Thomas A. Humphreys, Morrison & Foerster LLP
Anna T. Pinedo, Morrison & Foerster LLP
Benjamin Katz, HSBC Securities (U.S.A.) Inc.
June 29, 2011
NY2 689798
© 2011 Morrison & Foerster LLP All Rights Reserved | mofo.com
Financing and Liability Management
Developments for
Financial Institutions
Agenda
 Introduction
 Market update
 Regulatory developments
Dodd-Frank
Basel III
Securitization market
 Smaller financial institutions
TARP repayment
Restructurings/exchanges
 Large financial institutions
Addressing outstanding trust preferreds
Preparing to replace trust preferreds
 replacement capital covenants
 remarketings
2
Agenda
 Large financial institutions (cont’d)
“Replacements” for trust preferreds
Contingent capital
 Liability management considerations
3
Introduction
 Commentators have noted that banks had insufficient capital to
weather the extreme stresses of the financial crisis
 Rating agencies and policymakers observed that certain hybrid
instruments (which had traditionally been used by financial
institutions) may not have been as “loss absorbent” as had been
anticipated
 Investors also reacted negatively at the opacity of certain more
complex financial instruments and questioned the reliability of
regulatory capital ratios
Reliance on TCE
Return to simplicity
4
Market Update
5
Healthy New Issue Supply
Weekly Investment Grade New Issue Volume
2011 supply is up 40%
versus the same period
in 2010
40
35
3yr, 5yr and 10yr
remain the favored
maturities
Volume ($bn)
30
FRNs up 4x versus
2010 as a percentage of
total volume
Financial
Investment Grade Supply
$bn
%FIG
2011YTD 435
55%
2010FY
711
49%
2009FY
715
35%
2008FY
619
52%
2007FY
743
64%
Corporate
25
20
15
10
5
Yankee financial
borrowers continue to
take advantage of the
U.S.’s firm market tone
0
Jan
10
Rating
Aaa
Aa
A
Baa
Jan
17
Jan
24
Jan
31
Feb
7
Feb
14
Feb
21
Feb
28
Mar
7
Mar
14
Maturity
XO
<2
2% 3%
2
3
10%
4-6
7-9
10-12
Mar
21
Mar
28
Apr
04
Apr
11
Apr
18
Apr
25
May
2
Coupon Type
fixed
>12
frn
May
9
May May
16
23
Dom FIG
1% 5%
Y FIG
May Jun
30
6
Jun
13
Jun
20
Sector
Dom Corp
Y Corp
12%
19%
26%
24%
30%
34%
33%
32%
31%
2%
81%
25%
Source: IFR Corporate & Financial Issuance
30%
6
Financial Issuance by Maturity
Issuance Volume by Maturity
Year-to-date, twothirds of financial
supply is less than
10yrs in tenor
<2yr
2yr
3yr
4-6yr
7-9yr
10-12yrs
>12yr
600
500
$473bn
$473bn
$431bn
We expect increased
issuance in 10yrs as
regulators push
banks to issue
longer-dated
liabilities
400
Issuance ($bn)
The increase in 3yrs
has been driven by
FRNs
$348bn
$321bn
300
$251bn
$239bn
200
100
0
2005
2006
5yrs currently is
seeing very strong
investor demand
2007
2008
2009
2010
2011
4%
5%
Issuance Percentage by Maturity
<2yr
2yr
3yr
4-6yr
7-9yr
10-12yrs
100%
90%
19%
80%
70%
14%
10%
19%
22%
18%
29%
4%
29%
29%
40%
26%
25%
2%
2%
27%
1%
25%
29%
2%
3%
2%
36%
27%
60%
50%
>12yr
41%
37%
17%
2%
2%
1%
2010
2011
32%
30%
23%
Source: IFR Financial Issuance
20%
10%
0%
12%
31%
12%
7%
12%
14%
12%
0%
1%
0%
9%
0%
14%
3%
1%
2005
2006
2007
2008
2009
7
5%
Secondary Performance Across Sectors
Corporate, Insurance and Bank
Sector Spread Performance
Current
173
187
111
CORP
INS
Sector Share Performance
BANK
S&P
INS
550
500
100
105
Relative Performance
450
Spread (bps)
400
350
300
250
200
187
150
173
75
45
25
111
100
50
Jun-06
Jun-07
Jun-08
Jun-09
Jun-10
0
Jun-06
Jun-11
Secondary Market Liquidity
Daily TRACE Vol
Jun-07
Jun-08
Jun-09
Jun-10
Jun-11
10-year Composite Index
AA
Dow Jones
18.0
13000
16.0
12800
14.0
A
BBB
9.0
8.0
12600
12400
10.0
12200
8
Jan-11
May-11
Sep-10
Jan-10
3.0
May-06
6/24
6/21
6/16
6/8
6/13
6/3
5/31
5/25
5/20
5/17
5/9
5/12
11400
5/4
0.0
Yield Curr Dif Max Dif
AA 4.10%
--A 4.42% 32bps 121bps
BBB 4.80% 70bps 284bps
4.0
May-10
11600
Sep-09
2.0
5.0
11800
Jan-09
4.0
12000
6.0
May-09
6.0
$8.7bn
$8.5bn
$7.9bn
$11.7bn
$11.1bn
$12.6bn
Sep-08
2006
2007
2008
2009
2010
2011
Jan-08
8.0
Dow Index
7.0
12.0
4/29
Daily Volume ($bn)
54
50
May-08
In financials,
equity valuations
remain well below
pre-crisis levels
while corporates
(as measured by
the S&P) are
trading above
their ’06 levels
Despite the
recent downturn
in equities and
market sentiment,
secondary
trading in
investment grade
bonds has not
diminished
BANK
125
600
Sep-07
AVG
243
223
137
Jan-07
MAX
564
584
361
May-07
MIN
74
85
76
Sep-06
Sector
Bank
Insurance
Corporate
Historical ‘A’ Spread vs. Yield Analysis
‘A’ 5yr Financial Spread vs. Yield Performance
5yr Spread
5yr Yield
9
6
5
Yield
2.86
5.05
2.74
8.28
Spread
+141
+154
+55
+619
600
500
400
4
300
3
Spread (bps)
Current
Avg
Min
Max
7
Yield (%)
The current yield and
credit spread
environment create a
compelling new issue
environment
700
8
200
2
100
1
Jun-11
Jun-10
Jun-09
Jun-08
Jun-07
Jun-06
Jun-05
Jun-04
Jun-03
Jun-02
Jun-01
0
Jun-00
0
‘A’ 10yr Financial Spread vs. Yield Performance
10yr Spread
10yr Yield
12
700
Current
Avg
Min
Max
10
Yield (%)
8
Yield
4.42
5.83
3.91
9.63
Spread
+149
+163
+68
+590
600
500
400
6
300
4
9
Jun-11
Jun-10
