Transcript www.iflr.com

IFLR Webinar:
Hybrid Capital
February 3, 2010
NY2 668716
© 2010 Morrison & Foerster LLP All Rights Reserved | www..mofo.com
Agenda
•Introduction
•Criticisms of hybrids during the financial crisis
•Current state of the hybrid market
•A review of hybrid securities
•New developments affecting hybrids
•Regulatory capital discussions
•Contingent capital
•Predictions
This is MoFo 2
Old World Structures
•Preferred stock
•Convertible preferred stock
•REIT preferred
•Equity units (preferred stock)
This is MoFo 3
Criticisms of hybrids during the crisis
•Prior to the financial crisis, financial institutions had become reliant on
hybrid securities for their capital needs
•Traditionally, hybrid issuers had called the securities at the first
opportunity; however, faced with few sources of replacement capital,
issuers surprised investors when they did not call outstanding hybrids
•Rating agencies downgraded hybrids based on a belief that hybrids
would suffer losses during the crisis and payments on hybrids would
be deferred by issuers seeking state aid
This is MoFo 4
Hybrids during the financial crisis
•Although hybrids suffered losses, commentators have observed that
these securities did not prove to be as “loss absorbent” as intended
and therefore did not provide sufficient financial flexibility for the bank
issuers
•There has been a bit of a backlash against hybrid securities
•Investors have become more focused on “tangible common equity”
as a measure of financial strength
This is MoFo 5
New World Structures
•Common stock
•Surviving Hybrids
• Trust Preferred
• Enhanced Trust Preferred
• Equity Units
•Special Situations
• Common Equivalent Securities
• Citigroup T-DECS
•Contingent Capital
This is MoFo 6
State of the Hybrid Market
This is MoFo 7
Subordinated Issuance Volumes 2002-2010
• Subordinated issuance peaked in 2006-2007 period (EUR 155bn and EUR163bn equiv. issued)
• 2008 - EUR115bn equiv. capital raised from state injections, subordinated supply falls to
EUR45bn equiv. (down 28% from peak)
• 2009 – Total capital raised similar to pre-crisis levels (EUR151bn equiv.), subordinated supply
accounting for EUR47bn equiv.
• Liability management new issues accounted for EUR18bn in 2009
• Including GBP7.5bn of new contingent capital securities (Lloyds)
Global Subordinated Supply by year 2002- to date
EUR Equiv (billion)
250
200
150
100
50
0
2002
2003
Subordinated
2004
2005
2006
State Injections
2007
2008
2009
2010
LM Exercises
Source: Bondware/ Calyon Notes: In all major currencies (USD/GBP/EUR)
This is MoFo 8
Subordinated Issuance Volumes 2009 to date
• Rapid recovery of the subordinated debt markets in 2009
• Re-opening of subordinated T1/T2 debt market:
• February (Bank T1 – Mizuho)
• May (Ins T2 – RSA, Bank T1 and T2 – Rabobank)
• July (Ins Hybrid – Prudential)
• October (Corp Hybrid – Hero)
• Greater application to a broader array of issuers/sectors – banks, insurance, corporates, rated/unrated and EM
issuers
Global hybrid debt issuance (non government provided) by
issuer type Jan 2009-to date
14
EUR Equiv (billion)
12
10
8
6
4
2
Jan-10
Dec-09
Ins T2
Nov-09
Oct-09
Sep-09
Ins Hybrid
Aug-09
Jul-09
Jun-09
Apr-09
Bank T2
May-09
Bank T1
Mar-09
Feb-09
Jan-09
0
C orp Hybrid
Source: Bondware/ Calyon
This is MoFo 9
Subordinated Supply by Issuer Geography
• European issuers active in 2009 (66% of total supply)
• US activity primarily from subordinated issues placed in the domestic market (22% of total supply)
• Fall in Asian issuer activity (in USD/EUR/GBP) as issuers choose to access the market in local
currencies (8% of total supply)
Global Subordinated Debt Supply in 2009
OTHER
4%
ASIA
8%
US
22%
EUROPE
66%
Source: Bondware/ Calyon. Notes: In all major currencies (USD/GBP/EUR)
This is MoFo 10
Subordinated Supply by Issuer Rating
• Post crisis – more AA issuers in the market
• 47% of total deals issued in 2009 (versus 41% in 2006)
• Pre-crisis – issuance split more evenly over rating bands
• 2009: AA (47%), A (39%), below A (14%)
• 2006: AA (41%). A (42%) , below A (17%)
Moody’s Issuer Rating for Subordinated Issuers in 2006 versus 2009
60
No of Deals
50
40
30
20
10
0
Aaa
Aa1
Aa2
Aa3
A1
A2
A3
Baa1
Baa2
Baa3
B1
Ba1
Ba2
Ba3
Moody's Issuer Rating
2006
2009
Source: Bondware/ Calyon. Notes: In all major currencies (USD/GBP/EUR)
This is MoFo 11
Subordinated
Spreads
and
Differentials
Subordinated spread differentials continue to narrow
•
The costs associated with the risk factors for hybrid capital (subordination, deferral risk, extension
risk) have fallen further, as indicated by the chart below:
•
LT2 cost - risk factors: subordination + extension risk (where the issue is callable): Now 73% lower vs Q109
•
UT2 cost - risk factors: subordination + deferral risk + extension risk:
Now 30% lower vs Q109
•
T1 cost - risk factors: more subordination + more deferral risk + extension risk:
Now 60% lower vs Q109
iBoxx Bank Secondary Spread Differentials
Subordinated Spread Differentials
Senior-LT2
LT2 - UT2
UT2 - T1



