IFLR Webinar: Hybrid Capital February 3, 2010 NY2 668716 © 2010 Morrison & Foerster LLP All Rights Reserved | www..mofo.com Agenda •Introduction •Criticisms of hybrids during the financial crisis •Current state of the hybrid market •A review of hybrid securities •New developments affecting hybrids •Regulatory capital discussions •Contingent capital •Predictions This is MoFo 2 Old World Structures •Preferred stock •Convertible preferred stock •REIT preferred •Equity units (preferred stock) This is MoFo 3 Criticisms of hybrids during the crisis •Prior to the financial crisis, financial institutions had become reliant on hybrid securities for their capital needs •Traditionally, hybrid issuers had called the securities at the first opportunity; however, faced with few sources of replacement capital, issuers surprised investors when they did not call outstanding hybrids •Rating agencies downgraded hybrids based on a belief that hybrids would suffer losses during the crisis and payments on hybrids would be deferred by issuers seeking state aid This is MoFo 4 Hybrids during the financial crisis •Although hybrids suffered losses, commentators have observed that these securities did not prove to be as “loss absorbent” as intended and therefore did not provide sufficient financial flexibility for the bank issuers •There has been a bit of a backlash against hybrid securities •Investors have become more focused on “tangible common equity” as a measure of financial strength This is MoFo 5 New World Structures •Common stock •Surviving Hybrids • Trust Preferred • Enhanced Trust Preferred • Equity Units •Special Situations • Common Equivalent Securities • Citigroup T-DECS •Contingent Capital This is MoFo 6 State of the Hybrid Market This is MoFo 7 Subordinated Issuance Volumes 2002-2010 • Subordinated issuance peaked in 2006-2007 period (EUR 155bn and EUR163bn equiv. issued) • 2008 - EUR115bn equiv. capital raised from state injections, subordinated supply falls to EUR45bn equiv. (down 28% from peak) • 2009 – Total capital raised similar to pre-crisis levels (EUR151bn equiv.), subordinated supply accounting for EUR47bn equiv. • Liability management new issues accounted for EUR18bn in 2009 • Including GBP7.5bn of new contingent capital securities (Lloyds) Global Subordinated Supply by year 2002- to date EUR Equiv (billion) 250 200 150 100 50 0 2002 2003 Subordinated 2004 2005 2006 State Injections 2007 2008 2009 2010 LM Exercises Source: Bondware/ Calyon Notes: In all major currencies (USD/GBP/EUR) This is MoFo 8 Subordinated Issuance Volumes 2009 to date • Rapid recovery of the subordinated debt markets in 2009 • Re-opening of subordinated T1/T2 debt market: • February (Bank T1 – Mizuho) • May (Ins T2 – RSA, Bank T1 and T2 – Rabobank) • July (Ins Hybrid – Prudential) • October (Corp Hybrid – Hero) • Greater application to a broader array of issuers/sectors – banks, insurance, corporates, rated/unrated and EM issuers Global hybrid debt issuance (non government provided) by issuer type Jan 2009-to date 14 EUR Equiv (billion) 12 10 8 6 4 2 Jan-10 Dec-09 Ins T2 Nov-09 Oct-09 Sep-09 Ins Hybrid Aug-09 Jul-09 Jun-09 Apr-09 Bank T2 May-09 Bank T1 Mar-09 Feb-09 Jan-09 0 C orp Hybrid Source: Bondware/ Calyon This is MoFo 9 Subordinated Supply by Issuer Geography • European issuers active in 2009 (66% of total supply) • US activity primarily from subordinated issues placed in the domestic market (22% of total supply) • Fall in Asian issuer activity (in USD/EUR/GBP) as issuers choose to access the market in local currencies (8% of total supply) Global Subordinated Debt Supply in 2009 OTHER 4% ASIA 8% US 22% EUROPE 66% Source: Bondware/ Calyon. Notes: In all major currencies (USD/GBP/EUR) This is MoFo 10 Subordinated Supply by Issuer Rating • Post crisis – more AA issuers in the market • 47% of total deals issued in 2009 (versus 41% in 2006) • Pre-crisis – issuance split more evenly over rating bands • 2009: AA (47%), A (39%), below A (14%) • 2006: AA (41%). A (42%) , below A (17%) Moody’s Issuer