Fintech Focus: Are Regulators Dictating Fintech Deal Terms?

Speaker A: Welcome to Fintech Focus Skadden's podcast for fintech industry professionals. The global regulatory and legal updates you need start now.

Speaker B: Hi there and welcome to Scadden's first ever fintech focused podcast. My name's Joe Kamiar. I'm a lawyer in our London M and A and fintech practice. And our plan for this series is to cover the latest news and trends that we're seeing in the fintech space. Today I'm joined by Azad Ali. He leads, uh, our financial services regulatory team here in London. Azad, welcome to the podcast.

Speaker C: Thank you, Joel. Very pleased to be here and look forward to doing the podcast with you today.

Speaker B: So, over the next couple of episodes, we thought we'd take a look at the extent to which regulators are, uh, dictating fintech investment terms here in the uk. And we're a couple of years on since the PRA published its approach to new and growing banks. And given some of the attention that neobanks are getting at the moment, we thought we'd kick things off with this episode looking at neobanks and I guess reflect on how that guidance and also the regulator's approach has shaped neobank fundraisings over the past couple of years. Azad, uh, maybe before we kind of delve straight into the detail of the regulatory guidance, maybe I should kick things off with what I'm seeing as an M and a lawyer in the market at the moment, because I think it's fair to say that historically, at least, neobank fundraisings didn't look or feel that much different to any other kind of tech fundraising. So you had multiple share classes in your investment documents with a layering of preferred rights for different rounds of investors. But obviously us M and A lawyers were also conscious of the, um, issues of raising capital for banks. So, ah, you have to think about regulatory capital recognition and specifically common Equity Tier one here in the uk. But I've realised I've just thrown out a load of jargon there on regulatory topics. Maybe, Azad, you could quickly remind listeners what we mean by terms like common equity Tier one.

Speaker C: Yeah, thanks, Joe. Absolutely, yeah. Common Equity Tier one is a key part of a bank's capital structure for regulatory purposes. It includes ordinary share capital as well as other items such as retained profits. It is regarded as the highest quality of regulatory capital, as it is the most loss absorbent and subordinated to other tiers of capital. Banks, by virtue of regulation, are expected to maintain a particular ratio and amount of CET1 capital to risk weighted assets and CET1 capital also forms the largest component of capital for leverage ratio purposes as well.

Speaker B: Well, I guess it's that reason, right, that us, uh, M and A lawyers have always tried to ensure that capital raises have been CET1 eligible. And I guess that factor itself has always caused a slight divergence to traditional venture capital type deal terms. And I guess the classic examples are things like liquidation preferences, anti dilution rights and those sorts of terms that you'd look to bake into your investment agreements. And I guess a quick back to basics and reminder of what we mean by those sorts of terms, say liquidation preferences for, ah, those that aren't familiar with them, um, essentially are a provision in your investment agreement which sets out an order in which shareholders get paid out on liquidation events, say on a winding up, for example, or any other type of exit event. Ah, and essentially the most senior shareholders would receive their initial investment amounts first, potentially with a premium on top, and then things like anti dilution provisions. On the other hand, they normally kick in on what's called a down round. And a down round is essentially where you're raising money as a company at a price per share less than your last fundraising. So if we were to take the British Venture Capital Association's standard form, anti dilution, right, the way that that would work is that on, uh, a down round, as the preferred investor, you'd essentially be issued more shares and those shares would be paid up out of the company's reserves rather than you as an investor having to pay for them. So I mean, some of the features I've just described there as are clearly some of Those wouldn't be CET1 compliant, presumably. And so aren't the sorts of things that we could put into neobank investment agreements?

Speaker C: That is correct. The investments will need to satisfy CE21 eligibility criteria. And these criteria are found in legislative Terms in Article 28 of the Capital Requirements Regulation. In summary, they are that the shares have to be subordinated to any other item in the capital stack, but can rank Paripassu with other existing CET1 eligible share capital. To your point on liquidation preferences. And secondly, the acquisition of those shares should not be funded directly or indirectly by the institution, which goes to your point. And certain types of anti dilution provisions, I guess.

Speaker B: Are there any other kind of provisions within Article 28 which would impact the sorts of investment terms that we might look to negotiate?

Speaker C: There are a couple of other terms to note. Terms of the shares cannot allow any preferential distribution rights, uh, regarding the order or payment of distributions, including in relation to CET1 instruments. The terms of the shares also cannot include any discretionary purchase terms in most instances, as any repurchase of CET1 instruments would require PRA approval. And so any pre agreed share buyback mechanisms are effectively off the table.

Speaker B: I mean that's a really helpful background I guess. Those are terms though, aren't they? Which we've all been living with for a while now. And the existence of Article 28 didn't necessarily cause neobanks to shift away from, as I said, the traditional approach to tech fundraising. So you still had neobanks with multiple share classes, waterfalls of preferred rights, particularly for things like exits and realization events, but as we mentioned, not for things like liquidation preferences. I've definitely noticed in the last couple of years a uh, shift away from that. So if you looked at kind of fundraisings up to 2021 ish, you still had neo banks creating new share classes. Whereas if you look at the banks more recently, they're either issuing shares out of pre existing share classes, so they're not creating new share classes or in the case of the more newly established banks, they're maintaining a single class of all new shares. I mean that seems to me to be a trend which has grown off the back of the more recent PRA guidance. So maybe you could talk us through that guidance and how that's kind of shaped the PRA's approach to structures of neobanks.

