chinese government will require token issuers to return money toinvestors follow recent news in the United States regarding the SEC reportedly having contacted token issuer Protostarr,leading to the shutdown of the Protostarr token sale. [7]

While this author cannot speak or read Chinese and, accordingly, is reliant on media reports, the message from China –that some token sales may be sales of securities, that investors need to be wary of fraudsters and bad actors, and thattoken sales are not somehow exempt from the need to consider and comply with regulatory frameworks and laws – sounds

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somewhat consistent with the messages that the United States Securities and Exchange Commission (the " SEC"), theCanadian Securities Administrators (the " CSA ") and the Monetary Authority of Singapore (the " MAS") recently havereleased. Although China appears to have taken an additional step to ban token sales [8] – at least for the time being– while the U.S., Canada and Singapore have not done so, China’s actions this week may be an example of anothergovernment trying to understand, regulate and educate the public of the risks involved in this new form of capital raising.

It is interesting to consider whether the Chinese token sale stoppage will be a permanent one. A moving target often ismore difficult to hit, and it is worth considering whether the Chinese government may be "pressing pause" on token salesin order to explore ways to assess and regulate future token sales, rather than issuing a permanent ban on all token sales.Perhaps this may lead to the maturation and development in China of legally compliant token sales under applicable law.

Hong Kong Joins the Pack: Certain Tokens May Be Securities

On September 5, 2017, Hong Kong made clear that certain tokens may be securities. [9] In its release, Hong Kong'sSecurities and Futures Commission (SFC) stated that it "has noticed an increase in the use of initial coin offerings (ICOs) toraise funds in Hong Kong and elsewhere. This statement serves to explain that, depending on the facts and circumstancesof an ICO, digital tokens that are offered or sold may be “ securities” as defined in the Securities and Futures Ordinance(SFO), and subject to the securities laws of Hong Kong." [10]

Explaining that, when a given digital token constitutes a " security" (a category that the SFC mentions includes debentures,interests in a collective investment scheme and shares) under Hong Kong law, dealing in or advising in connection withsuch token, or managing or marketing a fund that invests in such token, "may constitute a ' regulated activity'.[….] Partiesengaging in a ' regulated activity' are required to be licensed by or registered with the SFC irrespective of whether theparties involved are located in Hong Kong, so long as such business activities target the Hong Kong public." [11]

In addition, the SFC sent a warning to token issuers, secondary traders of tokens and cryptocurrency exchanges thatsecurities laws and other legal requirements may apply to them, including requirements for certain registrations andauthorizations (unless an exemption applies). Among other things, the SFC stated: "Parties engaging in the secondarytrading of such tokens (eg, on cryptocurrency exchanges) may also be subject to the SFC’s licensing and conductrequirements. Certain requirements relating to automated trading services and recognised exchange companies may beapplicable to the business activities of cryptocurrency exchanges." [12]

The SFC ended its release by cautioning potential investors regarding the possibility of fraud, significant investmentrisks and potential lack of liquidity, but not before reminding issuers of anti-money laundering and similar matters. Notingthat tokens issued in token sales may be transacted or held on an anonymous basis, the SFC stated that "inherent andsignificant money laundering and terrorist financing risks" exist and referenced its January 16, 2014 circular remindinglicensed corporations and associated entities "to take all reasonable measures to ensure that proper safeguards exist tomitigate these risks." [13]

Key Takeaways

While it is unclear which jurisdiction will be the next one to speak out about token sales, many issuers are beginningto realize that no token sale is an island, so to speak. If an issuer is marketing, offering or selling digital tokens into ajurisdiction, ignorance of that jurisdiction's laws does not mean that laws do not apply. A new token sale era arguably isbeginning.