1400
Deferral risk?
x


1200
Extension risk?
X (for bullets)


1000
Q109
+ 399
+ 220
+ 462
Q209
+ 261
+ 143
+ 389
Q309
+ 152
+ 157
+ 201
Q409
+141
+ 159
+ 186
To date
+ 107
+ 155
+ 186
Change Q109 to date
- 73%
-30%
-60%
1800
Subordination?
Euribor spread (bp)
1600
800
600
400
200
Senior
Source: Calyon
Senior -LT2
LT2-UT2
UT2-T1
Jan-10
Nov-09
Sep-09
Jul-09
May-09
Mar-09
Jan-09
Nov-08
Sep-08
Jul-08
May-08
Mar-08
Jan-08
0
Source: Calyon
This is MoFo 12
Evolution of Hybrid Structures
• Contingent Capital have already been issued in the past
• Bespoke structures providing one-off solutions for issuers
• Now the market wants commoditisation, liquidity and hedgebility



Fortis issue €1.25bn of
Floating Rate EquityLinked Subordinated
Hybrid Capital Securities
(FRESH)

Receives Tier 1 regulatory
treatment

Automatic exchange price
is set – FRESH will
convert to equity if
ordinary shares trade
above this price
2002

A number of US companies are
threatened with significant EPS dilution
following the FASB’s proposal to require
issuers to reflect “contingent
convertibles” (CoCos”) under the ifconverted method of accounting
Deutsche Bank issue €200m of
5NC3 senior debt which is
exchangeable into innovative
Tier 1 (PNC10) capital at the
option of DB at any time - (March
2007)
Deutsche Bank issue $800m of
PNC10 UT2 securities which are
exchangeable into noninnovative Tier 1 capital at the
option of DB within the first 5
years - (May 2007)
2004

Fortis issue €3bn of Convertible
and Subordinated Hybrid EquityLinked Securities (CASHES)

Receives Tier 1 regulatory
treatment

After 40 days holders can
exchange into ordinary shares at
the exchange price or CASHES will
automatically convert if shares
trade at or above the Automatic
Exchange Price
2007

Swiss Re issue €672m of Mandatory
Convertible Notes

Achieved the highest equity treatment
possible from rating agencies

Holders of the notes will automatically be
converted into ordinary shares at the
exchange price in 3 years
2008

Deutsche Bank issue €1bn of 30NC10 UT2 securities which
are exchangeable into non-innovative Tier 1 (PNC10)
capital at the option of DB within the first 5 years (May 2008)

Deutsche Bank issue $1.265bn of PNC10 UT2 securities which
are exchangeable into non-innovative Tier 1 capital at
the option of DB within the first 5 years - (May 2008)