Speaker C: Sure. You're absolutely right of course to point out the connection between simplified share capital structures in the direction of travel of the PRA. PRA's supervisory statement on non systemic UK banks which was issued in 2021 that talked about the PRA's preference for simple plain vanilla share structures consisting of only one class of share that is fully subordinated as well as setting out an expectation that shares with features that impact loss absorption add, uh, undue complexity should be avoided. In addition, in the supervisory statement by the PRA on the definition of capital for CRR regulated firms, those banks that are subject to the capital requirements regulation, PRA has come out to state that it strongly discourages the inclusion of non voting shares and that it expects firms to avoid features such as preferential realization provisions and anti dilution clauses in CET1 instruments, those are ah, viewed as adding undue complexity and compromise the loss absorption features of the capital structure. So investors effectively would likely seek only to have exposure to the bank with equal or superior rights to other existing investors which can impact overall capital investment. And uh, the firm's recapitalization strategy, of course.

Speaker B: Okay. I guess in terms of trying to get around that, when you're looking at side agreements between shareholders, I've definitely in the past seen some examples where, uh, there's been side agreements between the shareholders, but not the regulated entity, almost in an attempt to create kind of shadow parallel structures. But again, I haven't seen those sorts of side agreements over the past few years. So presumably the PRA has something to say about those sorts of structures.

Speaker C: Absolutely. A PRA is averse to anything that could Veer away from CET1 eligibility criteria. As I mentioned earlier, Article 28 of the CRR, uh, specifies any arrangement enhancing the seniority of claims in insolvency liquidation would prevent the instrument in terms of qualifying for CET1 eligibility. Beyond this, Article 79A of the CRR requires institutions to look at the substantial features of the instrument when assessing its own funds, instruments as a whole, not just its legal character. So the PRA expects firms to look at both the substantial features of the instruments and to consider all arrangements relating to the instruments in terms of compliance with the eligibility criteria. Having said that, their concerns would likely be limited to the extent that any shareholder arrangements actually impact the eligibility of the instrument for CET1 purposes. Shareholders agreements may not affect the characterization of the instrument as far as the firm's capital structure is concerned.

Speaker B: So I guess sticking with kind of recapitalization strategies, would you say the position. The PRA's position applies more broadly than just the sorts of provisions we've been talking about. So if you were to look at things like reserve matters, for example, vetoes on capital raising, share issuances and so on, does the PRA have a view on those sorts of terms as well?

Speaker C: Well, as long as such shareholder rights don't interfere with the features a CET1 instrument is required to have in terms of eligibility, PRA wouldn't necessarily object to those type of shareholder reserve matters for share issuances. That said, we do need to mention and reiterate the point we discussed earlier about the PRA reviewing all the arrangements relating to the instruments. So they would or they should be expected to cast some scrutiny over shareholder arrangements.

Speaker B: Makes sense, I guess, sticking with kind of governance as a topic. One of the things I always notice when I'm doing fundraisings for the same target kind of year after year is every time you come to the governance section of your sha, you're very frequently making tweaks to it. So whether it's about board positions, committee structures, board composition, number of ineds and so on. As far as I'm aware there's nothing kind of hard coded into the CRR addressing that. But is there ah, guidance out there or PRA policy which is driving some of the changes that you might see as a bank goes through its life cycle?

Speaker C: Yeah, well as banks grow and develop the expectations from the PRA certainly around governance setup will shift accordingly. Uh, certainly PRA expects banks to invest in their control functions, risk internal audit compliance, hr, such that they are aligned with the scale of the business and are never outgrown. For example, PRA would expect a new bank to have at least two independent non executive directors sitting on its board and a bank in the third year of growth to have at least three of such directors. And by its fifth year, uh, PRA would expect the bank's board to be majority independent. That would be subject of course to the particular structure and complexity and size of the bank. Moreover, banks do need to have up to date development and succession plans to ensure their boards have an appropriate level of skill, knowledge, uh, and experience. And this principle of proportionality underlies the whole of the PRA policy on governance. Which is why you've observed continuous incremental tweaks I guess.

Speaker B: In today's discussion we've been focusing mainly on PRA licensed neobanks. So we're thinking about the Monzo's and Starlings of the world. But the term um, neobank is generally looked at more broadly than that. Right. So if you take for example Revolut, it's historically been licensed as an FCA regulated E money institution. And I guess where I'm going with this is to what extent does everything we've just said translate to those sorts of neobanks?

Speaker C: Yeah, um, EMIs, M or electronic money institutions or E Money institutions are subject to, to their own simple form of uh, capital requirements which is found in the electronic money regulations. EMIs are FCA regulated. They're subject to simpler rules in terms of how much capital needs to be calculated to be required to be held. It's typically a function of the EMI's fixed overheads or the payment volume it manages. Alternatively it's a function of its revenue. And then a fourth option is 2 uh percent of any amount of issued E money. But in terms of the composition, quality of the capital required to be held by EMIs, they're subject to the same conditions and eligibility criteria as PRA regulated neobanks. So the restrictions on CET1 eligible share capital are just the same as those applying to neobanks regulated principally by the pra.

Speaker B: Thanks very much, Azad. That's all clear to me. And that's a wrap for, uh, today's episode.

Speaker C: Thank you.

Speaker B: Thank you to everyone that's been listening. And please join us next time we'll be continuing this theme, except we'll be looking at the FCA's approach to regulating payment businesses. So thank you again and, um, see you then.

Speaker C: Thank you.

Speaker A: Thank you for joining us on FinTech Focus. If you enjoyed this conversation, be sure to subscribe in your favorite podcast app so you don't miss any future conversations. Additional information about Skadden can be found@skadden.com.