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[1] https://www.linkedin.com/pulse/sec-issues-investor-alert-warn-investors-ico-related-klayman-kuzar, https://www.investor.gov/additional-resources/news-alerts/alerts-bulletins/investor-alert-public-companies-making-ico-related, https://www.mofo.com/resources/publications/170726-howey-got-here-sec-token-offerings.html , https://www.sec.gov/litigation/investreport/34-81207.pdf, https://www.mofo.com/resources/publications/170802-singapore-token-offerings.html, http://www.mas.gov.sg/news-and-publications/media-releases/2014/mas-to-regulate-virtual-currency-intermediaries-for-money-laundering-and-terrorist-financing-risks.aspx, http://www.osc.gov.on.ca/en/SecuritiesLaw_csa_20170824_cryptocurrency-offerings.htm, http://bloombergtv.ca/shows/bloomberg-markets-canada/bloomberg-markets-canada-episode/?epid=828&sgid=6, https://www.linkedin.com/pulse/bull-china-shop-reportedly-halts-token-sales-prior-klayman-kuzar

[2] https://www.blockchaintechnews.com/articles/attorneys-offer-perspective-on-sec-ruling/

[3] https://www.cnbc.com/2017/08/31/new-cryptocurrencies-and-icos-create-financial-risk-says-chinas-national-internet-finance-association.html

[4] http://www.atimes.com/article/60-ico-token-distribution-platforms-face-investigation/, https://siliconangle.com/blog/2017/09/03/china-bans-initial-coin-offerings-pending-review, http://fortune.com/2017/09/04/ico-china-central-bank-ban/

[5] https://siliconangle.com/blog/2017/08/31/chinese-regulators-consider-massive-crackdown-initial-coin-offerings/

[6] https://siliconangle.com/blog/2017/08/31/chinese-regulators-consider-massive-crackdown-initial-coin-offerings/

[7] http://www.iii.co.uk/articles/441171/cryptocurrencies-plunge-china-bans-initial-coin-offerings

[8] https://siliconangle.com/blog/2017/09/03/china-bans-initial-coin-offerings-pending-review

[9] http://www.sfc.hk/edistributionWeb/gateway/EN/news-and-announcements/news/doc?refNo=17PR117





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SEC Issues Investor Alert to Warn Investors About ICO-RelatedClaims

Joshua Ashley Klayman

08/30/2017

Banking + Financial Services, Emerging Companies + Venture Capital, Financial Technology, Financial Transactions,Private Equity Funds, and Technology Transactions

Client Alert

On August 28, 2017, only slightly more than one month after the United States Securities and Exchange Commission (the “SEC”) issued formal guidance regarding token offerings [1] [2] (including an investor bulletin on token offerings as part of itsinvestor education and investor protection mission (the “Investor Bulletin”)), [3] the SEC spoke again–this time releasingan investor alert (the “ Investor Alert”) to warn investors about public companies making token offering-related claims. [4]

Citing a wave of recent temporary trading suspensions, the SEC’s Office of Investor Education and Advocacy warnedinvestors about “potential scams involving stock of companies claiming to be related to, or asserting they are engaging in,Initial Coin Offerings (or ICOs). Fraudsters often try to use the lure of new and emerging technologies to convince potentialvictims to invest their money in scams. These frauds include ‘pump-and-dump’ and market manipulation schemes involvingpublicly traded companies that claim to provide exposure to these new technologies.”

The Investor Alert specifically mentioned four companies that have been affected by the SEC’s recent temporary tradingsuspensions. One of them, First Bitcoin Capital Corp. (“ BITCF”) is a Canadian corporation. On August 24, 2017–the sameday on which the Canadian Securities Administrators (“ CSA”), an organization comprised of Canada’s provincial andterritorial securities regulators, released Staff Notice 46-307 Cryptocurrency Offerings (the “ CSA Notice”), addressing howCanadian securities laws may apply to cryptocurrency [5] offerings, investment funds and exchanges [6] that trade suchproducts [7]–the SEC temporarily suspended trading in the securities of BITCF due to concerns about “the accuracy andadequacy of publicly available information about the company including, among other things, the value of BITCF’s assetsand its capital structure.” [8]

Some have asked why the SEC chose to release the Investor Alert on Monday. While the answer is unclear, some maypoint to the sheer number of token offerings that have been launched or are planned, or the estimates by some that, as ofAugust 25, 2017, nearly $1.8 billion had been raised via token offering. [9] Others may note that the dangers that “pump-and-dump” and market manipulation schemes pose to investors, especially unsophisticated investors, are reason enough toissue such an Investor Alert educating investors about how to recognize certain potential scams.

