United States: Federal Reserve Rule Regarding Capital Treatment of Trust Preferred Securities

The Federal Reserve Board (the Fed) has adopted a rule that would continue to permit trust preferred securities (which are cumulative)1 to be treated as Tier 1 capital; however, the rule subjects these securities to stricter quantitative limits than under current Fed policy.

Background of Rule

Fed action on the topic of capital treatment of trust preferred securities has been anticipated since late December 2003 when (1) FASB issued Interpretation No. 46R (FIN 46R), Consolidation of Variable Interest Entities,2 which clarified FASB’s view that the proper GAAP accounting treatment for trust preferred securities was for a bank holding company, or BHC, to deconsolidate the trust that issued the trust preferred securities (the issuer trust) and record the principal amount of the subordinated debenture issued to the issuer trust by the BHC as debt on its financial statements (rather than consolidating the issuer trust and recording the trust preferred securities as minority interest) and (2) the Staff of the Securities and Exchange Commission (SEC) made clear its agreement with FASB regarding GAAP accounting treatment for trust preferred securities through informal guidance given to bank holding companies.

Trust preferred securities generally continue to be accounted for as equity for GAAP purposes at the level of the trust that issues them, but the instruments may no longer be treated as minority interest in the equity accounts of a consolidated subsidiary on a BHC’s consolidated balance sheet. Instead, under FIN 46 and FIN 46R, a BHC must reflect on its consolidated balance sheet the deeply subordinated note the BHC issued to the deconsolidated special purpose entities (SPE).

GAAP accounting for a capital instrument does not necessarily change the regulatory capital treatment of that instrument, although GAAP informs the definition of regulatory capital. BHCs are required to follow GAAP for regulatory reporting purposes.3

Trust preferred securities provide financial support to a consolidated BHC because of their deep subordination and the ability of the BHC to defer dividends for up to 20 consecutive quarters. Although trust preferred securities, like other forms of minority interest, are not included in GAAP equity and cannot forestall a BHC’s insolvency, trust preferred securities are available to absorb losses because the issuing trust’s sole asset is a deeply subordinated note of its parent BHC and the ability to defer payments on the junior subordinated notes enables the BHC to use the cash flow anywhere within the consolidated organization. Dividend deferrals on equity issued by the typical operating subsidiary, on the other hand, absorb losses and preserve cash flow only within the subsidiary; the cash generally cannot be used elsewhere in the consolidated organization.

The Fed has decided, as proposed, to retain in the final rule the standard that voting common stock should be the dominant form of a BHC’s Tier 1 capital. The final rule continues to caution that excessive non-voting elements likely will be reallocated to Tier 2 capital.

Pooled issuances generally constitute the issuance of trust preferred securities by a number of BHCs to a pooling entity that issues asset-backed securities representing interests in the BHCs’ pooled trust preferred securities. Such pooling arrangements, which have become increasingly popular and typically involve 30 or more separate BHC issuers, have made the issuance of trust preferred securities possible for even very small BHCs, most of which had not previously enjoyed capital market access for raising Tier 1 capital.

The following is a summary of the most significant aspects of the proposed rule:

Changes in Capital Rules for Trust Preferred Securities

1. STRICTER TIER 1 LIMIT

  • Since October 1996, the Fed has permitted a bank holding company to count trust preferred securities, together with cumulative preferred stock issued by the bank holding company, up to 25 percent of the amount of Tier 1 capital without regard to goodwill.
  • Under the final rule, trust preferred securities may be included in the Tier 1 capital of BHCs but subject to tightened quantitative limits for trust preferred securities and a broader range of Tier 1 capital components defined as restricted core capital elements. There will be a 15 percent limit (which excludes mandatory convertible preferred securities) applicable to internationally active BHCs and certain others, and a "new" 25 percent limit (which counts mandatory convertible preferred securities). Specifically, restricted core capital elements are defined to include qualifying cumulative perpetual preferred stock (and related surplus), minority interest related to qualifying cumulative perpetual preferred stock directly issued by a consolidated U.S. depository institution or foreign bank subsidiary (Class B minority interest), minority interest related to qualifying common or qualifying perpetual preferred stock issued by a consolidated subsidiary that is neither a U.S. depository institution nor a foreign bank (Class C minority interest) and qualifying trust preferred securities.
  • The Fed has decided to apply the 15 percent limitation only to internationally active BHCs .4 The Fed will generally expect and strongly encourage opt-in AIRB BHCs to plan for, and come into compliance with, the 15 percent limit on restricted core capital elements as they approach the criteria for internationally active BHCs. The Fed intends to set forth the 15 percent Tier 1 sub-limit for internationally active BHCs, as well as this expectation and encouragement for opt-in AIRB BHCs, in its forthcoming notice of proposed rulemaking.
  • Although BHCs that are not internationally active BHCs are not required to comply with the 15 percent Tier 1 capital sublimit, these BHCs are encouraged to ensure the soundness of their capital bases.5
  • Because of the "netting" of goodwill and the inclusion of additional restricted core capital elements subject to the limit, the proposed 25 percent limit in practice reduces the amount of trust preferred securities that may be included in Tier 1 capital for any bank holding company with goodwill and Class B minority interest and/or Class C minority interest. The restrictive effect of the new 25 percent limit on any particular bank holding company will depend on the bank holding company’s amount of goodwill and other restricted core capital elements that count against the limit.6
  • In general, the new 25 percent limit will have a potentially greater effect on bank holding companies that have been (or intend to be) more acquisitive.

2. NEW TIER 2 SUBLIMIT FOR TRUST PREFERRED SECURITIES

  • Trust preferred securities that do not qualify as Tier 1 capital because of the existing 25 percent limit may qualify as Tier 2 capital.
  • Under the final rule, trust preferred securities which do not qualify as Tier 1 capital because of the new 25 percent limit may be included in Tier 2 capital up to 50 percent of the amount of Tier 1 capital. However, in addition to trust preferred securities not included in Tier 1 capital, this same Tier 2 capital sublimit also applies to subordinated debt, limited term preferred stock and Class C minority interests not included in Tier 1 capital.

3. CAPITAL TREATMENT DURING LAST FIVE YEARS OF SUBORDINATED DEBENTURE UNDERLYING TRUST PREFERRED SECURITIES

  • During the last five years prior to maturity of the subordinated debenture related to the trust preferred securities (i.e., years 26 to 30 for a typical 30 year debenture), trust preferred securities may not be included in Tier 1 capital.
  • During this period, such trust preferred securities may be treated as Tier 2 capital, subject to the Tier 2 capital sublimits.
  • In addition, during this five-year period, such trust preferred securities would be amortized out of Tier 2 capital by one-fifth of the original amount each year and excluded completely in the last year of the life of the subordinated debenture.

4. SUBORDINATED DEBENTURE FEATURES

  • Junior subordinated debt underlying trust preferred securities generally must meet the criteria for qualifying Tier 2 subordinated debt. For bank holding companies and state member banks the subordinated debt:

  1. must be subordinated in right of payment to the claims of the issuer’s general creditors and, for banks, to the claims of depositors
  2. must be secured
  3. must state clearly on its face that it is not a deposit and is not insured by a federal agency
  4. must have a minimum average maturity of five years
  5. must not contain provisions that permit debtholders to accelerate payment or principal prior to maturity except in the event of bankruptcy of or the appointment of a receiver for the issuing organization
  6. must not contain or be covered by any covenants, terms, or restrictions that are inconsistent with safe and sound banking practice
  7. must not be credit sensitive

  • Junior subordinated debt may be pari passu with obligations to trade creditors and with junior subordinated debt underlying another issue of trust preferred securities, junior subordinated debt may be senior to, or pari passu, with deeply subordinated capital instruments that the Fed may in the future authorize for inclusion in Tier 1 capital.
  • Junior subordinated debt also may accelerate in the event that a major bank subsidiary of the BHC goes into receivership. Junior subordinated debt also may accelerate if the trust issuing the trust preferred securities goes into bankruptcy or is dissolved unless the junior subordinated notes have been redeemed or distributed to the trust preferred securities investors or the obligation is assumed by a successor to the BHC.

