In the wake of the near collapse of the American banking system, much attention has been given to how to prevent a recurrence. One of the things that U.S. (as well as non-U.S.) banking regulators are talking about is “contingent capital.” For example, last month, William Dudley, president of the Federal Reserve Bank of New York stated that the Fed was “extremely interested” in the contingent capital idea.1

What is contingent capital? Broadly speaking, contingent capital is a hybrid security, the purpose of which would be to provide a financial institution leverage in good times, but provide a buffer in bad times. For example, the instrument, in good times, would act like debt and provide leverage to the institution. In bad times, when the issuer finds it difficult to raise capital, it would act as equity, and provide a cushion to convince depositors and other creditors that their money is safe.

So what might contingent capital be? The most straight-forward contingent capital instrument would be mandatorily convertible debt. In this structure, the issuer would issue a debt instrument to investors. Upon certain events (e.g., a decline in its tangible common equity, Tier 1 capital, or other regulatory events) the debt instrument would automatically convert into a predetermined amount of the issuer’s equity. A more complicated structure is one in which the issuer creates a separate entity, which raises proceeds by issuing securities to investors and then purchases securities from, and enters into financial contracts with, the issuer. This entity would be structured to be a pass-through entity for tax purposes. For example, the proceeds raised from investors could be invested in short-term highly liquid debt instruments. In addition, the separate entity could enter into a contract with the issuer. Under the terms of the contract, the issuer would have the right to sell its equity to the separate entity at any time. In addition, under the contract, there could be automatic triggers, such as the ones described above. Under this structure, the notion is that the entity’s short-term assets will be available to invest in the issuer’s stock when the contract is exercised.

In November, a Lloyds Banking Group affiliate issued £9 billion in a form of contingent capital called “enhanced capital notes” to existing Tier 1 and Upper Tier 2 security holders. The purpose of the offering was to allow Lloyds to avoid the need for further support from the U.K. government. The enhanced capital notes have a ten year term and pay fixed, non-deferrable interest. They are convertible into a fixed number of Lloyds ordinary shares if Lloyds’ consolidated core Tier 1 ratio falls below five percent.

Earlier this month, the U.S. House of Representatives passed the “Wall Street Reform and Consumer Protection Act of 2009” (H.R. 4173), which contains a section on “contingent capital.” That section would authorize the Federal Reserve Board of Governors to issue regulations “that require a financial holding company to maintain a minimum amount of long-term 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.”

In the U.S. the exact form a contingent capital security will take, if any, is not clear. From a federal income tax standpoint, however, a mandatory convertible type security a la Lloyd’s enhanced capital notes raises serious federal income tax issues if the issuer intends to claim a deduction for interest on the security. For example, creditors rights are an important, if not essential, element of debt treatment for U.S. federal income tax purposes. Whether a holder of a mandatory convertible has creditors rights is unclear and will depend on the “trigger” built into the instrument. Thus, under the formulation in H.R. 4173 a holder would have creditors rights so long as the issuer’s distress does not coincide with “threats to United States financial system stability”. Is that sufficient to give the holder creditors rights? Also, depending on the circumstances, the actual conversion of a contingent capital security into equity may be unlikely to occur so that the expectation is that a holder will be paid in full on its debt claim. Should that be taken into account, and if so, what is the standard, a reasonable expectation of repayment? Other tax issues arise under section 163(l) which disallows an interest deduction for corporate debt payable in the issuer’s equity. Should that section apply to a contingent capital instrument? If contingent capital is to become a reality in the U.S. and issuers demand an interest deduction for interest on the security, these questions and others will have to be answered by counsel, if possible, or, in a perfect world, by the Treasury.