The Federal Reserve Board (“Fed”) has put an end to the banking community's concerns about the capital treatment of trust preferred securities, at least temporarily, by proposing to impose stricter limitations on trust preferred securities, but continuing to allow the securities to be included in the Tier 1 capital of bank holding companies. Speculation about the Fed's position on the Tier 1 capital treatment of trust preferred securities ranged from a best-case scenario of “no change” to a worst-case scenario of completely disallowing Tier 1 capital treatment, with existing trust preferred issues being “grandfathered” to preserve the Tier 1 capital treatment. The Fed's proposal, announced earlier this month, is a compromise between the best- and worst-case scenarios.
Under the proposal, trust preferred securities will continue to count as Tier 1 capital up to 25% of a bank holding company's total core capital elements. However, the Fed proposes to deduct goodwill from core capital when applying the 25% limitation (which is a deduction that is not required under the current rules). For bank holding companies that have trust preferred securities in excess of the 25% limit, the Fed proposes to include the excess in Tier 2 capital, subject to certain limitations.
The Fed also proposes to apply the 25% limitation to an aggregate amount of trust preferred securities and a range of other capital instruments, such as preferred securities issued by real estate investment trust subsidiaries. Additionally, for internationally active bank holding companies, the Fed proposes that trust preferred securities counting as Tier 1 capital be limited to 15% of a holding company's total core capital elements, net of goodwill. The Fed has provided a three-year transition period before the new rules go into effect.
James Hill, Managing Director in Investment Banking of Friedman, Billings, Ramsey & Co., Inc.'s Irvine, California office, commented that the “proposal should be viewed positively by community bank holding companies since (1) it is considerably less onerous than many anticipated, and (2) the almost three-year phase-in period should provide ample time for companies to grow into any excess trust preferred which they currently have on their balance sheets.”
About trust preferred securities
Trust preferred securities are hybrid securities that have debt characteristics that provide preferential treatment as debt for income tax purposes. However, trust preferred securities also have equity characteristics that allow bank holding companies to count the securities as Tier 1 capital for regulatory purposes. While counted as equity for Tier 1 capital purposes, trust preferred securities are not included in the equity calculation when computing per share return-on-equity ratios. These differing treatments explain why trust preferred securities have been an efficient and attractive way for bank holding companies to raise capital.
To raise capital using trust preferred securities, bank holding companies issue trust preferred securities through trust subsidiaries that are special purpose entities. The bank holding company purchases the common securities of the trust (which represent about 3% of the overall equity of the trust). The trust then issues preferred securities to investors. The trust loans the proceeds of both the common and preferred securities to the bank holding company, which, in turn, issues debentures as evidence of its indebtedness to the trust. The minority interest in the trust that shows up on the bank's consolidated financial statements has historically been allowed as Tier 1 capital with a historical limitation of up to a 25% limitation of Tier 1 capital. The Tier 1 treatment of trust preferred securities hinges on the securities being representing a minority interest in the equity accounts of a consolidated subsidiary on a bank holding company's balance sheet.
Tier 1 capital generally is defined as the sum of a bank holding company's core capital elements less any amounts of goodwill, other intangible assets, interest-only strips receivable, deferred tax assets, non-financial equity investments and other items that are required to be deducted for purposes of calculating regulatory ratios. A bank holding company's core capital elements have historically included common stockholders' equity, noncumulative perpetual preferred stock (including related surplus), cumulative perpetual preferred stock (including related surplus) and minority interest in the equity accounts of consolidated subsidiaries.
New accounting rules
The anxiety about the capital treatment of trust preferred securities began in 2003, after the Financial Accounting Standards Board (“FASB”) issued new accounting rules, which required that trust preferred securities no longer be consolidated on the financial statements of a bank holding company. Because the Tier 1 treatment of trust preferred securities is based on the securities representing a minority interest in the equity accounts of a consolidated subsidiary, this de-consolidation called into question the Tier 1 capital treatment of the securities.