5. STEP-UP PROVISIONS PROHIBITED

  • The Fed has decided to continue prohibiting step-up provisions in Tier 1 capital instruments and Tier 2 subordinated debt. Because such features provide the issuer with the incentive to redeem an instrument, step-ups change the economic nature of instruments from long-term to short-term since the market expects that BHCs will almost always redeem such instruments on the step-up date to preserve market access for future capital raising initiatives. Basically, investors view a step-up provision as an informal commitment by a BHC issuer to call such securities at the time of the step-up, which tenor is inconsistent with the Fed’s view that regulatory capital should provide long-term, stable support to a BHC.

6. CALL OPTIONS NO LONGER REQUIRED

  • The Fed will no longer require that qualifying trust preferred securities include call provisions (partly to accommodate institutional investors who do not want such call options because they are not required in perpetual preferred stock). The Fed call options provide flexibility and are beneficial from both a financial and supervisory perspective because in a declining interest rate environment BHCs would redeem their trust preferred securities and replace them with new issuances at lower rates.

7. OTHER FEATURES

  • Provisions that prohibit interest deferral on junior subordinated debt if a default event has occurred are permissible only if the event of default is one that is authorized to trigger the acceleration of principal and interest under the final rule. Thus, an indenture provision that prohibits deferral upon a default that arises from failure to follow the proper deferral process or upon any other event of default that the final rule does not allow to trigger acceleration is unacceptable.
  • Perpetual preferred stock may provide voting rights to investors upon the non-payment of dividends, or for junior subordinated debt and trust preferred securities to provide voting rights to investors upon the deferral of interest and dividends, respectively. The clauses conferring voting rights may contain only customary provisions, such as the ability to elect one or two directors to the board of the BHC issuer, and may not be so adverse as to create a substantial disincentive for the banking organization to defer interest and dividends when necessary or prudent.

GAAP Accounting Treatment for Trust Preferred Securities

  • For bank holding companies with outstanding issuances of trust preferred securities, this will require deconsolidation of issuer trusts and recording the subordinated debentures issued to issuer trusts as debt.

Actions During Transition Period

  • The Fed has decided to extend the transition period from the end of the first quarter of 2007 to the end of the first quarter of 2009 to give BHCs more time to conform their capital structures to the revised quantitative limits. The result of this extension is that the revised quantitative limits will become applicable to BHCs ’ restricted core capital elements for reports and capital computations beginning on March 31, 2009, the reporting date for the first quarter of 2009.

Footnotes

1. Trust preferred securities are undated cumulative preferred securities issued out of an SPE, usually in the form of a trust, in which a BHC owns all of the common securities. The SPE’s sole asset is a deeply subordinated note issued by the BHC. The subordinated note, which is senior only to a BHC’s common and preferred stock, has terms that generally mirror those of the trust preferred securities, except that the junior subordinated note has a fixed maturity of at least 30 years. Trust preferred securities allow dividends to be deferred for at least a twenty-consecutive-quarter period without creating an event of default or acceleration. After the deferral of dividends for this twenty-quarter period, if the BHC fails to pay the cumulative dividend amount owed to investors, an event of default and acceleration occurs, giving investors the right to take hold of the subordinated note issued by the BHC. At the same time, the BHC’s obligation to pay principal and interest on the underlying junior subordinated note accelerates and the note becomes immediately due and payable. For tax purposes the dividends paid on trust preferred securities, unlike those paid on directly issued preferred stock, are a tax deductible interest expense because the Internal Revenue Service ignores the trust and focuses on the interest payments on the underlying subordinated note. Because trust preferred securities are cumulative, they have been limited since their inclusion in Tier 1 capital in 1996, together with a BHC’s directly issued cumulative perpetual preferred stock, to no more than 25 percent of a BHC’s core capital elements.