It is interesting to consider, however, whether the SEC’s Investor Alert may have been motivated in part by something elsethat was issued on August 24, 2017: BITCF’s letter to its shareholders, commenting on the SEC’s temporary suspension(the “ BITCF Letter”). [10]

In the BITCF Letter, BITCF characterized the SEC’s actions as likely being based on a misunderstanding and constituting“drastic actions.” Specifically, BITCF said, “We believe that there is likely a misunderstanding or a simple clarificationnecessary and that it would have been better for the SEC to ask us for this information before taking such drastic action. Infact, the SEC was so hurried in stopping trading that they inadvertently left in the symbol of another company (CIAU) as if

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our symbol which has nothing to do with BITCF. In the unrelated case of CIAU we applaud the SEC for that suspension andthat of two other so-called cryptocurrency companies that were either mimicking BITCF for publicity or were obvious scams.There are many more quickly emerging and we hope the SEC will move against those more rapidly.”

The BITCF Letter also suggested that the SEC’s suspension may have resulted from “the need to diminish theextraordinary demand for shares that have increased more than 24,000 percent in the 12 months–according to the Downews release.” In addition, BITCF asserted that investigations by law firms with respect to potential securities law violationsby companies whose shares temporarily are suspended from trading “mostly result in no action taken and are oftenintended for publicity and finding new clients.”

Could it be that the SEC’s Investor Alert was released, in part, to combat communications, like the BITCF Letter, that seekto minimize the gravity of a temporary trading suspension? Perhaps.

In any event, the SEC’s release of the Investor Alert on the heels of the Investor Bulletin suggests that the SEC is closelymonitoring the token offering market, and that it wants investors–and issuers–to be aware that it is watching.

[1] The term “token offering” refers to initial token offerings ( ITOs), token launches, token sales and initial coin offerings, anew capital-raising method being explored by issuers and others hoping to raise significant amounts of money from a broadbase of potential participants.

[2] Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: The DAO, Exchange ActRelease No. 81207 (July 25, 2017), available at: http://www.sec.gov/litigation/investreport/34-81207.pdf.

[3] Investor Bulletin: Initial Coin Offerings (July 25, 2017), available at: https://www.investor.gov/additional-resources/news-alerts/alerts-bulletins/investor-bulletin-initial-coin-offerings.

[4] Investor Alert, available at: https://www.investor.gov/additional-resources/news-alerts/alerts-bulletins/investor-alert-public-companies-making-ico-related.

[5] The CSA Notice explains, “Cryptocurrency may also be referred to as virtual or digital currency, among other terms.ICOs and ITOs may also be referred to as token generation events (TGE), among other terms.”

[6] The CSA Notice clarifies that the term “exchange” “used in this context is not intended to be the same as the term usedin National Instrument 21-101 Marketplace Operation and securities legislation of the jurisdictions of Canada, but insteadreflects what these entities are commonly referred to [as] today.”

[7] The CSA Notice states that it was being published in all of the jurisdictions of Canada except Saskatchewan. The CSANotice specifies that the Financial and Consumer Affairs Authority of Saskatchewan will advise of its approach in this matterafter the provincial by-election in Saskatchewan on September 7, 2017.

[8] More information is available at: https://www.sec.gov/litigation/suspensions/2017/34-81474.pdf.

[9] See “All-Time Cumulative ICO Funding” at: https://www.coindesk.com/ico-tracker/.