Jun-09
Jun-08
Jun-07
Jun-06
Jun-05
Jun-04
Jun-03
0
Jun-02
0
Jun-01
100
Jun-00
Source: HSBC, Bloomberg
200
2
Spread (bps)
The 10yr UST yield is
over 70bps below the
high reached earlier
this year
Subordination Premium: EUR, GBP, USD
iBoxx EUR Senior and Subordinated Indices
EUR Financials Sr
EUR Financials Sub
1000
EUR
Min
Max
Average
Current
750
Spread (bps)
The US market looks
advantageous to
issuers looking to
print capital trades
given the
substantially lower
subordination
premium in the US
500
Sr
14
334
91
116
Δ
21
558
147
197
Sub
35
892
238
313
250
0
Feb-05
Mar-06
Mar-07
Apr-08
Apr-09
May-10
May-11
iBoxx GBP Senior and Subordinated Indices
GBP Financials Sr
GBP Financials Sub
1000
Spread (bps)
750
500
GBP
Min
Max
Average
Current
Sr
26
421
137
176
Δ
20
321
105
169
Sub
46
742
242
344
250
0
Feb-05
Mar-06
Mar-07
Apr-08
Apr-09
May-10
May-11
Illustrative USD Example: GECC (Sr Rtg Aa2 / AA+, Sub Rtg Aa3 / AA)
Sub Premium
180
Z-Spread (bps)
160
140
GECC Sub 10yr
100
Subordination
Premium has
Averaged
~28bps
80
60
120
40
100
20
80
Jan-11
0
Jan-11
Feb-11
Mar-11
10
Apr-11
Apr-11
May-11
Subordination Premium (bps)
Source: iBoxx, HSBC
GECC Sr 10yr
The Dodd-Frank Act
11
Dodd-Frank
 Generally, imposes more stringent regulatory capital requirements on
financial institutions
 Requires the Council to make recommendations to the Fed regarding the
establishment of heightened prudential standards for risk-based capital, leverage,
liquidity and contingent capital
 Requires that the Fed, on its own, or with recommendations from the
Council, establish prudential standards for supervised nonbanks and
for bank holding companies with total consolidated assets equal to or
greater than $50 billion, that include:
 risk-based capital requirements,
 leverage limits,
 liquidity requirements,
 overall risk management requirements,
 requirements for a resolution plan, and
 concentration limits
12
Dodd-Frank
 Incorporates a revised Collins amendment (Sec 171)
Requires the establishment of minimum leverage and risk-based capital
requirements
Sets as a floor at the risk-based capital requirements and the Tier 1 to total assets
standard applicable to insured depository institutions under the prompt corrective
action provisions of the FDIA
 No deduction for investment in bank subsidiaries
 Effect on accounting issues and risk weights is unclear
 Limits discretion in establishing Basel III requirements (U.S. can
adopt more onerous standards, but cannot adopt looser standards)
13
Dodd-Frank
 Raises the specter of additional capital requirements for activities
that are determined to be risky
 Derivatives, securitized products, financial guarantees, securities borrowing and
lending and repos
 Assets valued based on models
 Concentrations of market share
 These requirements become effective upon implementing
regulations, which are required within 18 months of enactment
14
Dodd-Frank hybrid timeline
 Rules promulgated pursuant to the Collins amendment are expected
to exclude trust preferreds and other hybrids from the numerator of
Tier 1, subject to limited exceptions
 Mutual holding companies and thrift and bank holding companies with less than
$15 billion in total consolidated assets are not subject to this exclusion
 Intermediate U.S. holding companies of foreign banks have a five-year phase-in
period
 For newly issued securities (hybrids issued after May 19, 2010), the requirement
is retroactively effective
 For bank holding companies and systemically important nonbank financial
companies, phase-in for hybrids issued prior to May 19, 2010 will be phased in
from January 2013 to January 2016
15
Dodd-Frank hybrid timeline
 Within 18 months of enactment, the Comptroller must conduct a
study of the use of hybrid capital instruments as a component of Tier
1, which shall consider, among other things:
 the benefits and risks of allowing instruments to be used to comply with Tier 1
requirements,
 the economic impact of prohibiting the use of hybrids, and
 possible specific recommendations for legislative or regulatory actions regarding
the treatment of hybrids
16
Dodd-Frank
 Within two years of enactment, the Council must present the results
of a study on contingent capital that considers, among other things,
an evaluation of:
 the effect on safety and soundness of a contingent capital requirement,
 the characteristics and amounts of contingent capital that should be required,
and
 the standards for a triggering requirement
 Following the study, the Council may make recommendations to the
Fed to require a minimum amount of contingent capital
17
Basel III
18
Overview
 On December 17, 2009, the BCBS announced far-reaching
proposals for comment. From December 2009 to November 2010,
there were a number of revisions to these proposals
 Most of the significant elements of the framework have now been
finalized. The G-20 at its November 2010 meetings endorsed the
agreements that had been reached.
