Trust Preferred Securities: A Major Opportunity for Balance Sheet Management

The level playing field for financial companies has implications far beyond being able to provide a broad range of services to customers. Equally important, virtually all financial institutions now have access to many of the same balance sheet management options used by larger institutions.

Developments in the marketplace have given community banks the ability to issue trust preferred securities. These instruments increase capital at a very low cost without diluting the equity of current shareholders. Banks that issue trust preferreds are able to significantly increase long-term shareholder value.

But when the subject of issuing trust preferred securities comes up in conversation with community bankers, I’ve noticed that the directors and executive management of many institutions have reactions ranging from “It’s probably not available to us” to “We’re starting to seriously think about it.” A tall fence seems to separate the balance sheet management options community bankers will consider and those they leave to their counterparts in larger organizations. Trust preferreds tend to be in the latter category.

Trust preferreds have a number of features that make them very appealing to community bank holding companies.

Moreover, new structures for trust preferred securities transactions, including private placements and pooled securitizations, have made this funding source more accessible to small institutions.

My point is simple. If you haven’t already done so, you may want to consider whether trust preferreds would be an appropriate vehicle for simultaneously increasing your capital base, obtaining beneficial tax treatment, and enhancing shareholder value while maintaining regulatory capital. I hope this article will prompt you to take a fresh look at this unique, and often misunderstood, long-term balance sheet management tool.

A Crash Course

To raise capital funds, a special-purpose subsidiary of a bank holding company can issue trust preferred securities. These instruments were originally developed in the nonbanking capital markets but were widely adopted by large bank holding companies after October 1996, when the Federal Reserve Board authorized trust preferreds as a component of tier-one regulatory capital.

Basically, issuing trust preferred securities works as follows:

1. A bank holding company establishes a wholly owned subsidiary as a business trustu00e2u20ac”typically a Delaware business trust;
2. The trust issues all of its common stock to the holding company; it also issues cumulative preferred stock and sells those shares to investors;
3. The trust uses the proceeds from the sale of the preferred stock to purchase subordinated debentures of the holding company in the same amount and with the same terms as the preferred stock. The debentures are the trust’s sole asset.

The bank holding company’s payments on the debentures, which are deductible for income tax purposes, are then used by the trust to pay fixed or floating dividends to the investors who purchased the preferred stock. The holding company guarantees the payment of the preferred stock dividend, but only to the extent that the trust receives payments on the notes.

Trust preferreds are considered a “hybrid” instrument because they have the properties of both equity and debt instruments. Counting trust preferred securities as tier-one capital for regulatory capital purposes makes them similar to an equity. Having a fixed maturity, paying a fixed or floating dividend, and not offering voting rights to investors make them similar to a debt instrument. Trust preferreds are essentially a form of debt that can be treated as equity for regulatory capital purposes, with the interest being tax-deductible.

Financial and Accounting Benefits

One of the principal merits of trust preferred securities is that they provide a vehicle for raising capital without diluting existing bank ownership. How? For financial reporting purposes, trust preferreds are treated as a minority interest in a consolidated subsidiary, appearing between liabilities and common shareholders’ equity on the bank holding company’s balance sheet. Because trust preferreds are not included as an equity component for purposes of calculating return on equity, earnings per share are not diluted. Trust preferred securities are more cost effective than ordinary preferred stock because you can deduct dividend (interest) payments on trust preferreds but not on regular preferred stock. (I should note here that the Financial Accounting Standards Board is considering changes to the accounting treatment of trust preferred securities, but, to date, none have been proposed.)

How do trust preferred securities compare to using more traditional forms of debtu00e2u20ac”for example, subordinated debentures or creditu00e2u20ac”to fund capital for a bank subsidiary? The benefits of trust preferreds in this context may be even more compelling.

Trust preferred securities are treated as tier-one equity rather than debt for capital adequacy purposes (currently up to 25% of total core capital elements). In contrast, subordinated debentures count only as a component of tier-two capital for the first five years of a typical 10-year debenture. After that, their tier-two capital treatment must be phased out over the remaining five years. Alternatively, if a holding company takes out a loan or line of credit to raise capital, it typically is subject to restrictive operating covenants. In both cases, trust preferreds are more advantageous than traditional forms of debt.

Putting Trust Preferred Securities Proceeds to Work

Now suppose your holding company has issued trust preferred securities, and the cash proceeds of the stock sale are in place. What might you do with the resulting capital? As a long-term financing instrument, trust preferreds are well suited for a variety of uses, from funding growth to repurchasing common stock. Indeed, trust preferreds have enough advantages that most institutionsu00e2u20ac”even many smaller onesu00e2u20ac”should consider these hybrid instruments as part of their capital and funding plans.

There are many ways to put trust preferred securities proceeds to work.
Funding from trust preferreds can be used to

• provide funding to make acquisitions or purchase branches while maintaining capital ratios;
• make capital contributions to subsidiaries for further leveraging and to support growth;
• refund existing straight cumulative preferred stock either at its maturity or call;
• repurchase common stock to improve earnings per share and thereby potentially increase long-term shareholder value;
• repurchase stock to reduce the number of shareholders in order to qualify for a Subchapter S election;
• raise equity in Subchapter S corporations without risking exceeding the maximum shareholder limit;
• repurchase existing preferred stock in connection with a Subchapter S election;
• enhance overall capital without diluting the ownership position of existing common stock shareholders; and
• reduce the cost of capital for a portion of regulatory capital.