The new accounting rules, partly adopted in response to the collapse of Enron, are set forth in FASB Interpretation No. 46, “Consolidation of Variable Interest Entities” (“FIN 46”), which was later revised (“FIN 46R”). The rules require the consolidation of variable interest entities onto the balance sheets of the companies determined to be the primary beneficiary of those entities. Trust preferred securities had already been consolidated on the balance sheets of bank holding companies, but under FIN 46, the bank holding company is not deemed the primary beneficiary of the trust preferred securities, which, in turn, requires that trust preferred securities no longer be consolidated on the financial statements of the bank holding company.
The result is that under generally accepted accounting principles (“GAAP”), trust preferred securities generally continue to be accounted for as equity at the level of the trust that issues them, but the instruments may no longer be treated as minority interest in the accounts of a consolidated subsidiary on a bank holding company's balance sheet , which . This result threw into question how the Fed would treat these instruments for regulatory capital purposes.
In its proposal, the Fed notes that bank holding companies are required to follow GAAP for regulatory reporting purposes. Accordingly, there should be no substantive difference in the treatment of trusts for regulatory reporting and GAAP accounting and bank holding companies should determine the appropriate application of FIN 46 and FIN 46R to their trusts issuing trust preferred securities.
However, the Fed asserted that the change in GAAP accounting does not necessarily change the regulatory capital treatment of trust preferred securities. The Fed explained that the definition of Tier 1 or Tier 2 capital is designed to ensure a banking organization's safety and soundness, while accounting designations are designed to ensure the transparency of financial statements. Accordingly, the Fed confirmed its authority over the regulatory capital arena and upheld the Tier 1 capital treatment of trust preferred securities, subject to stricter limitations.
Impact on the trust preferred capital market
Ever since the new accounting rules brought into question the capital treatment of trust preferred securities, there has been a flurry of activity in the capital markets , as the banking community has scrambled to issue trust preferred securities on the gamble that current issuances would be grandfathered into the Tier 1 capital treatment.
Now that the Fed has issued its proposal about the capital treatment of trust preferred securities, Joel Comer, a principal at Sandler O'Neill & Partners, L.P. thinks there will be additional activity in the trust preferred market as some companies held back from issuing trust preferred securities because of the capital treatment uncertainty. Comer thinks the new rules “draw a line in the sand” and bank holding companies will now have certainty if they decide to participate in the trust preferred securities market and also will be able to start managing their capital base to comply with the new limitations.
Comer said another impact on the capital markets could be a surge in secondary offerings of common stock to increase Tier 1 capital. Implications of the proposed rule are complicated, according to Comer, especially because companies that participate in mergers and acquisitions will now have to determine the effect of netting goodwill from the equation of Tier 1 capital.
Definition of a regulatory capital event
The terms of most outstanding trust preferred securities require that the securities be redeemable by a bank holding company if a “regulatory capital event” occurs. A “regulatory capital event” generally occurs if there is a change in the law that affects the Tier 1 capital treatment of the trust preferred securities. Bank holding companies should review their trust preferred documentation to analyze the impact of the Fed proposal and to determine whether the final rules adopted pursuant to the Fed proposal could be considered a “regulatory capital event.”
Under most trust preferred documents, the final rules likely will not be considered a “regulatory capital event.” However, companies with large amounts of goodwill on their balance sheet might be able to argue that the final rules trigger a “regulatory capital event.” Most trust preferred documentation imposes a time limit during which the securities are redeemable as a result of a “regulatory capital event,” so bank holding companies should begin reviewing their trust preferred documents as soon as possible and, if applicable, begin planning for a redemption event soon after the final rules are effective.
Deducting goodwill from core capital
Under the proposal, the Fed has tightened regulatory capital requirements relating to trust preferred securities by making bank holding companies deduct goodwill from total core capital before applying the 25% limitation. Under the proposed rules, “total core capital” includes:
- common stockholders' equity,
- noncumulative perpetual preferred stock (including related surplus),
- minority interest in qualifying stock issued by a consolidated U.S. depository institution or foreign bank subsidiary, and
- trust preferred securities and a range of other capital instruments, which the Fed refers to as “restricted core capital elements.”
According to Hill, the proposed rules “represent a fair compromise among the various widely-rumored alternative treatments and reflect the economic reality of goodwill versus core deposit intangible as a component of leveragable regulatory capital.”