 The new Basel framework (referred to as Basel III) responds to the
comments and statements of the G-20, as well as of policymakers
and commentators, and their collective assessments regarding
loopholes or weaknesses that may have contributed to the financial
crisis.
19
Four major components
 Quality, consistency and transparency of the capital base
Greater emphasis placed on the common equity component of Tier 1 capital
Simplification of Tier 2
Elimination of Tier 3
Detailed regulatory capital disclosure requirements
 Enhancement of risk coverage through enhanced capital
requirements for counterparty credit risk
Enhanced risk coverage will address issues that arise in connection with the use
of derivatives, repos, and securities financing arrangements
 Changes to non-risk adjusted leverage ratio
This ratio will supplement the Basel II risk capital framework
 Measures to improve the countercyclical capital framework
20
Quality, Consistency & Transparency
 The definition of Tier 1 capital will move toward the definition of
“tangible common equity.”
 Tier 1 capital (referred to as going concern capital) must consist
primarily of common equity + retained earnings – regulatory
adjustments (including deductions of tangible assets).
 Non-equity Tier 1 must be subordinated and have discretionary
dividends/coupons with no incentive to redeem in times of stress.
 There will be an explicit minimum ratio of common equity to risk
weighted assets.
 There will be specific eligibility criteria for common equity.
21
Eligibility Criteria for Common Equity
 14 criteria are identified, which must be satisfied in order for common
shares to be included as common equity.
 Common shares must be fully subordinated to all other claims in
liquidation, with no fixed or capped claim on liquidation, except at the
discretion of the issuing bank. There cannot be any obligation on the
issuer’s part to repurchase or redeem the securities.
 Several “innovative” Tier 1 instruments would be phased out,
including, for example, step up instruments; cumulative preferred
stock; and trust preferred securities.
22
Tier 1 Additional Going Concern Capital
 Tier 1 Additional Going Concern Capital also is defined by reference
to specific criteria, including that:
The instrument is subordinated to depositor claims;
The instrument is perpetual, with no maturity date or incentive to redeem;
The instrument may be redeemable at the issuer’s option only after five years and
then subject to certain conditions
The instrument must permit discretion on the issuer’s part to cancel payments
The instrument cannot impede recapitalization
23
Tier 2 and Tier 3 Capital
 The framework simplifies Tier 2 capital by establishing a single set of
eligibility criteria for Tier 2 capital and eliminating Upper and Lower
Tier 2.
 In order to qualify as Tier 2 capital, Tier 2 must be subordinated to
depositors and general creditors; not secured; not guaranteed; must
have an original maturity of at least five years; and must be callable
by the issuer only after a minimum of five years.
 Tier 3 will be eliminated completely.
24
Regulatory Adjustments to Be Harmonized
 Currently, regulatory adjustments vary across jurisdictions. The
framework will provide for harmonized adjustments that will be
applied to the common equity component of Tier 1 (in contrast to
applying currently to Tier 1 + Tier 2).
 Harmonized adjustments will include:
Minority interests;
Deferred tax assets up to a limit;
Shortfall in reserves;
Goodwill and other intangibles (including mortgage servicing rights);
Unrealized gains and losses;
Gains and losses due to changes in own credit risk; and
Defined benefit pension fund assets and liabilities.
25
Highlights
 Minimum common equity requirement will be set at 4.5% (up from
2%) of risk weighted assets.
 Minimum Tier 1 capital requirement will be set at 6% (up from 4%).
 Minimum total capital requirement will be set at 8%.
 Capital conservation buffer: for each category, there will be a 2.5%
conservation buffer that must be met with equity. If an institution
“uses up” the conservation buffer and approaches the minimums it
will become subject to restrictions on dividends, restrictions on
compensation, etc.
26
Basel III Capital Threshold Phase-ins
Phase-in arrangements (all dates are of January 1 of each year)
(%)
2011
2012
2013
Minimum Common Equity Capital Ratio
3.50
2014
2015
4.00
4.50
Capital Conservation Buffer
2016
2017
2018
2019
4.50
4.50
4.50
4.50
0.625
1.25
1.875
2.50
Minimum Common Equity plus Capital Conservation
Buffer
3.50
4.00
4.50
5.125
5.75
6.375
7.00
Minimum Tier 1 Capital
4.50
5.50
6.00
6.00
6.00
6.00
6.00
6.625
7.25
7.875
8.50
Minimum Tier 1 Capital plusCapital Conservation
Buffer1
Minimum Total Capital
8.00
8.00
8.00
8.00
8.00
8.00
8.00
Minimum Total Capital plus Capital Conservation
Buffer
8.00
8.00
8.00
8.625
9.25
9.875
10.50
20
40
60
80
100
100
Phase-in of deductions from Tier 1(including
amounts exceeding limit for DTAs, MSRs and certain
investments)
Phase-out capital instruments no longer qualifying
as Tier1 capital or Tier 2 capital
Phased out over 10 year horizon
(10 per year beginning 2013)
Public Sector Capital Injections
Leverage Ratio
Liquidity Coverage Ratio (LCR)
Net Stable Funding Ratio (NSFR)
Source:
Not included in capital
(as of Jan. 1 2018)
Included in Capital
Parallel run
Jan. 1 2013 – Jan. 1 2017
Disclosure startsJan. 1 2015
Supervisory monitoring
Final
Adjustments
3.0 (Unless Adjusted)
Introduce
minimum
standard
Observation
period begins
Introduce
minimum
standard
Observation
period begins
Annex 2, BCBS Press release, Group of Governors and Heads of Supervision announces higher global minimum capital standards, 12 September 2010
27
Smaller Financial Institutions
28
Smaller banks
 Threshold issues:
Will Collins trust preferred phase out be applicable?
Will Basel III be applied to smaller banks?
What regulatory capital structure will develop?
 Various categories
Some banks still need to repay TARP
Some must undertake restructurings and obtain capital infusions
Some stronger banks have emerged that are well positioned to make acquisitions
29
Repaying TARP
 PIPE transaction
 Registered direct or wall-crossed offering
 Usually multiple offerings
common stock
non-cum preferred stock
debt in certain cases
30
Restructurings
 Many small banks had financed with trust preferreds and sold trust
preferreds into “pooled” vehicles, or trust preferreds CDOs
 Even where private equity investors are interested in making an
investment in a distressed institution, recapitalizations or
restructuring transactions are often made difficult by trust preferred
CDOs
 CDO interests principally held in street name through DTC, making it
difficult to contact holders directly
 Restructurings will raise a host of tax issues
31
How do trust preferreds work?
 What is a “trust preferred security”? Technically, it is a preferred
equity interest in a special purpose statutory trust whose assets
consist entirely of the junior subordinated debt of the BHC
Sub. Debt
Indenture Trustee
BHC
100% of
Bank
Common
Stock
Bank
CDO Indenture
Trustee
Owner
Trustee
Capital Trust
(Statutory
Trust)
32
Trust
Preferred
Securities
Cash
Investors (or
CDO Trust)
Investors (if a
CDO Trust)
How do trust preferred CDOs work? (cont’d)
 Pooled TruPS CDO Structure:
CDO Trust
AAA Senior Class
Sequentially Lower Rated Senior
and Mezzanine Classes
CDO Trustee
(e.g., BNY Mellon)
Subordinated Classes
TruPS
BHC 1
BHC 2
BHC 4
BHC 3
BHC 5
 Assets of the CDO Trust consist of TruPS sold by multiple BHCs
(up to 30 or 40 contributors in some deals)
33
How do trust preferreds work? (cont’d)
 In order to obtain regulatory capital treatment, BHC TruPS provide
that interest may be deferred up to 5 years if the BHC cannot pay it.
 This is not considered a default
 Most BHC TruPS issued prior to the financial crisis are in deferral
 Note that there are at least 2, and in many cases 3, trustees in a
TruPS transaction. This is a source of considerable confusion, but is
critical to understand
 First, the junior subordinated debentures (the “Sub Debt”) are issued under an
indenture (the “Sub Debt Indenture”) with an independent indenture trustee (the
“Sub Debt Indenture Trustee”)
 Second, the issuer of the TruPS, typically a Delaware statutory trust, is
administered by a trustee (the “Owner Trustee”)
 Third, the TruPS are contributed to a CDO trust (“CDO Trust”). The CDO debt
obligations are issued pursuant to a CDO indenture (the “CDO Indenture”)
administered by an independent indenture trustee (the “CDO Indenture Trustee”),
more often than not The Bank of New York (“BNY Mellon”)
34
Blocking Role of TruPS Holders
 As holders (in effect) of debt securities, TruPS investors have the
benefit of negative covenants in the Sub Debt Indenture that gives
them rights to consent to, or block, various types of corporate
transactions, and which rights are even more extensive when the
Sub Debt is in an interest deferral period:
 No merger or consolidation, or sale of substantially all assets, of the BHC unless
merger counterparty or acquiror expressly assumes TruPS subordinated debt in a
supplemental indenture (without consent of TruPS holders)
 During interest deferral period, no payment of dividends on common or preferred
stock, or repurchase or redemption of common or preferred stock
 Consent to these actions requires majority or 66 2/3% of Sub Debt
holders, depending on deal (note that there is a single holder--the
CDO Indenture Trustee--in CDO deals)
 As in almost all debt deals, changes affecting material terms of the
TruPS, such as interest rate, maturity and principal amount, cannot
be made without consent of all affected TruPS holders
35
Blocking Role of TruPS Holders (cont’d)
 These rights make it difficult to induce new investors to recapitalize
the BHC or a subsidiary bank without the consent of TruPS holders
 Even where it is possible to structure a recapitalization without
triggering a consent requirement, new investors are not willing to put
money into an enterprise where a substantial portion will be used to
repay non-productive TruPS holders
 Early in the financial crisis, it was sometimes possible to convince
financial holders of TruPS to resell securities to the issuing BHC at a
substantial discount
 As the financial crisis has matured, more and more TruPS have
found their way into the hands of opportunistic or “vulture” investors,
who take the position that they will not consent to a sale or
recapitalization unless they are repaid at par—even when failure to
achieve the recapitalization will doom the bank to failure and an
FDIC seizure
36
Examples of Blocking Behavior by TruPS Holders
 Sterling Financial Corporation (Spokane)
 Original Investment Agreement with THL in May 2010 called for a “TruPS
exchange” as a closing condition
 Also called for Treasury to exchange TARP securities at a deep discount
 Treasury agreed to the exchange; TruPS holders did not agree and the condition
was dropped—investors contributed $734 million in August 2010 without a TruPS
exchange
 Pacific Capital Bancorp (Santa Barbara)
 Gerald J. Ford made an offer to invest $500 million in PCB in April 2010
conditioned on Treasury exchanging TARP at steep discount, and TruPS and
subordinated debt tendering for a 20% discount
 Treasury agreed to the discount
 Despite ongoing exchange offers, including price sweeteners, TruPS holders would
not budge
 In July 2010, Ford announced he would close the deal without requiring TruPS and
subordinated debt holders to exchange, giving TruPS holders a substantial
increase in value
37
Alternatives
 363 sale – AmericanWest Bancorporation
 Prepack – CIB Marine
38
Acquisitions
 Stronger banks may need to finance in order to undertake
acquisitions. Financings may take the following forms:
financing through a PIPE transaction or a wall-crossed offering, no contingencies
• dilutive
• if acquisition bid is not successful then may prove expensive
financing with an escrow or subject to contingencies
blind pools
39
Larger Financial Institutions
40
Addressing financing needs and capital requirements
 Trust preferreds that are outstanding
 New financing
 satisfy Dodd-Frank and Basel III requirements
 tax-efficient
 attractive to investors
 Contingent capital
41
Addressing Outstanding
Hybrid Securities
42
Transactions to consider
 Consent solicitations
 Many banks had entered into replacement capital covenants in connection with their
hybrid issuances
 These banks may wish to consider consent solicitations to do away with
replacement capital covenants in order to gain additional flexibility for the future
 Banks with outstanding remarketable securities may wish to consider consent
solicitations to modify the terms of these securities prior to their remarketing date
 Tax considerations
43
Transactions to consider
 Opportunistic repurchases
 Redemptions
On a redemption date
Regulatory event – terms of most trust preferreds provide
for a special redemption if the
security will no longer be considered
Tier 1 capital
44
Risk Factors Relating to Redemption
Language
Fifth Third (FITB) recently called
its $400mm 8.875% Trust
Preferred. The main takeaway
is that FITB may have materially
impacted issuers' ability to
include par call features in
capital securities absent tightly
defined events
It is also our view that FITB’s
call was somewhat of a unique
event and we do not expect a
flood of redemptions until the
formal phase-out of trust
preferreds begins in 2013
Issuers will need to be cautious
in including language on
changing regulations as risk
factors and strike a balance
between call flexibility and
investor receptivity
• While U.S. regulators have yet to opine on the redemption of capital securities, FITB's action gives us a
window into U.S. regulators' thinking in that U.S. regulators did not object to FITB undertaking a call that was
not investor friendly
• In contrast, Canada's OSFI, made it clear that they will not require banks to redeem securities using a
Special Event Redemption call and will instead allow issuers to redeem them at the first call date if desired,
unless the bank needs to do so in order to meet its Basel 3 minimum capital requirements
• It is notable that OSFI in its press release specifically intended for banks to act in an investor friendly
manner by not calling securities that were trading well-above the call price
• If the market interpretation of the U.S. regulators' view is correct following FITB's announcement, the Fed's
opinion on calling such securities will likely not be as investor friendly
• This is consistent with our view that U.S. regulators are "nudging" issuers to utilize common stock and
preferred stock for capital and to rely less on other forms of securities
• FITB later announced that they will compensate investors who purchased the 8.875% Securities between
May 16 and May 18 for any amount they paid above $25.18. This payment was to compensate investors
who purchased the security after Fifth Third delivered the call notice to its Trustee but before Fifth Third filed
an 8-K
• Most Preferreds include in their redemption language a 90 day window in which the issuer can call the
security after a capital treatment event. Fifth Third's redemption language lacked the 90-day limitation to the
call following a capital treatment event, making them redeemable at virtually any point in time after a change
in regulatory capital treatment associated with the security
• Fifth Third's documentation only called for a make-whole call in the event of a "rating agency event". The
make-whole price would have been ~2 points higher than the price the securities were trading at, as
opposed to the $25 par call price, which was ~1.5 points below where they were trading
• Although Comerica also utilized a par call in September 2010 when CMA redeemed its 6.576% trust
preferred securities, those securities were trading in the $94-95 range and were called at par ($100). At the
time CMA issued a statement saying "The recently signed Dodd-Frank Act changes the treatment of this
type of security, so it is no longer an effective form of equity capital for us."
45
Transactions to consider
 Tender offer – requires cash
 Exchange offer
private exchange
3(a)(9) exempt exchange
registered exchange
46
Tax considerations for issuers
 An issuer may be required to recognize cancellation-of-indebtedness
(“COD”) income if all or a portion of its debt has been economically
cancelled.
 Corporations that issue obligations with OID as part of their
restructuring need to be mindful of potential limitations on the
deductibility of this discount.
 For corporations that issue certain high yield obligations with
significant OID (“AHYDO”), a portion of the discount is treated as a
non-deductible dividend, with the remaining discount not deductible
until actually paid.
47
Tax considerations for issuers (cont’d)
 American Recovery and Reinvestment Act of 2009 (the “Act”)
permits certain tax payers to elect to defer the taxation of COD
income arising from certain repurchases, exchanges or modifications
that occur after 12/31/08 and before 1/01/11.
 The Act suspends the AHYDO provisions for AHYDOs issued in
exchange for non-AHYDOs fo the same corporation between
8/31/2008 and 1/1/10 (extended to 1/11/11).
 Provisions no longer available.
48
Tax considerations for issuers (cont’d)
 An issuer that repurchases its debt at a discount from its adjusted
issue price must recognize as ordinary income the amount of the
discount.
 Applies whether purchased directly or through a third party.
 An issuer that exchanges new debt for old debt will recognize
ordinary COD income to the extent the adjusted issue price of the old
debt exceeds the issue price of the new debt.
49
Tax considerations for issuers (cont’d)
 A modification of existing debt will be treated as an exchange of such
debt for new debt if the modification is “significant.”
 Generally, modifications are “significant” if, among other things:
 The yield changes by the greater of 25 basis points and 5% of the existing
yield;
 Scheduled payments are materially deferred;
 Modified credit enhancements change payment expectations; or
 The nature of the security changes (e.g., from debt to equity or from recourse
to nonrecourse).
 Consent solicitations that seek to change “customary accounting or financial
covenants” would not, in themselves, be significant modifications.
50
Tax considerations for issuers (cont’d)
 An issuer engaged in a debt equity swap will recognize ordinary
COD income to the extent the adjusted issue price of the debt
exceeds the market value of the equity it issues.