Good News for Virtually All Institutions

The feasibility of using publicly issued trust preferred securities has been effectively restricted to large bank holding companies because an issue size of $15 million to $20 million generally has been required to be a rated issuer in the trust preferred securities public markets. Although this size requirement is no longer set in stone, other properties of trust preferreds have kept smaller organizations from considering these instruments as alternative financing vehicles.

For example, the rating agencies will not rate individual trust preferred securities issuances by community banks, regardless of the issue size or the asset size of the issuer. In addition, many smaller holding companies are closely held, and the owners may not view public registration as an acceptable option. Finally, the costs associated with publicly issuing trust preferred securities and the complexity of the relationship between the issuer, trust, and investors have effectively excluded most smaller organizations from using trust preferreds.

Marketplace developments are changing the equation for smaller holding companies, however. The emergence of privately placed trust preferred securities under the Securities and Exchange Commission’s private placement rules and the creation of pooled or securitized trust preferreds by investment bankers are making this funding source more available and attractive for smaller institutions.

Community bankers interested in testing the waters should focus on the following five areas:

Pooled Trust Preferred Securitiesu00e2u20ac”In a pooled trust preferred securities issue, a number of bank holding companies collectively sell trust preferreds to a trust or limited liability corporation created by an investment banking firm. The pool sells to investors a variety of long-term notes that are collateralized by the individual trust preferreds. These notes may be tiered, meaning that they may carry different interest rates, maturities, and rights to the cash flow generated by the pool. The assets of the trust or LLC are the trust preferred securities issued by the participating institutions. As a result, these individual issues can be much smaller than the $15 million to $20 million required for single issuers.

Each pool specifies eligibility requirements for participating holding companies. Generally, to participate in a pooled trust preferred securities issue, a community bank holding company must have total assets of at least $200 million, deposits insured by the Bank Insurance Fund, a minimum of five years’ operating history, “average or better” financial performance relative to peers, and a tier-one capital-to-risk asset ratio of at least 10%, including the trust preferred securities.

Although trust preferred pools use fairly standard forms, you should seek legal and investment banking assistance if you wish to participate in a pooled trust preferred securities issue. The typical minimum transaction size is $3 million, with a term of 30 years and a call option after five years.

Private Placementu00e2u20ac”Trust preferred securities may be issued to directors or other limited groups of accredited investors. These private placements are particularly advantageous for closely held bank holding companies.

Trust preferreds also can be sold directly to institutional investors, including other banks. Each of the bank regulators has rules that permit banks and savings institutions to invest in trust preferred securities as long as they meet certain rating and marketability requirements. This option may be especially attractive for smaller institutions that may not be eligible for participation in a trust preferred securities pool.

Finally, holding companies may participate in a trust preferred securities issue held by a “lead bank,” similar to how banks engage in credit participations. This alternative also may be attractive to smaller bank holding companies whose issue size is too small for inclusion in a pool.

Purchasing Trust Preferred Securities as Loansu00e2u20ac”Even if your institution doesn’t have a current need to issue trust preferred securities as a funding vehicle, another possibility may be attractive. Banks have received regulatory approval to purchase privately placed trust preferreds and treat them as loans.

Interpretive Letter No. 908, released last spring by the Office of the Comptroller of the Currency, articulates the issues that the regulators have considered. The interpretation was in response to a situation in which a national bank wished to purchase trust preferred securities issued by a wholly owned business trust organized by another bank holding company. The OCC had previously permitted national banks to purchase and hold trust preferreds as investment securities, but to qualify for that treatment, the securities must meet certain rating and marketability requirements.

Trust preferred securities sold in private placements do not clear these hurdles.

Instead, the OCC reasoned that the National Bank Act expressly authorizes banks to purchase and hold debt securities as loans. The OCC characterizes trust preferred securities as “debt-like instruments,” which may be purchased and held as loans under banks’ authority to discount and negotiate evidences of debt.

If you choose this option, you must comply with your institution’s applicable lending limit requirements found in the banking regulations. The OCC also advises you to conduct an independent analysis of the deal and not rely completely on the representations of the seller.

Trust Preferred Securities for Subchapter S Corporationsu00e2u20ac”Trust preferred securities can also be quite advantageous to banking institutions organized as Subchapter S Corporations. An S Corporation is not permitted to have more than one class of outstanding stock, so it cannot issue ordinary preferred stock. However, trust preferreds are not considered a separate class of outstanding stock. In addition, an S Corporation is subject to limitations on the total number of shareholders. Trust preferreds do not push S Corporations over the limit because investors in trust preferred securities are not considered shareholders.

Capitalizing on the Trust Preferred Securities Opportunityu00e2u20ac”The following five-step program is recommended when considering trust preferreds:

1. Develop strategic objectives for use of the proceeds;
2. Carefully model the impact on the balance sheet;
3. Negotiate favorable rates and terms;
4. Work with the bank’s attorneys and specialists in the field to expedite the process;
5. Proceed to funding.

Both the rates and the terms that issuers of trust preferreds can obtainare growing highly competitive, thus the opportunity to generate better pricing and terms is fast becoming a reality. The dollar savings over the life of the instrument can be significant, and the terms can provide the flexibility every banker wants when raising additional capital.

The Bottom Line

The bottom line is that trust preferred securities are still not for everybody. But the new issuance structures that have emerged make this long-term financing vehicle a feasible balance sheet management tool for a wider variety of banking organizations, not just the largest ones. In many cases, trust preferreds may be appropriate as part of a broad strategy to increase long-term shareholder value. In any case, their many benefits make trust preferred securities well worth exploring with your financial adviser.