In a previous alert, 'UK Regulatory Capital Reforms: A Boost for Start-Up Founders and Venture Capital Investors?', we discussed the Financial Conduct Authority (FCA) consultation on simplifying the capital rules for investment firms — such as wealth managers, financial advisers, and brokers — set out in the MIFIDPRU section of the FCA rules. The FCA has now published PS25/14: Definition of capital for FCA investment firms setting out its final rules (Final Rules), which includes the eligibility for inclusion of shares as common equity tier 1 (CET1) regulatory capital.
For founders and investors, especially in early-stage investment firms, the Final Rules will not allow the CET1-eligible investor shares to rank ahead of the founder/employee shares in the event of a firm's liquidation. They will, however, allow the investors to have the founder/employees share equally the risk of the firm's failure. This will help align the share eligibility rules for investment firms with those of, for example, mortgage lenders or other types of firms in the fintech sector, noting that the changes in the Final Rules have also been included in the proposed FCA regime for crypto-firms. (See CP25/15: A prudential regime for cryptoasset firms.) This is good news for investors.
The Final Rules are due to come into effect on 1 April 2026.
Regulatory Capital Composition: A Reminder
MIFIDPRU sets out the rules on the types of capital instruments which investment firms are allowed to include in their regulatory capital.
MIFIDPRU requires a firm to hold an amount of capital comprising CET1, alternative tier 1 (AT1), and common equity tier 2 (CET2) which is at least equal to the firm's 'own funds requirement' (OFR). These capital instruments must adhere to composition ratios: (1) the firm's CET1 must be equal to or greater than 56% of the firm's OFR; (2) the sum of the firm's CET1 and AT1 must be equal to or greater than 75% of the firm's OFR; and (3) the firm's total CET1, AT1, and CET2 must be greater than 100% of the firm's OFR.
The Requirement to Rank Last
The limits on ratios are important when considering external investment, noting that firms — especially early-stage firms — will usually require that investment to boost the firm's regulatory capital. As CET1 is designed to act as the primary buffer against losses, all or part of an external investor's investment in a firm will typically have to be in CET1 items such as ordinary shares.
The current issue for investors is that for the capital they provide to be a part of a firm's CET1, the investors have to rank last, alongside the other CET1 capital providers in the firm's liquidation. Specifically, the requirement is set out as follows in the UK version of the Capital Requirements Regulation (UKCRR): 'The common equity tier 1 instruments must rank below all other claims in the event of liquidation'.
Therefore, non-CET1-eligible shares — for example, those which give the founders and employees rights only where the firm meets certain profitability or performance targets, entitling the founders and employees to so-called golden shares — will have to rank ahead of investor shares in a liquidation for those investor shares to be CET1-eligible.
The fact that the investors will have to take the risk of being paid out after the founders or employees, assuming that the firm meets the performance targets, is viewed by some as an investment disincentive, especially in firms which are still in the early stages of building their businesses.
Restating the Broad Criteria for CET1 Eligibility
Amongst the changes confirmed in the Final Rules are the changes to the CET1 eligibility, which require any CET1 instruments — including shares and other financial instruments, share premium accounts, retained earnings, and other reserves — to have the following core characteristics:
(a) They are able to absorb losses as they occur
(b) They rank below all other claims in liquidation
(c) They are permanent
(d) There is no obligation to make a distribution
(e) The level of distributions is not capped
The Final Rules, therefore, restate the basic requirements for CET1 eligibility in the UKRR but provide some more detail which alters specific requirements in the UKCRR.
Sharing Loss Equally: A Fix for the 'Ranking Below' Issue
Addressing point (b) in the above list, the Final Rules confirm that a firm's issuance of non-CET1 shares which rank equally in a liquidation with other shares will not exclude those other shares from being CET1-eligible. Specifically, the Rules state, 'The common equity tier 1 instruments must rank below all other claims in the event of liquidation, except for claims from holders of other ordinary shares which rank pari passu with the instruments'. The underlined words add to those in the UKCRR, noted above.
The effect of this change is that the holders of CET1 shares will be able to share the risk of losses in the value of a firm's capital equally with the holders of non-CET1 shares. This should serve as a better incentive for investors because, for example, the non-CET1-eligible performance-related shares awarded to managers will no longer have to rank ahead of the CET1-eligible shares of investors.
Specifying a Percentage of Residual Assets: Clarifying the 'Cap' on Distributions Issue
Related to this change is the clarification that non-CET1 shares which carry a claim on a given proportion of a firm's residual assets in a liquidation will not undermine the point noted in (e) above prohibiting caps on the levels of distribution. The Final Rules make it clear that 'a claim specified as a percentage of residual assets does not constitute a fixed or capped claim'.
This should have the effect of giving investors further rights because they will be allowed to be paid a prescribed amount expressed as a percentage of the firm's remaining assets in the event of a liquidation.
The Need for Disclosure (with Useful Examples)
The Final Rules seek to offset any risk to investors from the two measures listed above by requiring clear disclosure of these 'non-standard ranking arrangements'. The Final Rules will require that, where a firm has non-CET1 instruments which rank equally with CET1 instruments, the firm must provide clear disclosures in the MIFIDPRU 8 reporting template, which provides the following line items to be addressed:
- Write-down features
- Position in capital structure
- Description of any equal ranking arrangements with other instruments
- Loss absorption mechanics where equal ranking exists
- Proportion of residual assets claimed
- How losses are shared between equally ranked instruments (where applicable)
- Link to the terms and conditions of the instrument
The policy paper accompanying the Final Rules provides some useful examples of how these items would be addressed in four situations. The following are examples of features which would not render shares non-CET1 eligible:
- Non-voting ordinary shares
- Shares with mandatory dividend features
- Redeemable shares ranking equally
- Shares with capped distributions
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