DB converted both these securities into Tier 1 in October
2008
Source: Calyon
This is MoFo 13
A review of hybrid securities
•Trust Preferreds
•Enhanced Trust Preferreds
•Equity Units
This is MoFo 14
Trust Preferred
Financial Holding
Company
$100 million
Subordinated Loan
Common (nominal)
Delaware
Statutory Trust
$100 million Trust Preferred Securities
This is MoFo 15
Trust Preferred (cont’d)
• Trust is a grantor trust for federal income tax purposes
• Trust preferred securities represent an interest in the $100 million
subordinated loan
• 5-Year interest deferral on subordinated loan (and trust preferred)
• Federal Reserve treats as Tier 1 capital for bank holding company (up to
25% limit); 15% limit for “internationally active” BHCs
• Interest on subordinated loan is tax deductible by bank holding company.
• Individual holders taxed at maximum 35% ordinary income rates on interest
(and OID)
• Interest and OID not subject to U.S. 30% withholding tax when paid to nonU.S. investors
This is MoFo 16
Enhanced Trust Preferred - CENts
Financial Holding
Company
$100 million
Junior
Subordinated
Loan
Common (nominal)
Delaware
Statutory Trust
$100 million Capital Securities (CENts)
This is MoFo 17
Enhanced Trust Preferred – CENts (cont’d)
•60-year junior subordinated loan with 30-year scheduled maturity
date – equity issued to repay subordinated loan
•Enhanced interest deferral features in years 5-10
•Essentially has same US tax consequences to Issuer and holders as
a “regular” trust preferred offering
•Moody’s: C or D Basket
•Internal Revenue Service: Chief Counsel Memorandum 200932049
(March 10, 2009) enhanced trust preferred is debt for federal income
tax purposes based on view that equity like features very unlikely to
ever be relevant.
This is MoFo 18
Equity Units (Common)
FINANCIAL HOLDING
COMPANY
Forward contract
over Common Stock
5-Year
Subordinated Debt
Custodian
Unit
Investors
This is MoFo 19
Equity Units (Common)
• Unit
• Note and Forward
• Corporate Units
• Note alone
• Treasury Units
• Treasuries and Forward
• Subordinated
• Interest deferral
• Remarkets after three years; rate is reset
This is MoFo 20
Common Equivalent Securities
• Problem: need capital now but insufficient common shares authorized under
charter; a shareholder vote can be obtained in a slightly longer time frame.
Preferred stock is authorized under charter
• Solution: issue preferred stock under state law that converts into common
stock when the shareholders authorize more common stock
• Preferred stock’s terms mirror economics of common with same dividend
rights as common
• Sweetners:
• Includes warrant to acquire additional common shares if vote fails
• Dividend step up if vote is delayed
This is MoFo 21
Citigroup T-DECS (12/14/09)
• Tangible Dividend Enhanced Common Stock--gives the investor common
stock exposure plus something that looks like current income in excess of
current common dividend
• Unit consisting of:
• Prepaid 3 year stock purchase contract to buy common stock
• Amortizing subordinated note with final payment due in 3 years, produces return on the
investor’s original issue price, installments are deferrable but not beyond 6 years
• Allocation of value to stock purchase contract and to amortizing note
• Units trades on exchange
• Components are separable
This is MoFo 22
New Developments
This is MoFo 23
New Developments
•Both rating agencies have been studying hybrid ratings. Moody’s has
already announced a new methodology for notching.
•The ECB has published guidance on “innovative Tier 1 instruments”
•The new Basel framework announced in mid December would phase
out the use of various hybrid instruments
This is MoFo 24
Ratings
and
Regulatory Capital
This is MoFo 25
Rating agency developments
Moody’s Tool Kit
This is MoFo 26
Rating agency developments
S&P Debt-Equity Continuum
• Little or questionable permanence
• Terms or nomenclature that
restrict or discourage
discretion over payments
• After-tax or conversion terms that
may become unattractive to the
issuer
Minimal Equity
Content
• Most preferred stock,
from: (a) 30-year trust
preferred with five-year
deferral rights; to (b)
perpetual preferred with
unlimited deferral rights
Intermediate Equity
Content
• Mandatory component,
either regarding deferral
of ongoing payments, or
near term conversion
into a fixed number of
common equity shares