51
Tax considerations for holders
 Tax consequences for holders depend on whether the restructuring
constitutes a “recapitalization” under the Code.
 Generally debt exchanges of securities with terms longer than five years will qualify
as recapitalizations.
 A holder may have gain or loss equal to the difference between the
amount of cash received and the holder’s adjusted tax basis in the
debt.
 If the holder acquired the debt with market discount, a portion of any gain may be
characterized as ordinary income.
52
Tax considerations for holders (cont’d)
 If an exchange or modification of debt constituted a recapitalization,
it should not result in gain or loss to the holder.
 However, depending on the terms of the new debt relative to the old, there may be
tax consequences.
 If the principal amount of the new debt exceeded that of the old, the holder could
recognize gain equal to the fair market value of the excess.
 Exchanges and modifications also can create OID, or conversely, an amortizable
premium, due to differences in the issue price of the new date and the stated
redemption price at maturity.
53
Tax considerations for holders (cont’d)
 If a debt equity swap constitutes a recapitalization, it should not
result in gain or loss to the holder.
 Market discount accrued on the exchanged debt will carryover to the equity.
54
Transactions to consider (cont’d)
 Remarketings
 Modifying the terms of the remarketings
 Many banks issued securities that must be remarketed in 2011 and 2012
 Banks may want to evaluate alternatives to and/or modifications of
remarketings, including liability management options (to address remarketing
itself), or may want to participate in the remarketing, or may want to have the
remarketing agent act as principal, or may want to change the terms of the
instrument
55
Recent Remarketings (Financial Institutions)
 On December 15, 2010, Citigroup completed a remarketing of
$1,875,000,000 4.587% junior subordinated deferrable interest
debentures (representing the third of four series of debt securities
required to be remarketed under the terms of Citigroup’s Upper
DECS Equity Units)
 On February 1, 2011, U.S. Bancorp completed a remarketing of
$676,378,000 3.442% Remarketed Junior Subordinated Notes due
2016 (in connection with Normal ITS)
 On February 11, 2011, State Street completed a remarketing of
$500,100,000 4.956% Junior Subordinated Debentures due 2018 (in
connection with Normal APEX)
 On February 15, 2011, Wells Fargo completed a remarketing of
$2,501,000,000 in principal amount of remarketable junior
subordinated notes (in connection with Wachovia WITS)
56
Wells Fargo Remarketing
 The remarketing was structured as a sale by selling securityholders
of newly issued notes obtained in exchange for remarketable junior
subordinated notes
 The selling securityholders purchased the remarketable junior
subordinated notes from Wachovia Capital Trust III
 The selling securityholders were Morgan Stanley and Credit Suisse
 The difference between the amount received by the selling
securityholders for the newly issued notes, inclusive of accrued
interest, and the price paid by the selling securityholders for the
junior subordinated notes in the remarketing was approximately
$6.25 per $1,000 principal amount of notes and $15,631,733.14 in
the aggregate
57
Tax
 Tax considerations need to be taken into account for any
remarketing, especially:
 Rev. Rul. 2003-97
 PLR 201105030
58
Market Activity
Tier 1 Instrument Proposals
59
Mandatory Convertible Instruments —
Common Stock Equivalents
Issue Date
ISSUER / CORPORATION
3 Year Forward Contract
Over Common Stock
$100 Face Amount
5 Year Note
Purchase Price = $100
(From Sale of Note in
Remarketing)
Quarterly Interest:
Years 1 – 3 = Fixed/Floating
Years 4 – 5 = Reset Rate Set At
End of Year Three
in Remarketing
(No Cap)
CUSTODIAN
Units
Investors
60
Mandatory Convertible Instruments —
Common Stock Equivalents (cont’d)
Year 3
ISSUER / CORPORATION
Note with
Reset Rate
New Investors
Note
Cash
Remarket
Note for
$100
Settle Forward for
$100 - - To Buy
Common Stock
CUSTODIAN
Units
Investors
61
Mandatory Convertible Instruments —
Preferred Stock Equivalents
Issue Date
BANK HOLDING COMPANY
$100 Face Amount
39-Year
Subordinated Note
Quarterly Interest:
Years 1 – 5 = Fixed/Floating
Years 6 – 39 = Reset Rate Set
in Remarketing
(No Cap)
Five Year Forward Contract
over Non-Cumulative
Perpetual Preferred Stock
CUSTODIAN
Units (WITS)
Investors
62
Purchase Price = $100 (From
Sale of Note in
Remarketing)
Mandatory Convertible Instruments —
Preferred Stock Equivalents (cont’d)
Year 5
BANK HOLDING COMPANY
34-Year
Note with
Reset Rate
New Investors
Note
Settle Forward for $100;
Receive Non-Cumulative
Perpetual Preferred Stock
Cash
Remarket
Note for
$100
CUSTODIAN
Unit (WITS)
Investor
63
T-DECs
CITIGROUP, INC.
$20.28 Face Amount
6.15% 3-Year
Amortizing
Subordinated Note—
Potential Deferral to
2015
Quarterly Interest and Principal
Payments Result in 7.5% Yield
on Investment
CUSTODIAN
$100 T-DECS
Investors
64
Three Year Prepaid Forward
Contract over Common
Stock—Receive Between 25.4
and 31.7 Citigroup Shares
Depending on Stock Price;
Prepayment is $79.72
“REIT” Preferred
$150x Mortgages
Bank
REIT/Tax Partnership
$50x C.
