Canadian laws relating to the ownership, powers and regulation of financial institutions reflect both a sophisticated regulatory regime and political compromise. The last several years have seen a significant realignment of participants in the financial services industry. The four leading mutual life insurance companies have all completed recent demutualizations. The leading trust companies (companies which may exercise fiduciary powers but otherwise have many of the attributes of banks) have been acquired by the banks. The leading securities dealers have also been acquired by the banks, or by foreign securities firms. The domestic banks have grown larger in terms of domestic impact but maintain that they are falling steadily behind in terms of global impact and competitiveness. They therefore wish (generally though not universally) to grow in size, competitiveness and profitability through increased powers in areas such as the marketing of insurance products and the conduct of automobile leasing, and through mergers, joint ventures and strategic alliances. The Canadian public however seems to regard the size, influence and profitability of the leading domestic banks with unease, and the government has recently responded to this concern by: (i) rejecting the recommendations of a government-appointed task force which would have allowed the banks to market insurance through their branches and engage in automobile leasing; (ii) rejecting merger proposals (in 1998) which would have reduced the number of significant domestic banks from five to three; and (iii) introducing new legislation that will increase visible consumer protection measures and encourage new entrants and foreign competitors in the financial services area in order to broaden competition in the offering of financial services in Canada. These last noted initiatives present increased opportunities for international participation in the Canadian market.
THE NEW LEGISLATION
The government had intended to introduce broad reforms to federal financial institution legislation in 1996. It discovered however that the process was too fraught with competing economic and institutional interests to permit easy resolution. It instead appointed a broadly-constituted task force and charged it with the duty of making a non-partisan, non-political set of recommendations, after receiving submissions and conducting hearings in order to obtain input from all interested parties. The government responded to the task force report by conducting further hearings of its own, leading to the release in June 1999 of a policy paper outlining in general terms the reforms which it intended to implement. These reforms are now reflected in Bill C-38, an omnibus bill of considerable length, which was introduced in Canada's Parliament on June 13 2000. The Canadian financial services industry, while not pleased with everything in the Bill, has welcomed the potential relief from uncertainty and is preparing to move forward when the Bill is passed. This is not expected to occur before the end of the year 2000.
EXISTING OWNERSHIP RULES
Ownership rules applicable to Canadian banks until enactment of Bill C-38 are generally as follows. The Bank Act divides banks participating in the Canadian market into three categories: (i) Schedule I banks, which are widely-held domestic banks (in which no person may hold more than 10% of any class of shares or otherwise exert de facto control), of which there are only 8; (ii) Schedule II banks, which are closely-held (by anyone fit and proper to do so within the first 10 years of the bank's existence, and thereafter only by widely-held Canadian non-bank financial institutions, foreign banks or widely-held foreign non-bank financial institutions, which in all such cases must control the Schedule II bank), of which there are 44, only two of which are domestic; and (iii) Schedule III banks, a new category for branches (rather than subsidiaries) of foreign banks, of which there were two as of June 2000.
PROPOSED OWNERSHIP RULES
Bill C-38 makes important changes to the ownership rules. It divides banks into three new categories: banks having equity of C$5 billion ($3.4 billion) or more, banks having equity between C$1 billion and C$5 billion, and banks having equity of less than C$1 billion (which we will refer to as large, medium and small banks respectively), and applies different ownership requirements at each level.
A large Canadian domestic bank must still be widely-held but will be able to satisfy the test if it does not have a major shareholder, being a person holding more than 20% of the voting shares or 30% of a class of non-voting shares. As it is the government's intention to permit an increase in joint ventures and strategic alliances through these relaxed ownership provisions, but not to permit Canada's leading financial institutions to fall under the control of foreign banks or commercial entities, the ability to acquire a 20% voting interest is subject to a constraint that no person may acquire de facto control of a large bank. The means of establishing de facto control or lack thereof is not yet clear.
The three existing widely-held Schedule I banks with shareholders' equity of less than C$5 billion have been deemed by Bill C-38 to be large banks for purposes of the ownership rules. The minister of finance has however been granted the ability to cancel the application of this provision to any particular bank so long as its equity remains below C$5 billion. The affected banks all have a regional bias, and this provision gives the minister the opportunity to take regional and other interests into account when considering the potential ownership of such institutions.
A medium bank may have a controlling shareholder but must eventually have voting shares that carry at least 35% of the voting rights publicly listed and not beneficially owned by a major shareholder. This provision applies on its face to Canadian subsidiaries of foreign banks, although there is provision for ministerial exemption. It applied previously to Schedule II banks with equity over C$750 million. The only foreign bank subsidiary which had exceeded the minimum equity threshold to date was granted such an exemption.