High Equity
Content
This is MoFo 27
Moody’s guidelines
•In November 2009, Moody’s published Guidelines for Rating Bank
Hybrid Securities and Subordinated Debt
•The guidelines:
• remove systemic and regional support from hybrid ratings;
• provide for wider notching among different classes of bank hybrids; and
• provide flexibility to position hybrid ratings based on case specific and country
specific considerations
This is MoFo 28
Moody’s guidelines
•As a result of the Moody’s guidelines, Moody’s lowered ratings for
40% of hybrids by one or two notches; and lowered ratings for 50% of
hybrids by three to four notches
This is MoFo 29
Moody’s revised guidelines
Typical
Regulatory
Treatment
Coupon Non-Payment
Number of Notches below Adjusted BCA
(Adj. BCA = BCA + Parental and/or
Cooperative Support)
Lower Tier 2
None
Generally, will receive uplift
from Adjusted BCA to BDR – 1
Hybrid Subordinated Debt
Tier 2 and
Tier 3
Mandatory, cumulative, subject to
maturity extension
Lower of BDR – 1 or Adjusted BCA + 2
Junior Subordinated Debt
Upper Tier 2
Optional, cumulative
Adjusted BCA - 1 or – 2
Dated Junior Subordinated
Debt with Principal Writedown
Upper Tier 2
Optional/mandatory, cumulative
Adjusted BCA - 2 to – 4
Tier 1
Optional/mandatory, cumulative,
non-cumulative, or non-cash
cumulative (ACSM) settlement
Adjusted BCA - 2 to – 4
Hybrid Subordination
“Plain Vanilla” Subordinated
Debt
Preferred Securities
Anchor point for hybrid ratings generally removes systemic support and will be based on banks’ intrinsic financial
strength (the “adjusted baseline credit assessment”)
This is MoFo 30
Regulatory Developments
This is MoFo 31
ECB developments
•
EU Capital Requirements Directive (CRD)
•
•
May 2009 amendments to the CRD
•
•
•
enacted Committee of European Banking Supervisors (CEBS) proposals for Hybrid Tier 1 eligibility
criteria
common definitions of hybrid capital instruments that could be regarded as “innovative” Tier 1 capital “principles” type criteria; important details missing
The most important features of Hybrid Tier 1 Instruments are:
1.
2.
3.
4.
•
implements the Basel II Accord in the European Economic Area (EEA)
Permanence
Flexibility of payments
Loss absorbency
Mandatory conversion, (for eligibility beyond the 35% limit under the CRD amendments).
CEBS launched a consultation which closed in September 2009 in conjunction with
its proposals for more detailed guidelines for national bank supervisors in Europe
This is MoFo 32
Permanence
(1) Undated (or perpetual) instruments - may provide for a “moderate”
incentive to redeem, arising not earlier than 10 years after
issuance.
•
recommendations provide, where the incentive consists of (A) an interest rate “step-up” 
step-up capped at 100 basis points or 50% of the initial credit spread, less the swap spread
between the initial index basis and the stepped-up index basis, (B) a principal stock
settlement mechanism coupled with an issuer redemption (call option)  conversion ratio
capped at 150% of the conversion ratio at the date the hybrid instrument was issued, and
(C) other incentives  to be assessed by the relevant national bank supervisor case by
case.
This is MoFo 33
Permanence (cont’d)
(2) Dated instruments must have minimum maturity of at least 30 years and
may not provide for an incentive to redeem.
(3) Both undated and dated instruments
•
•
•
•
hybrids which are dated or contain an incentive to redeem - limited to an aggregate
maximum of 15% of a bank’s Tier 1 capital.
may contain an issuer call option exercisable after 5 years, but any redemption requires
the prior consent of the competent authority
•
consent may be granted if the requesting bank’s financial condition and solvency are
not affected
consent to earlier redemption may be granted in the case of an unforeseen change in tax
or regulatory treatment.
as to dated instruments, consent must be withheld, or redemption suspended, if issuer
non-compliant with its regulatory capital obligations.
This is MoFo 34
Permanence (cont’d)
• CEBS guidelines recommend issuer’s request for consent to be supported by:
• a well-founded explanation of the reason therefor
• current solvency data, including the capital position before and after redemption
• a confirmation that the issuer will remain in compliance with all regulatory requirements after
redemption