Stock
$100x Preferred
Conversion into
Bank Preferred on
Regulatory Event
Investors
65
Income From
Mortgages Flows
Through REIT/Tax
Partnership to Preferred
(as Dividend) Without
Corporate Level Tax
Standby Stock Facilities
BHC
Cash
Put Option (on noncumulative perpetual
preferred stock of BHC)
Liquid
Assets
Del. Biz
Trust
Investors
66
Market Activity
Contingent Capital
67
Contingent capital
 Contingent capital could be viewed as the latest incarnation of
hybrids; forms of contingent capital may include:
-
Contingent debt instruments, including mandatorily convertible debt
Contingent funding vehicles/contingent “facilities”
Securities with permanent or temporary write-down features
Collateralized insurance policies
68
Possible Conversion Features
Three Possible Conversion
Features
Contingent
Capital
Structure
Potential Outcomes
If Trigger is Breached
1
Principal write down
without write up
Investors suffer losses
2
Principal write down and
write up
Investors may suffer
losses
Conversion to equity
Depends on specifics
of structure; Common
stock may be diluted
3
69
If Trigger is not
Breached
Investors
receive par
under all 3
structures
Possible Conversion Triggers –
Pros & Cons
Pros
Real-time
•
Transparent
•
Real-time
•
Prospective
•
Transparent
•
Potential “false
positive” triggering
•
Strong potential for
“death spiral”
scenario if
instrument converts
to stock
•
•
Some potential for
“false positive”
triggering
•
May be lagging
indicator
•
Potential for “false
negative” triggering
Some potential for
“death spiral” scenario •
if instrument converts
to stock
70
Less potential for
“false positive”
because it may be
slow to trigger
•
Real-time
•
Prospective
Two-Part Trigger
(specific; systemic)
Regulatory Metric or
Discretion
Financial Metric
Stock Price
Trigger
Cons
•
•
May be less
transparent
•
May allow individual
firms to fail in
absence of systemic
problem
Lloyds Bank — November 2009
 ₤7.5 Billion Issue (Exchange Offer)
 Styled as “Enhanced Capital Notes”
 Ten year term
 Fixed interest rate, non-deferrable
 Converts to a fixed number of common shares if Lloyd’s core Tier
One ratio falls below 5%
 Intended to be lower Tier 2 bonds for regulatory purposes
 Lloyds and holders agree to treat as equity for U.S. federal income
tax purposes
71
Rabobank Senior Contingent Notes —
March 2010
 Sale of €1.25b of 6.875% Senior Contingent Notes due 2020
 Notes are senior unsecured notes, with a ten-year term
 Subject to a Write Down of principal if a Trigger Event occurs
 Write Down is not a “default”
 Trigger Event: if Equity Capital Ratio falls below 7%
(Equity Capital Ratio = Equity Capital/RWA)
 Sold to institutions
72
Rabobank Perpetual Non-Cumulative Capital Securities
— January 2011
 The capital securities are perpetual and have no scheduled maturity
date
 Bear interest at the initial interest rate of 8.375% to (but excluding)
July 26, 2016, payable semi-annually, and thereafter at a rate reset
every five years based on the U.S. Treasury benchmark rate plus
6.425%
 Coupons are not cumulative and can be deferred in the following
circumstances:
-
Payments on the capital securities and other parity or junior securities are
greater than distributable profits
Regulatory solvency rules prohibit coupon payments
Equity capital ratio (equity capital divided by risk weighted assets) is less
than 8%
The Dutch Central Bank believes that there will be a coupon deferral
73
Rabobank Perpetual Non-Cumulative Capital Securities
— January 2011 (cont’d)
 Constitute direct, unsecured and subordinated obligations of the
issuer and rank pari passu and without any preference among
themselves
 Optional and mandatory redemptions
-
-
Issuer may redeem the capital securities, in whole but not in part, on or
after July 26, 2016, but must redeem the capital securities on the first
interest payment date on or after January 26, 2041 if certain conditions
are met
Issuer may redeem the capital securities, in whole but not in part, prior to
July 26, 2016 upon the occurrence of a tax event or a capital event
 Upon the occurrence of a capital event, the issuer may substitute or
vary the terms of the capital securities so that they remain regulatory
compliant securities
74
Rabobank Perpetual Non-Cumulative Capital Securities
— January 2011 (cont’d)
 Loss absorption is triggered if:
-
Equity capital ratio falls or remains below 8%
Either the issuer or the Dutch Central Bank believes that there has been
such a significant reduction in the issuer’s retained earnings or similar
reserves causing a significant deterioration in the issuer’s financial and
regulatory solvency position that the equity capital ratio will fall below 8%
in the near term
 If loss absorption is triggered, the issuer will cancel any accrued but
unpaid interest and write-down the prevailing principal amount of the
capital securities
-
The write-down amount is determined by multiplying the losses
precipitating the trigger relative to the equity capital ratio prior to the loss
incurrence by the ratio of the aggregate outstanding principal amount of
capital securities relative to equity capital and all similar loss absorbing
securities
75
Credit Suisse Tier 1 Buffer Capital Notes – February
2011
 Credit Suisse entered into an agreement with Qatar Holding LLC and
The Olayan Group to issue USD 3.5 billion and CHF 2.5 billion of
Tier 1 buffer capital notes (“Tier 1 BCNs”) with a coupon of USD
9.5% and CHF 9.0%, respectively, for cash or in exchange for USD
3.5 billion of 11% and CHF 2.5 billion of 10% Tier 1 capital notes
issued in 2008
 The purchase or exchange of the Tier 1 BCNs will occur no earlier
than October 2013, which is the first call date of the Tier 1 capital
notes
 Subject to the implementation of Swiss regulations requiring Credit
Suisse to maintain buffer capital and receipt of all required consents
and approvals from shareholders, including approval for additional
conditional capital or conversion capital
76
Credit Suisse Tier 1 Buffer Capital Notes – February
2011 (cont’d)
 The Tier 1 BCNs will be converted into ordinary shares if Credit
Suisse’s reported Basel III common equity Tier 1 ratio falls below 7%
