Redemption of trust preferreds following new Federal Reserve capital rules

On June 7, 2012, the Federal banking agencies (the OCC, Federal Reserve Board and FDIC) (the “Agencies”) formally proposed for comment, in three separate but related proposals, significant changes to the U.S. regulatory capital framework: the Basel III Proposal, which applies the Basel III capital framework to almost all U.S. banking organizations; the Standardized Approach Proposal, which applies certain elements of the Basel II standardized approach for credit risk weightings to almost all U.S. banking organizations; and the Advanced Approaches Proposal, which applies changes made to Basel II and Basel III in the past few years to large U.S. banking organizations subject to the advanced Basel II capital framework.⁹ The publication of these proposals constitutes, for most issuers, a Tier 1 capital event under the terms of their outstanding trust preferred securities, and as a result permits them to call their trust preferreds.

Basel III Proposal

This proposal is applicable to all U.S. banks that are subject to minimum capital requirements, including Federal and state savings banks, as well as to bank and savings and loan holding companies other than “small bank holding companies” (generally bank holding companies with consolidated assets of less than $500 million). There will be separate phase-in/ phase-out periods for minimum capital ratios; regulatory capital adjustments and deductions; non-qualifying capital instruments; capital conservation and countercyclical capital buffers; supplemental leverage ratio for advanced approaches banks; and changes to the Agencies Prompt Corrective Actions (“PCA”) rules. Almost all of these changes would be effective by January 1, 2019.

Common Equity Tier 1 Capital would be the sum of outstanding common equity tier 1 capital instruments and related surplus (net of treasury stock), retained earnings, accumulated other comprehensive income, and common equity Tier 1 minority interest, minus certain adjustments and deductions. Unrealized gains and losses on all available-for-sale securities held by the banking organization would flow through to common equity Tier 1 capital. Qualifying common equity Tier 1 capital would have to satisfy 13 criteria that are generally designed to assure that the capital is perpetual and is unconditionally available to absorb first losses on a goingconcern basis, especially in times of financial stress.

Standardized Approach Proposal

This proposal would be generally applicable to the same banks that would be subject to the Basel III Proposal. The proposed effective date is January 1, 2015, but banks have the option to adopt rules earlier. The proposal revises a large number, although not quite all, of the risk weights (or their methodologies) for bank assets. For nearly every class, the proposal requires a more complex, detailed and calibrated assessment of credit risk and calculation of risk weightings.

Advanced Approaches Proposal

This proposal applies to banking organizations that are subject to the “advanced approaches” rule under Basel II, including qualifying Federal and state savings associations and their holding companies. It addresses counterparty credit risk, removal of credit rating references, securitization exposures, and conforming technical changes. It also proposes the expansion of those banking organizations that are subject to the market risk capital rule.

Effect on Tax Deductible Bank Equity

As anticipated, the NPR would make the issuance of tax deductible bank equity much more difficult. For example, in the proposal, the banking agencies go beyond Basel III and note that instruments that are debt for GAAP purposes would not qualify as Tier 1 equity. The banking agencies have requested comment on this, and we anticipate that commenters may note that the more stringent U.S. requirement will put depository institutions in the United States at something of a competitive disadvantage.

The NPR, however, does leave some room for “REIT preferred.” In a REIT preferred transaction, the bank sets up a subsidiary that elects to be taxed as a real estate investment trust (“REIT”) for federal income tax purposes. The bank contributes cash or assets in exchange for the REIT’s common stock. The REIT issues non-cumulative perpetual preferred stock to investors. The terms of the REIT preferred provide that it will convert to bank stock upon the occurrence of certain regulatory events. The REIT uses the proceeds from the sale of the preferred and common stock to acquire qualifying REIT assets, e.g., mortgage loans either from the bank or in the market. Income on the assets is used to pay distributions on the REIT preferred with the remaining income being paid as dividends on the common stock. Because the REIT is a pass-through for federal income tax purposes, the transaction achieves the equivalent of a deduction for federal income tax purposes, that is, income on the REIT’s assets to the extent distributed on the REIT preferred is not subject to a corporate level tax. From a bank regulatory standpoint, the REIT preferred is treated as Tier 1 capital, e.g., equity in a subsidiary. Such transactions have been undertaken since the mid-1990s by banks including Chase Manhattan Bank. More recently, in 2006 Washington Mutual Bank issued a REIT preferred that converted into Washington Mutual, Inc. stock when Washington Mutual, Inc. went bankrupt in 2008.

The NPR requires that the REIT be an “operating company."¹⁰ It is not entirely clear what this means, however, it potentially means that the REIT must be in a profit-making business facing customers. Moreover, the NPR advises that the REIT structure must contemplate suspension of dividends on the REIT preferred. The concern here is that the REIT preferred is effectively cumulative because the REIT must pay dividends to avoid an entity level tax. The NPR, however, provides that a consent dividend procedure, where the common shareholder (e.g., the bank) consents to include the REIT’s taxable income in its income even though no dividend is paid on the REIT preferred or the REIT common could be sufficient. Moreover, REIT preferred is subject to the limits on minority interest set forth in the NPR. The utility of REIT preferred may be limited by the cap on minority interests, also set out in the NPR.

Redemption of Trust Preferreds

In connection with the proposed regulations and the related Tier 1 capital event, financial institutions are redeeming outstanding trust preferred securities due to the loss of Tier 1 capital status. For example, on June 11, 2012, JP Morgan Chase & Co. announced that certain of its trusts will redeem all of the issued and outstanding trust preferred capital securities.