• a 3-5 year plan for the development of such solvency data, evaluation of the issuer’s risks
exposure and the sufficiency of the Tier 1 capital level to cover those risks, including in
stressed circumstances.
• if the relevant authority asks, a demonstration of its ability to re-access the hybrids market.
• Consent must be refused where it would put issuer’s financial condition or solvency in material
jeopardy in the foreseeable future and issuer must maintain sufficient capital buffers levels above
the regulatory minimum.
This is MoFo 35
Permanence (cont’d)
(4) Repurchases (“buybacks”) - although CRD is silent as to “buybacks” of
hybrid instruments, CEBS regards buybacks as equivalent to a call
redemption, in economic and prudential terms
•
•
May permit repurchases up to 5% of the relevant issuance for market-making purposes
CEBS considering allowing repurchases, before 5 years and without replacement, in
limited circumstances, so long as the repurchase improves solvency of issuer, but some
concerns of national supervisors of permanence being compromised
This is MoFo 36
Flexibility of Payments
• Hybrid Tier 1 capital must give issuer ability to cancel, on a non-cumulative
basis, interest/dividend (“coupon”) payments
• National regulators may require cancellation of coupons based on issuer’s
financial condition or solvency
• Cancellation mandatory where issuer in breach of its regulatory capital requirements
• Exemption available for hybrid containing an Alternative Coupon Satisfaction Mechanism
(“ACSM” or alternative payment mechanism), i.e., permissible to issue shares in lieu of coupon
payment but national regulators can impose conditions on such substitutions
This is MoFo 37
Flexibility of Payments (cont’d)
• CEBS guidance on dividend pushers/dividend stoppers (not addressed by
CRD).
• A “dividend pusher” requires the issuer to pay the hybrid coupon if it pays a dividend on its
common stock; conversely, a “dividend stopper” prevents the issuer from paying a dividend on
common stock unless it also pays the hybrid coupon.
• According to CEBS, a dividend pusher is a permissible feature of Hybrid Tier 1 Capital, but
must be waived if:
• between the date of the coupon push and the date for payment, issuer breaches its
regulatory capital requirements
• the competent authority requires cancellation of the coupon based on financial
condition/solvency concerns, or
• the majority of the dividend on common stock is paid in shares, rather than cash
This is MoFo 38
Flexibility of Payments (cont’d)
•
As regards a dividend stopper, CEBS has only noted it should not hinder
recapitalisation
CEBS regards an ACSM as acceptable only if it achieves the same
economic result as a cancellation of the coupon (i.e., no decrease in
capital), meaning that the deferred coupons must be satisfied without
delay using newly issued shares up to an equivalent aggregate fair value
(at a maximum)
•
•
•
•
Hybrid holders must bear the risk that selling those shares may not yield the substituted
coupon amount in full
ACSM should not hinder recapitalisation, i.e., the issuer should be able to cancel the ACSM
in order to absorb losses
CEBS did not clarify whether issuer could sell the substituted shares on behalf of the hybrid
holders and pay them the net cash proceeds - left up to the national supervisors.
This is MoFo 39
Loss Absorbency
•
Under CRD, hybrids must be able to absorb losses both on a “going
concern” basis and in a liquidation, and to count as Tier 1 capital, may be
senior only to common stock and not have benefit of any guarantee or
security.
CEBS has stated that:
•
•
•
as to loss absorption on a “going concern” basis - the instrument must (A) help prevent
insolvency and (B) not hinder recapitalisation
•
Preventing insolvency requires that (i) no redemption is permitted, (ii) the issuer can
cancel the coupon, (iii) the hybrid holder cannot petition for the issuer’s insolvency
and (iv) the hybrid instrument would not be taken into account in determining whether
the issuer is insolvent.
•
of these, (iv) is arguably the most difficult to achieve where the insolvency test is
based on the balance sheet - if instrument qualifies as “debt” under the relevant
insolvency law, a mechanism for conversion into an equity instrument or write-down of
principal (whether permanent or temporary) may work.