[10] More information is available at: http://bitcoincapitalcorp.com/sec-suspension/.

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Howey Got Here: SEC Issues Guidance on Token Offerings

Jay G. Baris, Daniel R. Kahan, Joshua Ashley Klayman, and Alfredo B. D. Silva

07/26/2017

Banking + Financial Services, Capital Markets, Emerging Companies + Venture Capital, Financial Institutions + FinancialServices, Financial Technology, Private Equity Funds, Technology Transactions, and Investment Management

Client Alert

Also published in Banking Exchange (07/27/2017).

The Howey test lives on—now in a lesson in what not to do when it comes to token offerings.

Token offerings, also known as “initial token offerings,” “token launches,” “token sales,” “initial coin offerings,” or “ICOs,”represent a new capital-raising method being explored by many emerging companies; venture, hedge, and private equityfunds; large and well-established corporations; and others hoping to raise significant amounts of money quickly and froma broad base of potential participants. Token launches provide issuers with an alternative to more traditional forms offundraising, such as obtaining venture capital investments, which often involve significant due diligence by investors anddilute founders’ equity and rights.

To date, many issuers have launched ICOs from non-U.S. jurisdictions, with some taking the position that, so long as thetoken being offered was not a security under the laws of the jurisdiction of its issuance, there was no need to considerwhether the token constituted a security in the jurisdictions in which such token may have been purchased. Critics of TheDecentralized Autonomous Organization—more commonly referred to as The DAO and which used a Swiss foundation inconnection with its ICO—have long held the view that, while The DAO was successful in raising a precedent-setting amountof capital from purchasers located across the globe, it likely ran afoul of myriad securities regulations and regimes aroundthe world, including in the United States.

Yesterday, the U.S. Securities and Exchange Commission (the “SEC”) spoke formally on the topic for the first time,disappointing some individuals and issuers that had hoped tokens might fall outside of the definition of “securities.” [1] TheSEC also issued an investor bulletin on initial coin offerings as part of its investor-education and investor protection mission.[2]

Section 2(a)(1) of the Securities Act of 1933 (the “Securities Act”) and Section 3(a)(10) of the Securities Exchange Actof 1934 (the “Exchange Act”) both include an “investment contract” among the list of instruments that are considered a“security.” In SEC v. W.J. Howey Co., [3] the United States Supreme Court articulated a facts-and-circumstances test fordetermining whether a particular instrument should be considered an “investment contract,” and, therefore, a “security”subject to the Securities Act. That test has evolved over the years, but the core factors considered are: whether purchasersof the instrument contributed money or valuable goods or services; [4] whether purchasers were investing in a commonenterprise and reasonably expected to earn profits through that enterprise; [5] and whether the expected profits are to bederived from the efforts of others. [6]

In applying the Howey test to determine whether tokens are “investment contracts,” the SEC did not declare that tokensare all necessarily securities, but provided cautionary advice to market participants, observing that “the federal securities

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laws apply to those who offer and sell securities in the United States, regardless whether the issuing entity is a traditionalcompany or a decentralized autonomous organization, regardless whether those securities are purchased using U.S.dollars or virtual currencies, and regardless whether they are distributed in certificated form or through distributed ledgertechnology.” This guidance was issued in the context of the SEC’s Report of Investigation regarding the 2016 initial tokenoffering by The DAO. The SEC determined that “The DAO, an unincorporated organization, was an issuer of securities, andinformation about The DAO was ‘crucial’ to the DAO Token holders’ investment decision . . . . The DAO was ‘responsiblefor the success or failure of the enterprise,’ and accordingly was the entity about which the investors needed informationmaterial to their investment decision.”

In addition, after having previously declined to approve proposed rule changes to facilitate the listing and trading of sharesof the Winklevoss Bitcoin Trust, [7] the SEC followed the path of the U.S. Commodity Futures Trading Commission on July24, 2017, [8] and affirmed the SEC’s role in regulating platforms like those on which blockchain-based instruments aretraded. In its Report, the SEC noted that the platforms that traded The DAO’s tokens “provided users with an electronicsystem that matched orders from multiple parties to buy and sell DAO Tokens for execution based on non-discretionarymethods.” As such, these trading platforms appear to fall within the definition of a securities exchange and should haveregistered as a national securities exchange pursuant to Sections 5 and 6 of the Exchange Act or operated pursuant to anappropriate exemption (such as an alternative trading system that complies with Regulation ATS, which requires, amongother things, registration as a broker-dealer and filing of a Form ATS with the SEC to give notice of the alternative tradingsystem’s operations).

Although the SEC’s guidance is important, its analysis is limited to The DAO’s token, which, for several reasons, serves asa near-perfect example of a token that should have been treated as a security based on the Howey test: participants in TheDAO’s token offering made a contribution of value to the project, had a reasonable expectation of profits to be derived fromthe efforts of others, and had limited management capability. So while the SEC’s Report does confirm that some tokensare securities, it does not mean that all tokens are securities. Until the SEC has issued guidance on whether certain typesof tokens, such as “app tokens,” will be considered securities, issuers whose offerings have a U.S. nexus should considertaking a conservative approach, issuing tokens as securities and complying with the securities laws by registering theoffering or relying on a well-established exemption from Securities Act registration, such as Regulation D or Regulation S.

Issuers that propose to offer interests in tokens must also be mindful of the requirements of the Investment Company Act of1940 (the “1940 Act”), which requires “investment companies” to register with the SEC unless they qualify for one of severalexclusions from the definition. Generally, an investment company is an issuer that is engaged or proposes to engage in thebusiness of investing, reinvesting, owning, holding, or trading in securities, and owns or proposes to acquire “investmentsecurities” having a value exceeding 40 percent of the value of its total assets (exclusive of government securities and cashitems) on an unconsolidated basis. For this purpose, “securities” and “investment securities” are broadly defined, and insome cases include instruments that may not be securities under the Howey test.

An issuer that is required to register as an investment company but fails to register is subject to many potential penalties,including criminal sanctions. Notably, the SEC’s Report did not address whether The DAO would be an investmentcompany under the 1940 Act, leaving that analysis for another day and another issuer. Even if an issuer can avoid havingits tokens classified as securities for purposes of the Securities Act, it still must determine whether it falls within thedefinition of an investment company under the 1940 Act or within the scope of myriad other federal or state regulatoryregimes, including those applicable to money transmitters and financial institutions.

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The SEC’s next steps remain to be seen, as no enforcement action was sought with regard to The DAO. However, the levelof coordination demonstrated by this cross-divisional effort, managed by the SEC’s Distributed Ledger Technology WorkingGroup, signals that the SEC is taking issues regarding token markets seriously. We expect enforcement actions may followif the SEC becomes aware of future token sales that violate U.S. securities laws.

[1] Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: The DAO, Exchange ActRelease No. 81207 (July 25, 2017) (the “Report”), available at http://www.sec.gov/litigation/investreport/34-81207.pdf.

[2] Investor Bulletin: Initial Coin Offerings (July 25, 2017), available at https://www.investor.gov/additional-resources/news-alerts/alerts-bulletins/investor-bulletin-initial-coin-offerings.

[3] See SEC v. W.J. Howey Co., 328 U.S. 293 (1946).

[4] See Howey, 328 U.S. at 301; see also Uselton v. Comm. Lovelace Motor Freight, Inc., 940 F.2d 564, 574 (10th Cir.1991).

[5] See SEC v. Edwards, 540 U.S. 389, 394 (2004).

[6] See Howey, 328 U.S. at 299.

