Free rider problems and tax bills? The Kiwibank capital cock-up

On 15 March, New Zealand Kiwibank issued two odd statements regarding their Basel III compliant (or is it compliant) capital instruments. The announcements raised the prospect of disqualification of two capital instruments: the Tier 2 convertible subordinated bond issued on 6 June 2014 (Tier 2 Bond); and the Additional Tier 1 perpetual bond issued on 27 May 2015 (AT1 Bond).

I wrote about CoCos before, and Kiwibank confirms my view: they are trouble indeed. So, what’s new this time?

Actually, Kiwibank is secretive about this gaffe, not to say that it is completely unclear what actually went wrong. The two(!) statements of 15 March contain some cryptic information that only insiders may understand.

That said, it is important for maintaining trust in financial markets that everyone knows what is going on. Given Kiwibank’s opacity in this case, I will have to make a guess – also because most pundits, like this one here and this one here, only copied and pasted statements and views of others.

Accepting the risk that I am totally wrong, here is my 2 cents.

Why now?  It is tempting to think that the Reserve Bank has been sitting on this information for some time and because of the recently announced capital review decided to firm up its capital review processes. But, this interpretation doesn’t make sense. In my experience, market parties know very quickly when an instrument does and does not qualify. Most problems are identified before the instrument ‘goes live’. Moreover, the capital instruments look like bog-standard capital instruments to me, so it is unlikely that the instruments weren’t eligible at the moment of issue.

Something must have changed along the way. Until recently, Kiwibank’s obligations were protected by its owner, New Zealand Post, by way of the NZP Guarantee. This guarantee may have worked under a single owner. But since last October, New Zealand Post shares its ownership in Kiwibank with the Guardians of the New Zealand Superannuation Fund (25%) and the Accident Compensation Corporation (22%).

Are you thinking what I am thinking? Exactly, shared ownership will lead to free rider problems. When it is about money, these free rider problems are big.

To nip free rider problems in the bud, NZP ditched the Guarantee: “on 31 October 2016, NZP gave notice of the termination of the NZP Guarantee (with an effective date of withdrawal of 28 February 2017” (uh oh!) “This termination will not affect any payment obligations of Kiwibank that were already guaranteed at the time the guarantee was terminated.”

Bills, bills, bills But how would the elimination of the NZP guarantee affect the Kiwibank capital instruments? I mean, these instruments were not guaranteed anyway. In fact, capital instruments are meant to absorb losses – which is the opposite of being guaranteed. The cryptic lines in the Kiwibank announcements confirm my view: It is less about the about the instruments than about paying the bills. “… the shareholders of Kiwibank, NZ Post, the New Zealand Superannuation Fund and the Accident Compensation Corporation confirm their support as long term shareholders. … In the event that the RBNZ determines that the issuance to KCFL are not fully compliant, the Shareholders will ensure that the bank will be in no worse capital position than if the RBNZ had not changed the treatment of the capital.”

So, mom and dad will pay the bills.[1]

What bills? To answer this question, you should realise that the capital instruments are issued from a special purpose vehicle, an SPV named Kiwi Capital Funding Limited. KCFL has no assets and no employees. It uses no electricity or water to make coffee. What bills could KCFL possibly have? The prospectuses of the capital instruments offer clarity, KCFL has mainly small bills. These will be paid by Kiwibank: “KCFL will owe amounts to certain creditors in connection with your Perpetual Capital Notes, for example, brokerage relating to subscriptions for Perpetual Capital Notes and fees payable to the Trustee, the Registrar and NZX. However, KCFL and Kiwibank have entered into an Administration Agreement under which Kiwibank has agreed to pay these amounts on behalf of KCFL.”

So, before mom and dad pay any bills, Kiwibank pays first – the small bills, that is.

Except the tax bill perhaps? One bill however, may no be so small: the tax bill. Especially if the owners start sharing their tax bills with KCFL. This may look strange, but the prospectuses of both capital instruments contain a clause that forces KCFL to pay taxes when the owners can’t. “As a member of the New Zealand Post consolidated group for income tax purposes, KCFL may be jointly and severally liable for taxes payable by the consolidated group. … If no other member meets the tax liability of the consolidated group Inland Revenue is able to claim directly against KCFL.”

Holy Cow!

Because of this clause, Kiwibank’s capital notes do not only support the assets of Kiwibank, but also the tax bill of the entire consolidated New Zealand Post group. This basically means that the capital notes are not fully available to absorb losses of the bank, which then should lead to disqualification.

Disqualification, then what? Suppose the Reserve Bank disqualifies, then what are the options? It is tempting to brand the disqualification as a “Regulatory Event”. In case of such an event, the holders of the instruments get a full refund. That would be great for Kiwibank, because they then can get rid of an impotent capital instrument.

It is not clear to me if disqualification in this case would constitute a Regulatory Event. As far as I know, a Regulatory Event is the result of a change in the rules that cannot be foreseen at the moment of issuance. It’s like a total surprise, one that most regulators and lawyers would find out of whack. But a change of ownership is not an extraordinary event, and the decision to pull a guarantee is not a regulatory event either.

Just look at the prospectuses of the capital instruments. Kiwibank triggers the regulatory event clause when: “(a) there has been a change in New Zealand law, regulation or directive (including by way of the imposition of any New Zealand law, regulation or directive) that applies, or is to apply, after the Issue Date; (b) there has been a change in the interpretation or administration of any New Zealand law, regulation or directive by any authority (including the RBNZ) that applies, or is to apply, after the Issue Date; or (c) Kiwibank is or will be required to comply with any change in New Zealand law, regulation or directive or changed interpretation or administration, that adversely affects … regulatory capital treatment of the Kiwibank Bonds held by KCFL, provided such event is not minor and could not have been anticipated when the Kiwibank Bonds held by KCFL were issued.“[2]

Uh oh. Chances are that Kiwibank remains stuck with two useless capital instruments for some time to go. Which will be at the expense of their your profits interest rates. Or is is it the NZ taxpayer?

And here is how the bonds traded during the quarter:

kiwi


[1] And yes, such guarantees alone could already render capital instruments ineligible, but the guarantees that Kiwibank mentions in their announcements do not really look new to me and they are not about absorbing losses, but more the total amount of capital, not the structure of regulatory capital.

[2] Similar reasoning applies to a tax event.

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One thought on “Free rider problems and tax bills? The Kiwibank capital cock-up

  1. Pingback: Martien Lubberink probes the latest development in the Kiwibank-RBNZ capital impasse & suggests this is a spectacular Kiwibank problem, but not more than that - Moonlight Chartered Accountants in Manukau

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