Rating for Subordinated Issuers in 2006 versus 2009 60 No of Deals 50 40 30 20 10 0 Aaa Aa1 Aa2 Aa3 A1 A2 A3 Baa1 Baa2 Baa3 B1 Ba1 Ba2 Ba3 Moody's Issuer Rating 2006 2009 Source: Bondware/ Calyon. Notes: In all major currencies (USD/GBP/EUR) This is MoFo 11 Subordinated Spreads and Differentials Subordinated spread differentials continue to narrow • The costs associated with the risk factors for hybrid capital (subordination, deferral risk, extension risk) have fallen further, as indicated by the chart below: • LT2 cost - risk factors: subordination + extension risk (where the issue is callable): Now 73% lower vs Q109 • UT2 cost - risk factors: subordination + deferral risk + extension risk: Now 30% lower vs Q109 • T1 cost - risk factors: more subordination + more deferral risk + extension risk: Now 60% lower vs Q109 iBoxx Bank Secondary Spread Differentials Subordinated Spread Differentials Senior-LT2 LT2 - UT2 UT2 - T1 1400 Deferral risk? x 1200 Extension risk? X (for bullets) 1000 Q109 + 399 + 220 + 462 Q209 + 261 + 143 + 389 Q309 + 152 + 157 + 201 Q409 +141 + 159 + 186 To date + 107 + 155 + 186 Change Q109 to date - 73% -30% -60% 1800 Subordination? Euribor spread (bp) 1600 800 600 400 200 Senior Source: Calyon Senior -LT2 LT2-UT2 UT2-T1 Jan-10 Nov-09 Sep-09 Jul-09 May-09 Mar-09 Jan-09 Nov-08 Sep-08 Jul-08 May-08 Mar-08 Jan-08 0 Source: Calyon This is MoFo 12 Evolution of Hybrid Structures • Contingent Capital have already been issued in the past • Bespoke structures providing one-off solutions for issuers • Now the market wants commoditisation, liquidity and hedgebility Fortis issue €1.25bn of Floating Rate EquityLinked Subordinated Hybrid Capital Securities (FRESH) Receives Tier 1 regulatory treatment Automatic exchange price is set – FRESH will convert to equity if ordinary shares trade above this price 2002 A number of US companies are threatened with significant EPS dilution following the FASB’s proposal to require issuers to reflect “contingent convertibles” (CoCos”) under the ifconverted method of accounting Deutsche Bank issue €200m of 5NC3 senior debt which is exchangeable into innovative Tier 1 (PNC10) capital at the option of DB at any time - (March 2007) Deutsche Bank issue $800m of PNC10 UT2 securities which are exchangeable into noninnovative Tier 1 capital at the option of DB within the first 5 years - (May 2007) 2004 Fortis issue €3bn of Convertible and Subordinated Hybrid EquityLinked Securities (CASHES) Receives Tier 1 regulatory treatment After 40 days holders can exchange into ordinary shares at the exchange price or CASHES will automatically convert if shares trade at or above the Automatic Exchange Price 2007 Swiss Re issue €672m of Mandatory Convertible Notes Achieved the highest equity treatment possible from rating agencies Holders of the notes will automatically be converted into ordinary shares at the exchange price in 3 years 2008 Deutsche Bank issue €1bn of 30NC10 UT2 securities which are exchangeable into non-innovative Tier 1 (PNC10) capital at the option of DB within the first 5 years (May 2008) Deutsche Bank issue $1.265bn of PNC10 UT2 securities which are exchangeable into non-innovative Tier 1 capital at the option of DB within the first 5 years - (May 2008) DB converted both these securities into Tier 1 in October 2008 Source: Calyon This is MoFo 13 A review of hybrid securities •Trust Preferreds •Enhanced Trust Preferreds •Equity Units This is MoFo 14 Trust Preferred Financial Holding Company $100 million Subordinated Loan Common (nominal) Delaware Statutory Trust $100 million Trust Preferred Securities This is MoFo 15 Trust Preferred (cont’d) • Trust is a grantor trust for federal income tax purposes • Trust preferred securities represent an interest in the $100 million subordinated loan • 5-Year interest deferral on subordinated loan (and trust preferred) • Federal Reserve treats as Tier 1 capital for bank holding company (up to 25% limit); 15% limit for “internationally active” BHCs • Interest on subordinated loan is tax deductible