[7] Self-Regulatory Organizations; Bats BZX Exchange, Inc.; Order Disapproving a Proposed Rule Change, as Modified byAmendments No. 1 and 2, to BZX Rule 14.11(e)(4), Commodity-Based Trust Shares, to List and Trade Shares Issued bythe Winklevoss Bitcoin Trust, Exchange Act Release No. 34-80206 (Mar. 10, 2017), available at https://www.sec.gov/rules/sro/batsbzx/2017/34-80206.pdf.

[8] Press Release: CFTC Grants DCO Registration to LedgerX LLC (July 24, 2017), available at http://www.cftc.gov/PressRoom/PressReleases/pr7592-17.

6 Morrison & Foerster Tax Talk, April 2014

IRS ISSUES GUIDANCE ON VIRTUAL CURRENCY

In Notice 2014-21, the IRS issued guidance on virtual currency, such as Bitcoin. The notice, which is in the format of answers to frequently asked questions, describes how existing tax principles apply to transactions involving virtual currency.

By way of background, the IRS explained that virtual currency behaves like “real” currency, in that it may be used and accepted as a medium of exchange, although it is not recognized as legal tender in any jurisdiction. The notice, however, applies only to “convertible” virtual currency, which the IRS describes as virtual currency that has an equivalent value in real currency, or that acts as a substitute for real currency. In other words, convertible virtual currency is virtual currency that may be purchased for, or exchanged into, U.S. dollars or euros, for example.

As a threshold matter, the notice provides that convertible virtual currency is simply property for U.S. federal income tax purposes, even if it may be exchanged for

real currency. The IRS’s conclusion, of little surprise, helpfully confirms that transactions involving virtual currency will not be subject to the rules governing foreign currency. Instead, taxpayers will be subject to the full gamut of tax principles generally applicable to property transactions. Although treatment of convertible virtual currency as property makes sense and, at first blush, seems relatively straightforward, even some of the most basic transactions involving virtual currency are rife with latent tax implications and may result in a record-keeping nightmare for holders of virtual currency.

As an example, virtual currency holders will be required to track their basis in the currency since any exchange is likely to result in the holder recognizing gain or loss. The character of the gain or loss, in turn, will depend on whether the virtual currency is a capital asset in the hands of the taxpayer. In this vein, complex valuation issues abound. In anticipation of these valuation questions, the notice provides that if a virtual currency is listed on an exchange and the exchange rate is established by market supply and demand, the taxpayer may use the fair market value of the virtual currency as determined by converting the virtual currency into U.S. dollars at the exchange rate. Of course, this begs the question of which exchanges will be considered adequate marketplaces with respect to the relevant virtual currency – a question well outside the scope of our expertise.

Furthermore, if a virtual currency is received as payment for goods or services, the recipient will be required to include the fair market value of the virtual currency in gross income. Indeed, to the extent virtual currency is received as wages, it may be subject to employment taxes in appropriate circumstances. Moreover, transactions involving virtual currency may implicate certain information reporting and backup withholding obligations. Finally, “mining” – the process of creating or issuing the currency bysolving what essentially amounts to complicated math problems – may give rise to gross income, in cases where the taxpayer receives virtual currency as compensation for these activities.

In sum, although virtual currency may be commonplace in cyberspace, it continues to pose new and unexpected tax challenges. For now, however, virtual currency holders will have to make do with the guidelines set forth in the notice. As the IRS continues to navigate these uncharted waters, we promise to keep you in the loop.

continued on page 7

MORRISON & FOERSTER QUARTERLY NEWS

TAXTALKVolume 7, No. 1 April 2014

Authored and Edited By Thomas A. Humphreys

Anna T. PinedoStephen L. Feldman

Remmelt A. Reigersman Shiukay HungDavid J. Goett

http://www.mofo.com/bitcoin-legal-and-regulatory-considerations-05-08-2014/



Documents

Toronto Seminar Series Presentation Materials › documents › 171120-toronto-seminar-series.pdfToronto Seminar Series Monday, November 20, 2017 10:30 a.m. – 2:00 p.m. The Fairmont