2. FASB originally issued Interpretation No. 46 (FIN 46), Consolidation of Variable Interest Entities, in January 2003 to respond to Enron’s abuse of special purpose entities (the now infamous "raptor partnerships"). However, the majority of the big accounting firms concluded FIN 46 was applicable to a broad array of special purpose entities, including Delaware statutory trusts used by bank holding companies to issue trust secured securities. FASB issued FIN 46R to clarify many of the questions and issues raised by FIN 46.

3. Thus, BHCs should, for both accounting and regulatory reporting purposes, determine the appropriate application of GAAP (including FIN 46 and FIN 46R) to their trusts issuing trust preferred securities. Accordingly, there should be no substantive difference in the treatment of trust preferred securities issued by such trusts, or the underlying junior subordinated debt, for purposes of regulatory reporting and GAAP accounting.

4. For this purpose, an internationally active BHC is a BHC that (1) as of its most recent year-end FR Y-9C reports has total consolidated assets equal to $ 250 billion or more or (2) on a consolidated basis, reports total on-balance sheet foreign exposure of $ 10 billion or more on its filings of the most recent year-end FFIEC 009 Country Exposure Report. This definition closely proxies the definition proposed for mandatory advanced AIRB banking organizations in the Advance Notice of Proposed Rulemaking.

5. The Fed has also decided to exempt qualifying mandatory convertible preferred securities—consisting of the joint issuance by a BHC to investors of trust preferred securities and a forward purchase contract, which the investors fully collateralize with the securities, that obligates the investors to purchase a fixed amount of the BHC’s common stock, generally in three years—from the 15 percent Tier 1 capital sub-limit applicable to internationally active BHCs. Accordingly, under the final rule, the aggregate amount of restricted core capital elements (excluding mandatory convertible preferred securities) that an internationally active BHC may include in Tier 1 capital must not exceed the 15 percent limit applicable to such BHCs, whereas the aggregate amount of restricted core capital elements (including mandatory convertible preferred securities) that an internationally active BHC may include in Tier 1 capital must not exceed the 25 percent limit applicable to all BHCs. Typically, prior to exercise of the purchase contract in three years, the trust preferred securities are remarketed by the initial investors to new investors and the cash proceeds are used to satisfy the initial investors’ obligation to buy the BHC’s common stock. The common stock replaces the initial trust preferred securities as a component of the BHC’s Tier 1 capital, and the remarketed trust preferred securities are excluded from the BHC’s regulatory capital.

6. The Fed believes that the Tier 1 capital sub-limits for restricted core capital elements should be keyed more closely than at present to BHCs ’ tangible equity—that is, core capital elements less goodwill—and has decided to require the deduction of goodwill as proposed. Goodwill generally provides value for a banking organization on a going concern basis, but this value declines as the organization deteriorates and has little if any value in the event of insolvency or bankruptcy. Although goodwill is also deducted from the sum of a BHC’s core capital elements in computing its Tier 1 capital, the Fed does not believe that deducting it from the sum of core capital elements for purposes of computing the Tier 1 sub-limit for restricted core capital elements constitutes a double deduction of goodwill. The Fed, however, agrees it would be appropriate to modify the goodwill deduction by netting from the amount of goodwill deducted any associated deferred tax liability. Accordingly, the final rule limits restricted core capital elements to a percentage of the sum of core capital elements, net of goodwill less any associated deferred tax liability.

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.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
 
In association with
Related Topics
 
Related Articles
 
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Mondaq Free Registration
Gain access to Mondaq global archive of over 375,000 articles covering 200 countries with a personalised News Alert and automatic login on this device.
Mondaq News Alert (some suggested topics and region)
Select Topics
Registration (please scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these Terms or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.

Disclaimer

The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.

General

Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions