Trust Preferred Securities: They’re Not Just for Big Banks Anymore!

Since their first appearance in 1993, "trust preferred" securities have become a popular way for regulated companies, such as bank holding companies and insurance companies, to raise required regulatory capital. In 1996, the Board of Governors of the Federal Reserve System, in a one-page press release, clarified for the banking world that the proceeds from the sale of these hybrid securities, which share characteristics of both debt and equity, could be treated as coveted "Tier 1" capital by bank holding companies.

Since their first appearance in 1993, “trust preferred” securities have become a popular way for regulated companies, such as bank holding companies and insurance companies, to raise required regulatory capital. In 1996, the Board of Governors of the Federal Reserve System, in a one-page press release, clarified for the banking world that the proceeds from the sale of these hybrid securities, which share characteristics of both debt and equity, could be treated as coveted “Tier 1” capital by bank holding companies. What has resulted has been an avalanche of trust preferred securities offerings, both public and private. Initially, because of high transaction costs and credit rating issues, community banks were often prevented from participating in this growing trend for raising capital. However, in recent years, through the creation of pooled offerings and other marketing changes by investment banking firms, the opportunity to raise capital through trust preferred securities offerings has become readily accessible for most community banks so long as they operate in a bank holding company structure.

Why Use Trust Preferred Securities To Raise Capital?

Bank holding companies facing rapid expansion or acquisition opportunities have many alternatives for raising necessary Tier 1 capital. Tier 1 capital, which includes only a company’s common stock, qualifying preferred stock and minority interests in equity accounts of consolidated subsidiaries, is the primary measure established by the Federal Reserve System for assessing the capital adequacy of bank holding companies. Trust preferred securities provide the holding company with several advantages that traditional Tier 1 capital raising transactions do not. The most obvious advantage is the ability to raise equity capital for regulatory purposes while deducting the interest payments for tax purposes. This separates trust preferred securities from traditional preferred stock issued directly by the holding company. In addition, unlike the sale of common stock by the holding company, the trust preferred securities do not have a dilutive effect on the company’s common shareholders and financial results.

Whereas in the past, high transaction costs often prevented community banks from participating in the trust preferred arena, a community bank can now issue trust preferred securities with little or no transactional expenses. The primary reason for these reductions in costs is pooled trust preferred transactions. In these transactions, the trust preferred securities of multiple bank holding companies are issued into a pool with investors buying an interest in the pool of trust preferred securities as opposed to the trust preferred securities of any single issuer. Because these pools are rated by national credit rating agencies based on the diversity and credit quality of the issuers in the pool, the terms of these securities must be virtually identical, leaving the company little say in negotiating the contents of the documents. However, with marketing and other costs spread among all pool participants, the pooled trust preferred offerings significantly reduce transaction costs for bank holding companies. In fact, many of the investment banking firms arranging the pooled deals will pay the majority or all of the initial costs, including legal fees.

What Are Trust Preferred Securities?

Trust preferred securities are simply securities issued by a wholly owned trust subsidiary of the bank holding company. A trust preferred securities transaction, however, actually involves the issuance of three separate securities: the issuance of the trust preferred, or capital, securities to investors, the issuance of the trust’s common securities to the parent bank holding company and the issuance of debentures by the parent bank holding company to the trust. The trust preferred securities provide for a long maturity, generally 30 years, and periodic, typically quarterly or semi-annual, fixed or floating rate interest payments, and contain very limited rights, other than the right to receive payments of principal and interest. The common securities of the trust, which are owned by the parent bank holding company, include payment terms that are identical to the trust’s preferred securities. The trust uses the proceeds it receives from the sale of the capital securities and the common securities to purchase, from the holding company, an equal amount of debentures that also have identical payment terms to those of the trust preferred securities. The net effect of these three offerings results in a banking holding company issuing a hybrid security that possesses characteristics of both debt and equity securities. The securities are treated by the holding company as debt for tax purposes (with the interest payments deductible to the holding company) while also being treated as Tier 1 capital for regulatory purposes.

While the terms of any particular trust preferred security vary from issue to issue, the Federal Reserve requires several characteristics in order for the trust preferred securities to be treated as Tier 1 capital. First, the trust preferred securities must allow for a minimum five-year deferral period on the payment of interest to the security holders. Second, the underlying company debt, the debentures, must be subordinated to all other debt of the company and have the “longest feasible maturity.” It has generally been settled that a maturity of 30 years satisfies this requirement. Third, the trust preferred securities, together with any other cumulative preferred stock issued by the bank holding company, may only account for 25% of the holding company’s Tier 1 capital. Finally, the trust preferred securities must provide for prior approval of the Federal Reserve before they are redeemed. If any of these four factors are not included in the terms of the trust preferred securities, the Federal Reserve will not permit the proceeds from the sale to be treated as Tier 1 capital.
In addition to the factors required by the Federal Reserve, in order for the interest payments on the debentures to be deductible by the holding company, the IRS has enumerated several additional requirements. Among these are whether the holding company has an unconditional promise to pay on a fixed maturity date that is in the reasonably foreseeable future and whether or not the holders of the securities have the right to enforce payment of principal and interest. The 30-year maturity date common among trust preferred securities is generally considered to be in the “reasonably foreseeable future.” The requirement that the trust preferred securities holders (the “trust preferred holders”) be able to enforce their right to payments of principal and interest is met by issuing with each security an “unconditional” guarantee of payment. As discussed in more detail below, however, the guarantee is not as absolute as it sounds.

How Do Trust Preferred Securities Work?

The legal documents that control a trust preferred securities transaction can be complex and must be carefully drafted to meet all of the requirements of the Federal Reserve, the IRS and the SEC, among others. Three principal documents define a trust preferred securities transaction: a trust agreement, an indenture and a guarantee agreement.

THE TRUST AGREEMENT

The trust agreement governs the operations of the trust and defines the terms of the trust preferred securities. In order for the securities to receive the desired tax treatment, the trust must be formed in a jurisdiction, such as Delaware or Connecticut, that statutorily provides for business trusts that may be considered grantor trusts for tax purposes, and thus provide pass-through taxation. In addition to defining the terms of the trust’s securities, the trust agreement will also, among other things, name and provide the qualifications for the institutional trustee and provide for the payment of the trust’s expenses. The day-to-day operations of the trust and the trust’s actions are governed by officers or employees of the holding company who serve as administrators of the trust, with the institutional trustee serving as the gatekeeper of funds. As the trust receives interest payments on the holding company’s debentures, the trustee provides for such payments to be passed on to the holders of the trust’s preferred and common securities.

The trust’s operations are limited to issuing the trust preferred securities to investors and to holding the debentures purchased from the holding company. In order to satisfy the control requirements necessary for the trust to be treated as a consolidated subsidiary for financial reporting purposes, the holding company must purchase common securities of the trust with a value equal to at least 3% of the trust’s total assets. As the holder of all outstanding common securities of the trust, except in an event of default, the holding company can control the selection of administrators and the institutional trustee. The trust preferred holders generally will only have voting rights with respect to waiving a default and approving amendments to the trust agreement. If there is a default, any payments received by the trustee must be paid to the trust preferred holders before any payments can be made to the common security holder, which is, of course, the holding company.
The trust generally has a finite term of 35 years, but may be dissolved sooner. If the trust is dissolved prior to all trust preferred securities being redeemed, the debentures held by the trust are distributed, pro rata, to the trust preferred holders.

THE INDENTURE

The indenture governs the terms of the debentures issued by the holding company and purchased by the trust. The terms of the debentures mirror the terms of the trust preferred securities in all respects, including interest rate, maturity and payment dates. The same entity that serves as institutional trustee for the trust also serves as indenture trustee. As noted above, in order for the trust preferred securities to be treated as Tier 1 capital, the holding company must have the right to defer interest payments on the debentures, and thus ultimately the trust preferred securities, for up to five consecutive years. This deferral right does come with a price, however. During any deferral period, the holding company is prohibited from paying dividends, redeeming stock and other similar transactions. In addition, in order for the trust preferred securities to be treated as debt for tax purposes, the holding company’s intent to defer interest payments at the time the securities are issued must be “remote.”

Both the indenture and the trust agreement allow for the redemption of the debentures and the trust preferred securities after a period of five years. The redemption price may be at par value or at a premium, depending on the specific terms of the security. This redemption feature has allowed many bank holding companies who issued trust preferred securities in the mid-1990s at higher interest rates to redeem those securities by issuing new trust preferred securities to take advantage of the current, lower interest rates. In addition, there are certain special events that may trigger a redemption of the securities. Generally, these events are a “tax event,” a “capital treatment event” and an “investment company event.” These special redemption events are designed to protect the holding company in case a change in current laws removes the advantages associated with trust preferred securities. A tax event occurs if there is a change in the current tax laws that would prevent the holding company from deducting interest payments on the debentures, while a capital treatment event occurs if the Federal Reserve revises its position on the treatment of trust preferred securities as Tier 1 capital. The final special event, the “investment company event,” is designed to protect the holding company should law changes require the trust to register as an investment company under the Investment Company Act of 1940, which would involve great expense and ongoing reporting requirements.

THE GUARANTEE AGREEMENT

The final agreement, the guarantee agreement, while limited in scope, serves several very important functions. The guarantee agreement provides a guarantee of payment on the trust preferred securities, but only to the extent the trust has funds to make the payments. Therefore, the guarantee is only applicable if the holding company has made the interest payments on the debentures to the trust. While the guarantee itself contained in the agreement is rather limited, the guarantee agreement serves two other important functions. By issuing the guarantee to each trust preferred holder through the appointment of a guarantee trustee who holds the guarantee for the benefit of all trust preferred holders, a contractual connection is made between the holding company and the trust preferred holders. As a result of that connection, the trust preferred holders, subject to limitations set forth in the declaration of trust, may directly sue the holding company for nonpayment on the securities. This satisfies the IRS’s requirement regarding enforceability of payments of principal and interest. In addition, the guarantee agreement also serves to provide the trust with an exemption from registration as an investment company under the Investment Company Act of 1940.

Trust Preferred Securities — Worth Considering

The advantages of the combined debt and equity nature of trust preferred securities, coupled with the generally low transaction costs, make trust preferred securities a great alternative for raising capital. While the documents and structure of the transaction may appear daunting and scare away many bank executives, in reality trust preferred securities are very simple and straightforward and provide community banks with a unique opportunity for raising necessary Tier 1 capital.