the capacity of an instrument to absorb losses in a “liquidation” depends on the degree of
subordination
This is MoFo 40
Loss Absorbency (cont.)
•
In assessing whether an instrument renders a recapitalisation more likely,
a balance must be struck between the hybrid holders’ and the potential
new shareholders’ respective rights.
•
•
•
•
mechanisms proposed by CEBS (again) are (i) a conversion into an equity instrument or (ii)
a permanent or temporary write-down of principal, in each case to a meaningful extent (i.e.,
at least pari passu with shareholders), although it is unclear how a share can be “written
down.”
one or a combination of these mechanisms could be approved by a relevant competent
authority.
the mechanism(s) should take effect (A) immediately after losses cause a significant
deterioration in financial condition/solvency and (B) before the share capital is exhausted.
in practice the “trigger point” would occur when losses have significantly reduced retained
earnings and other reserves, but before the issuer has breached any required solvency
level.
This is MoFo 41
Mandatory Conversion
•
Hybrids that do not convert into shares are limited to a maximum of 35%
of the bank’s Tier 1 Capital
Beyond the 35% limit the Hybrid Tier 1 Capital must be convertible into
shares and the total Hybrid Tier 1 cannot exceed 50%
•
•
•
CEBS considers that there must be a mandatory conversion into equity in the event of the
issuer’s breach of its required capital ratio and perhaps also in other “emergency
situations.”
In addition, the competent authority should have the power to trigger the conversion if
necessary, having regard to issuer’s financial condition/solvency (i.e., the same
considerations as regards consents to call/redemption or a cancellation of coupons).
This is MoFo 42
Basel Framework
This is MoFo 43
Basel framework
•In mid December, the BCBS announced far-reaching proposals for
comment, which include changes to the components of capital;
increases to the basic minimum Tier 1 and total risk-based capital
rules; and a “capital buffer” concept that imposes a sliding scale of
enhanced regulatory restrictions to pay dividends and bonuses if
capital is not above the minimum.
This is MoFo 44
Highlights of Basel framework
•Emphasis on quality, consistency and transparency of the capital
base
•The definition of Tier 1 capital is moving closer to the definition of
“tangible common equity”
•Tier 1 (or going concern) capital must consist principally of common
equity, plus retained earnings, net of regulatory adjustments,
including deductions of intangible assets
This is MoFo 45
Basel framework—Tier 1 changes
•The proposal enumerates a list of 14 criteria to be satisfied in order
for common shares to be included as common equity
•Common shares must be fully subordinated to all other claims in
liquidation with no fixed or capped claim on liquidation, except at the
discretion of the issuing bank
•As a result of these criteria, certain instruments would no longer be
considered included—for example, step-up instruments, cumulative
preferred, and trust preferred
This is MoFo 46
Regulatory adjustments
•The proposals would harmonize regulatory adjustments, including
adjustments for:
• Minority interests,
• Deferred tax assets,
• Shortfall in reserves,
• Goodwill & other intangibles,
• Unrealized gains and losses
• Investments in other financial institutions
• Gains and losses due to changes in own credit risk
This is MoFo 47
Tier 2 & Tier 3
•Tier 3 capital would be completely eliminated
•Tier 2 (or gone concern) capital would be simplified by establishing a
single set of eligibility criteria and eliminating all Tier 2 sub-categories
•Upper and lower Tier 2 would be eliminated
•Tier 2 capital would be required to be subordinated to depositors and
general creditors, not secured, not guaranteed, having an original
maturity of at least five years and callable by the issuer only after a
minimum of five years
This is MoFo 48
Contingent Capital
This is MoFo 49
Contingent Capital
• “A second kind of market discipline initiative is a requirement that large
financial firms have specified forms of ‘contingent capital’…For example, a
regularly issued special debt instrument that would convert to equity during
times of financial distress could add market discipline both through the
pricing of newly issued instruments and through the interests of current