Small banks may continue to be wholly owned until they become medium banks.
There are of course grace periods, transitional periods and exemptions.
Applications for approval for incorporation of a bank or for acquisition of a significant interest (more than 10% of any class of shares) in a bank must satisfy the minister on a wide range of issues, except that an application to hold up to (but not more than) 20% of the voting shares and 30% of a class of non-voting shares must pass only a test dealing with character, integrity and reputation. It will be possible to establish small banks with as little as C$5 million of capital, a reduction intended to encourage new participants.
NEW STRUCTURES AND POWERS
Canadian banks (including foreign-owned ones) are to be given the ability by Bill C-38 to restructure themselves into a bank holding company format. Subsidiaries of the holding company will however only be permitted to carry on businesses that the bank itself could carry on, directly or through its own subsidiaries. Some of the subsidiaries held through the holding company are expected to be subject to lighter levels of regulation, and the holding company itself is generally expected to be subject to somewhat lighter capital adequacy requirements than the bank.
The powers which a bank (and therefore other subsidiaries of a bank holding company) may exercise, while falling short of the banks' hopes in the insurance marketing and automobile leasing areas, have been enhanced in areas such as data processing services, information management systems, computer software and hardware, data transmission systems and specialized business management or advisory services. Some of these new powers cannot be exercised without prior ministerial approval.
MERGER REVIEW
When the government prevented two significant mergers in 1998, it said it would not consider further merger proposals until a new review framework and rules were put in place. In conjunction with the introduction of Bill C-38, the government has issued Merger Review Guidelines which it says it will implement when Bill C-38 becomes law. The guidelines apply to mergers among large banks and their holding companies. Parties wishing to merge must apply to the Competition Bureau, the Office of the Superintendent of Financial Institutions and minister of finance. The applicants will also be required to prepare a Public Interest Impact Assessment (PIIA). The PIIA is required to focus on issues such as impact on domestic small- and medium-sized businesses, branch closures, employment and other domestic concerns as well as the impact on international competitiveness, the bank's ability to develop and adopt new technologies and the overall structure of the industry. The House of Commons Standing Committee on Finance will be asked to conduct public hearings into the broad public interest issues that are raised by the merger proposal, using the PIIA as a key input. The Competition Bureau and the superintendent of financial institutions will address respectively the competitive and prudential aspects of the proposed merger. These documents would be available for scrutiny by the Finance Committee, which will be required to report to the minister on the broad public interest issues raised by the merger proposal. It would then be up to the minister to render a decision on whether the public interest, prudential and competitive concerns are capable of being addressed. If they are not, the transaction will be denied. If they are, an attempt will be made to negotiate remedies to address whatever concerns have been raised. Generally, Canadian commentators believe that the participation of the Finance Committee and the minister in the process will present political obstacles which may make obtaining approvals difficult, at least until the politicians are satisfied that the measures in Bill C-38 to increase competition in the Canadian financial services market are having, or are likely to have, some effect.
FOREIGN BANKS
Given the government's desire for greater competition and participation in the Canadian financial services industry, there should be increased opportunities for foreign banks in the Canadian market. The ability to acquire up to a 20% voting interest and up to a 30% non-voting interest in a significant Canadian bank, intended to encourage joint ventures and strategic alliances, is made relatively easy by Bill C-38, as noted above. In addition, the Bank Act has already been amended to permit foreign banks to establish branches in Canada. Until those recent amendments, foreign banks had to incorporate Canadian subsidiaries, whose lending powers were constrained by the level of their Canadian capitalization. Foreign banks which do establish, or convert to, Canadian branches (thereby becoming authorized foreign banks, or AFBs) are no longer limited by the size of their Canadian capital. Two types of branches are possible - a full service branch and a lending branch (terms used by the government but not found in the Bank Act). A full service branch generally has all the powers of a Canadian bank, except that it may not take deposits in an amount of less than C$150,000 and as a result is not required to be a member of the Canada Deposit Insurance Corporation. A lending branch is not allowed to take deposits or borrow at all, except from financial institutions (other than certain foreign banks). Such borrowings are to be transferable only in denominations of C$150,000 or more, and only to similar institutions.
The applicant foreign bank must be a properly regulated real bank in its jurisdiction of incorporation to be considered fit to establish a branch in Canada. The superintendent must then be satisfied that the authorized foreign bank has deposited unencumbered assets with a suitable Canadian financial institution, subject to a deposit agreement approved by the Superintendent. The value of the assets must be C$100,000 in the case of a lending branch and C$10 million (C$5 million under Bill C-38) for a full service branch, although the superintendent may specify a greater amount. Foreign banks which prefer to establish Canadian subsidiaries will be able to do so. After Bill C-38 comes into force, the minimum capitalization will be C$5 million rather than C$10 million.
