Increasing Capital With Trust Preferred Securities
By: LYNN M. GARDIN
June 2001
Bank holding companies continue to utilize the trust preferred securities model approved by the Federal Reserve Board in October of 1996 to increase the company's capital. The popular security results in an interest expense deduction (like debt) and yet is considered as capital for regulatory and accounting purposes.
To create this form of capital, the holding company creates a Delaware statutory business trust. The trust's common securities (which represent 3% of the trust assets) are owned by the holding company. The trust's preferred securities (which represent 97% of the trust assets) are sold to one or more investors. The trust uses the proceeds received from the sale of the common securities and the preferred securities to purchase a subordinated debenture issued by the holding company. The proceeds received from the sale of the holding company's debenture are used by the holding company to increase its capital.
All distributions to the trust's security holders are dependent on the subordinated debenture payments from the holding company to the trust. As the holding company makes interest payments on the subordinated debentures to the trust, the trust uses those funds to make the dividend payments on the trust securities.
Typically, the subordinated debenture has a 30-year term, which could be shortened or extended if certain conditions are met (including the holding company having received prior approval of the Federal Reserve to do so if then required under applicable capital guidelines or policies of the Federal Reserve). The holding company must have the right to defer payment of interest on the subordinated debenture at any time for a period of at least five years with respect to each deferral period. Once the holding company has paid all accrued interest, then it may elect another deferral period. The subordinated debenture is unsecured and deeply subordinated and junior in right of payment to all senior indebtedness of any nature.
The deep subordination, the long maturity date and the ability to defer interest are characteristics which allow the treatment of the trust preferred securities as capital for regulatory and accounting purposes. A significant benefit to the structure is the holding company's ability to deduct for federal income tax purposes the interest paid to the trust on the subordinated debentures, and the "pass-through" nature of the trust (such that the income received by the trust is not taxed at the trust level but instead passes through to the preferred security holder where it is taxed as interest income).
If your bank holding company is in need of capital, consider the use of trust preferred securities and the resulting benefits of nondilution of equity ownership and favorable tax treatment.