 The conversion price will be the higher of a floor price of USD 20 / CHF 20 per
share, subject to customary adjustments, or the daily weighted average sale price
of Credit Suisse’s ordinary shares over a trading period preceding the notice of
conversion
 The Tier 1 BCNs will also be converted if the Swiss Financial Market
Supervisory Authority (“FINMA”) determines that Credit Suisse
requires public sector support to prevent it from becoming insolvent,
bankrupt or unable to pay a material amount of its debts, or other
similar circumstances
 The Tier 1 BCNs will help Credit Suisse satisfy an estimated 50% of
its high trigger contingent capital requirement set by FINMA
77
Credit Suisse Tier 2 Buffer Capital Notes – February
2011
 Regulation S private issuance of USD 2 billion 7.875% Tier 2 Buffer
Capital Notes due 2041 (“Tier 2 BCNs”)
 Supplementing offering of the Tier 1 BCNs to Qatar Holding LLC and
The Olayan Group that was announced on February 14, 2011
 The Tier 2 BCNs will help Credit Suisse satisfy an estimated 70% of
its high trigger contingent capital requirement set by FINMA
 The Tier 2 BCNs are expected to carry a rating of ‘BBB+’ from Fitch
Ratings and to be listed on the Euro-MTF exchange
78
Credit Suisse Tier 2 Buffer Capital Notes – February
2011 (cont’d)
 The Tier 2 BCNs are subordinated notes with a 30-year maturity and
may be redeemed by the issuer at any time from August 2016
 Guaranteed on a subordinated basis by Credit Suisse Group
 The initial coupon is reset every five years from August 2016
 Interest payments will not be discretionary or deferrable
 Same conversion feature as the Tier 1 BCNs
79
Selected Tax Issues
Debt Versus Equity
Debt Characteristics:
 Debt under local law,
 A fixed maturity date on which a sum certain is payable,
 A right to receive fixed interest without deferral, and
 An unlikelihood of conversion at the time of issuance.
Issue:
 Depending on the specifics, the conversion feature may raise the question whether the holder has
an entitlement to repayment regardless of the issuer’s financial circumstances.
 Does the Holder have creditor’s rights?
Note: stock received on conversion may have FMV significantly lower than principal of contingent
capital instrument. Compare Rev. Rul. 85-119 (notes payable in stock or proceeds of stock sold in
offering, where FMV of stock equals principal on notes, treated as debt) and Notice 94-47 (Rev. Rul.
85-119 limited to its facts).
80
Selected Tax Issues
Section 163(l)
 If debt, Section 163(l) of the Code would have to be analyzed to see whether it could
deny issuer’s interest deductions
 Applies to “disqualified debt instruments”, including “indebtedness of a corporation
which is payable in equity of the issuer…”
 Internal Revenue Code employs a “substantial certainty” standard for debt payable in
equity at option of holder
 If same “substantial certainty” principle applied to contingent capital conversion,
Section 163(l) would not apply if likelihood of conversion was remote
81
Selected Tax Issues (cont’d)
Cancellation of Indebtedness
 If debt, conversion into stock generally tax-free to the holder under a number of
theories
 However, if principal amount exceeds FMV of stock, conversion could generate COD
income under Section 108(e)(8) to the issuer
 TAM 200606037 takes this position, citing Treas. Reg. § 1.61-12(c)(2) definition of
“repurchase” to include conversion
 Write down structure would generate similar concerns
82
Selected Tax Issues (cont’d)
Foreign Investor Concerns
 If equity:
No portfolio interest exemption from withholding for foreign holders
Potential application of the CFC and PFIC rules with respect to U.S. holders of
foreign issuers
 If debt: would portfolio interest exemption apply for interest paid to foreign investors?
83
Recent Contingent Capital Transactions
Rabobank’s Senior Contingent Notes

10-year senior notes, where if Rabobank’s Equity Capital Ratio falls below 7%, principal is written down by
75% and the remaining 25% is redeemed for cash
Potential U.S. tax issues: Debt vs. Equity, COD income
Lloyd’s Banking Group’s Enhanced Capital Notes

10-year senior notes that convert to a fixed number of common shares if Lloyd’s Tier 1 common capital ratio
falls below 5%
Potential U.S. tax issues: Debt vs. Equity, 163(l), COD income
Neither instrument would likely be treated as indebtedness
giving rise to tax deductible interest under current U.S. tax law
84
Recent Contingent Capital Transactions (cont’d)
Rabobank’s Perpetual Non-Cumulative Securities

Perpetual subordinated securities, where if (1) Rabobank’s equity capital ratio falls or remains below 8% or (2)
either Rabobank or the Dutch Central Bank believes that the equity capital ratio will fall below 8% in the near
term, principal is written down by an amount determined by multiplying the losses precipitating the trigger
relative to the equity capital ratio prior to the loss incurrence by the ratio of the aggregate outstanding principal
amount of capital securities relative to equity capital and all similar loss absorbing securities
Credit Suisse’s Tier 1 Buffer Capital Notes

Perpetual subordinated notes that convert to a fixed number of common shares if (1) Credit Suisse’s Basel III
common equity Tier 1 ratio falls below 7% or (2) the Swiss Financial Market Supervisory Authority determines
that Credit Suisse requires public sector support to prevent it from becoming insolvent
Neither instrument would likely be treated as indebtedness giving rise to tax deductible interest
under current U.S. tax law
85
Recent Contingent Capital Transactions (cont’d)
Credit Suisse’s Tier 2 Buffer Capital Notes

30-year subordinated notes that convert to a fixed number of common shares if (1) Credit
Suisse’s Basel III common equity Tier 1 ratio falls below 7% or (2) the Swiss Financial Market
Supervisory Authority determines that Credit Suisse requires public sector support to prevent it
from becoming insolvent
Potential U.S. tax issues: Debt vs. Equity, 163(l), COD income
May not be treated as indebtedness giving rise to tax deductible interest under current U.S. tax law
86