shareholders in avoiding dilution.” Fed Governor Daniel K. Tarullo at the
Exchequer Club, Washington D.C. on October 21, 2009.
This is MoFo 50
Lloyds Bank - November 23, 2009
• ₤7.5 Billion Issue (Exchange Offer)
• Styled as “Enhanced Capital Notes”
• Ten year term
• Fixed interest rate, non-deferrable
• Converts to a fixed number of common shares if Lloyd’s core Tier One ratio
falls below 5%
• Intended to be lower Tier 2 bonds for regulatory purposes
• Lloyds and holders agree to treat as equity for U.S. federal income tax
purposes
This is MoFo 51
Dodd Bill (Restoring American Financial
Stability Act of 2009)
§107 Enhanced Supervision and Prudential Standards for Specified Financial Companies
(c) CONTINGENT CAPITAL.—
(1) IN GENERAL.—The Agency shall promulgate regulations that require specified financial companies to maintain a
minimum amount of long-term hybrid debt that is convertible to equity when—
(A) a specified financial company fails to meet prudential standards established by the Agency; and
(B) the Agency has determined that threats to United States financial system stability make such a conversion necessary.
(2) FACTORS TO CONSIDER.—In establishing regulations under this subsection, the Agency shall consider—
(A) an appropriate transition period for implementation of a conversion under this subsection;
(B) the factors described in subsection (b)(3)(A);
(C) capital requirements applicable to the specified financial company and its subsidiaries; and
(D) any other factor that the Agency deems appropriate.
This is MoFo 52
Wall Street Reform and Consumer
Protection Act of 2009 (HR 4173)
•House passed HR 4173 on December 11, 2009; no Senate action yet
•Includes a section on “contingent capital” authorizing the Federal
Reserve Board of Governors to issue regulations “that require a
financial holding company to maintain a minimum amount of longterm hybrid debt that is convertible into equity when—
(1) a specified financial company fails to meet prudential standards…and
(2) the [agency] has determined that threats to United States financial system
stability make such conversion necessary.”
This is MoFo 53
Contingent Capital – Selected Tax Issues
Debt Versus Equity
Debt Characteristics:
• Debt under local law,
• A fixed maturity date on which a sum certain is payable,
• A right to receive fixed interest without deferral, and
• An unlikelihood of conversion at the time of issuance.
Issue:
• Depending on the specifics, the conversion feature may raise the question whether the holder has
an entitlement to repayment regardless of the issuer’s financial circumstances.
• Does the Holder have creditor’s rights?
Note stock received on conversion may have FMV significantly lower than principal of contingent
capital instrument. Compare Rev. Rul. 85-119 (notes payable in stock or proceeds of stock sold in
offering, where FMV of stock equals principal on notes, treated as debt) and Notice 94-47 (Rev. Rul.
85-119 limited to its facts).
This is MoFo 54
Selected Tax Issues (Cont.)
Section 163(l)
• If debt, Section 163(l) of the Code would have to be analyzed to see
whether it could deny issuer’s interest deductions
• Applies to “disqualified debt instruments”, including “indebtedness of a
corporation which is payable in equity of the issuer…”
• Code employs a “substantial certainty” standard for debt payable in equity at
option of holder
• If same “substantial certainty” principle applied to contingent capital
conversion, Section 163(l) would not apply if likelihood of conversion was
remote
This is MoFo 55
Selected Tax Issues (Cont.)
Cancellation of Indebtedness
• If debt, conversion into stock generally tax-free to the holder under a number
of theories
• However, if principal amount exceeds FMV of stock, conversion could
generate COD income under Section 108(e)(8) to the issuer
• TAM 200606037 takes this position, citing Treas. Reg. § 1.61-12(c)(2)
definition of “repurchase” to include conversion
This is MoFo 56
Selected Tax Issues (Cont.)
Foreign Investor Concerns
If equity:
• No portfolio interest exemption from withholding for foreign holders
• Potential application of the CFC and PFIC rules with respect to U.S. holders
of foreign issuers
If debt: would portfolio interest exemption apply for interest paid to foreign
investors?
This is MoFo 57
Predictions
This is MoFo 58