Netting out goodwill could be a significant change for bank holding companies that are actively engaged in acquiring other entities, as goodwill is most likely to appear on a company's balance sheet as a result of mergers and acquisitions. In general, goodwill is the difference between the purchase price and the book value of the acquired company's assets. If the Fed's proposal is adopted in its current form, Hill thinks “it may cause acquisitive community banks to consider ways to move more of any future acquisition premium into core deposit intangible rather than goodwill in order to maximize their trust preferred capacity.”
Applying the 25% limitation to other capital instruments
The Fed proposal further tightens the capital requirements of trust preferred securities by applying the 25% limitation, net of goodwill, to the aggregate amount of “restricted core capital elements,” which are the following:
- trust preferred securities,
- cumulative perpetual preferred stock,
- minority interest related to cumulative perpetual preferred stock issued by a consolidated U.S. depository institution or foreign bank subsidiary (referred to as “Class B minority interests”), and
- minority interest in the form of common stockholders' equity or perpetual preferred stock in a consolidated subsidiary that is not a U.S. depository institution or a foreign bank, such as REIT preferred securities and other asset-driven capital instruments (referred to as “Class C minority interests”).
The aggregate amount of all restricted capital elements that may be included in a bank holding company's Tier 1 capital, must not exceed 25% of the sum of all core capital elements (including the restricted core capital elements), net of goodwill. Amounts in excess of the 25% limit may be included in Tier 2 capital as set forth in the below table:
| Type of security |
Tier 2 treatment |
| Trust preferred securities and Class C minority interests |
Amounts in excess of the 25% limit may be included within Tier 2 capital, but the amounts are limited (together with subordinated debt and limited life preferred stock) to 50% of Tier 1 capital. |
| Perpetual preferred stock and Class B minority interests |
Amounts in excess of the 25% limit may be included within Tier 2 capital, with no sublimit. |
Revising trust preferred criteria
The Fed also proposes to revise other features of trust preferred securities. The most significant of these proposals: (1) affects the call option feature of trust preferred securities, and (2) changes the Tier 1 capital treatment of trust preferred securities during the last five years before maturity.
The Fed is seeking comment on whether to continue to require that trust preferred securities contain a call feature, at a bank holding company's option, commencing no later than 10 years from issuance. Companies often exercise the call option to redeem trust preferred securities that were issued in a high-interest rate environment and replace the trust preferred securities with lower-rate instruments. If the call option is no longer required, bank holding companies may still demand that the call feature remain in trust preferred securities in order to maintain flexibility. However, no longer will it be a given that a call option be included.
Another Fed proposal is to exclude trust preferred securities from Tier 1 capital for the last five years before maturity. In the last five years of the life of the trust preferred securities, the outstanding amount will be excluded from Tier 1 capital, but may be included in Tier 2 capital, subject to a limit of 50% of Tier 1 capital. During this period, the trust preferred securities will be amortized out of Tier 2 capital by 1/5th of the original amount each year and excluded totally from Tier 2 capital during the last year. During this five-year period, for currently outstanding trust preferred securities, companies could exercise the call option to redeem the trust preferred securities. However, if the proposal to eliminate the call option is adopted, then new issuances of trust preferred securities may not be redeemable during these last five years if a bank holding company has not negotiated for the right to a call option.
Three-year transition period
The Fed proposes to allow bank holding companies a three-year transition period to meet the new, stricter limitations within regulatory capital. Bank holding companies have until March 31, 2007 to comply with the new Tier 1 capital limits. During the interim period, bank holding companies with trust preferred securities in excess of the proposed regulatory limits on Tier 1 capital must consult with the Fed to prepare a plan to lessen reliance on the applicable elements in their capital base so that they will be in compliance by March 31, 2007.
What companies should do now
Companies may provide comment on the Fed's proposed rules by July 11, 2004, either directly or through trade associations. Companies should also start reviewing the new capital requirements and make strategic plans to be compliant with the new rules by March 31, 2007.
by Angelee J. Harris
Ms. Harris represents public and closely-held companies in connection with mergers and acquisitions, capital market transactions and corporate governance, including compliance with the Sarbanes-Oxley Act of 2002.
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