Foreign banks have been able to establish non-financial operations in Canada (helpful given the wide application of the defined term foreign bank, which can catch largely non-financial organizations that have a bank within the corporate group) and, subject to constraints as to size, operations providing unregulated financial services, so long as the foreign bank does not also operate in Canada by way of a subsidiary or branch (which would have allowed the foreign bank to conduct both regulated and unregulated operations in Canada, something a domestic bank was not able to do).
Under Bill C-38, a foreign bank may not, unless an exemption exists, carry on any activity in Canada or acquire or hold a substantial investment (a 10% voting interest or 25% equity interest) in a Canadian entity. Exemptions open to foreign banks (subject to appropriate regulatory approvals) include the following:
establishment of an authorized foreign bank branch;
foreign banks which do not have commercial activities may acquire or hold control of, or have a substantial investment in, a Canadian bank or other federally regulated financial institution;
foreign banks which do have commercial activities and are not AFBs, foreign insurance companies or foreign securities dealers and are not major owners of a regulated or unregulated Canadian financial institution may have a substantial investment in (but apparently not control of or major ownership in) a Canadian bank or other federally-regulated financial institution;
foreign banks which are determined by order of the minister to be banks technically but not substantially may be exempted from those parts of the Bank Act which constrain the ability of foreign banks to conduct business in Canada directly or through non-bank affiliates;
foreign banks which are not AFBs, foreign insurance companies or foreign securities dealers and are not major owners of a regulated or unregulated Canadian financial entity may acquire control of or a substantial investment in commercial entities, or carry on commercial operations consistent with their principal operations outside of Canada;
a designated foreign bank (one which the minister believes to be a properly regulated real bank) may acquire or hold control or become a major owner of a provincial financial institution, including a securities dealer, or a non-regulated financial institution which does not carry on any business which a regulated bank could not carry on;
a designated foreign bank which is not an AFB, a foreign insurance company, a foreign securities dealer, or the controller or major owner of an interest in a regulated or unregulated Canadian financial entity, may acquire or hold control of or a substantial investment in an entity which a Canadian bank could own which does not do things a Canadian bank is prohibited from doing;
if a foreign bank has an order under section 521 of the present Bank Act to provide a financial service which a Canadian bank may not offer, the order continues in force, exclusive of size limitations, provided the foreign bank is not an AFB or the controller or major shareholder of a Canadian bank or bank holding company; or
there are other transitional provisions dealing with previous exemptions under section 521, but the minister may revoke or vary any existing section 521 order.
INSURANCE COMPANIES
Although provincial incorporation is possible, most significant insurance companies are incorporated federally. Foreign companies may also establish branches under federal insurance laws. For such companies, federal laws apply in areas such as corporate governance and solvency, while provincial laws affect areas such as contracts, sales and market conduct. The Canadian life insurance industry is dominated by domestic companies, many of which have significant international operations. The property and casualty industry tends to have more foreign-owned participants. The balance of this commentary will focus on the life industry.
The Canadian insurance industry has seen two significant trends in the last decade. First, there has been extensive consolidation in the industry, with foreign companies pulling out due to the expense of carrying on Canadian operations with limited market impact, and Canadian companies acquiring both foreign-owned companies and each other. Second, recent amendments to the law have resulted in the four significant mutual companies demutualizing and becoming widely-held stock companies.
We have been left with a number of ownership structures: directly-owned subsidiaries or branches of foreign-owned companies; Canadian companies which are controlled subsidiaries within a larger corporate group; and four widely-held converted mutual companies. The government has decided in Bill C-38 that the two largest converted mutual companies must remain independent and widely-held by requiring that companies with equity of C$5 billion or more may not have a major shareholder (defined in the same manner as for banks). They may however immediately on enactment of Bill C-38 have shareholders up to that threshold, subject to ministerial approval for holdings in excess of the significant interest threshold and the requirement that there be no de facto control. The large converted companies could merge with each other after December 31 2001, but not with a bank. The minister is given the ability to suspend the takeover protection relative to any particular company. The smaller converted companies may not have shareholders in excess of the significant interest level until January 1 2002, at which stage they will no longer be protected from acquisition. Insurance companies with equity in excess of C$1 billion will be required to have a 35% public float of voting shares, but this is subject to potential exemptions where the controlling shareholder is a widely-held Canadian financial institution or a foreign financial institution.
Insurance companies are otherwise granted increased powers similar to those granted to banks, and are given the ability to have insurance holding companies and become members of the Canadian Payments Association.
This article is designed to provide information of a general nature and is not intended as a substitute for professional consultation and advice.