by bank holding company. • Individual holders taxed at maximum 35% ordinary income rates on interest (and OID) • Interest and OID not subject to U.S. 30% withholding tax when paid to nonU.S. investors This is MoFo 16 Enhanced Trust Preferred - CENts Financial Holding Company $100 million Junior Subordinated Loan Common (nominal) Delaware Statutory Trust $100 million Capital Securities (CENts) This is MoFo 17 Enhanced Trust Preferred – CENts (cont’d) •60-year junior subordinated loan with 30-year scheduled maturity date – equity issued to repay subordinated loan •Enhanced interest deferral features in years 5-10 •Essentially has same US tax consequences to Issuer and holders as a “regular” trust preferred offering •Moody’s: C or D Basket •Internal Revenue Service: Chief Counsel Memorandum 200932049 (March 10, 2009) enhanced trust preferred is debt for federal income tax purposes based on view that equity like features very unlikely to ever be relevant. This is MoFo 18 Equity Units (Common) FINANCIAL HOLDING COMPANY Forward contract over Common Stock 5-Year Subordinated Debt Custodian Unit Investors This is MoFo 19 Equity Units (Common) • Unit • Note and Forward • Corporate Units • Note alone • Treasury Units • Treasuries and Forward • Subordinated • Interest deferral • Remarkets after three years; rate is reset This is MoFo 20 Common Equivalent Securities • Problem: need capital now but insufficient common shares authorized under charter; a shareholder vote can be obtained in a slightly longer time frame. Preferred stock is authorized under charter • Solution: issue preferred stock under state law that converts into common stock when the shareholders authorize more common stock • Preferred stock’s terms mirror economics of common with same dividend rights as common • Sweetners: • Includes warrant to acquire additional common shares if vote fails • Dividend step up if vote is delayed This is MoFo 21 Citigroup T-DECS (12/14/09) • Tangible Dividend Enhanced Common Stock--gives the investor common stock exposure plus something that looks like current income in excess of current common dividend • Unit consisting of: • Prepaid 3 year stock purchase contract to buy common stock • Amortizing subordinated note with final payment due in 3 years, produces return on the investor’s original issue price, installments are deferrable but not beyond 6 years • Allocation of value to stock purchase contract and to amortizing note • Units trades on exchange • Components are separable This is MoFo 22 New Developments This is MoFo 23 New Developments •Both rating agencies have been studying hybrid ratings. Moody’s has already announced a new methodology for notching. •The ECB has published guidance on “innovative Tier 1 instruments” •The new Basel framework announced in mid December would phase out the use of various hybrid instruments This is MoFo 24 Ratings and Regulatory Capital This is MoFo 25 Rating agency developments Moody’s Tool Kit This is MoFo 26 Rating agency developments S&P Debt-Equity Continuum • Little or questionable permanence • Terms or nomenclature that restrict or discourage discretion over payments • After-tax or conversion terms that may become unattractive to the issuer Minimal Equity Content • Most preferred stock, from: (a) 30-year trust preferred with five-year deferral rights; to (b) perpetual preferred with unlimited deferral rights Intermediate Equity Content • Mandatory component, either regarding deferral of ongoing payments, or near term conversion into a fixed number of common equity shares High Equity Content This is MoFo 27 Moody’s guidelines •In November 2009, Moody’s published Guidelines for Rating Bank Hybrid Securities and Subordinated Debt •The guidelines: • remove systemic and regional support from hybrid ratings; • provide for wider notching among different classes of bank hybrids; and • provide flexibility to position hybrid ratings based on case specific and country specific considerations This is MoFo 28 Moody’s guidelines •As a result of the Moody’s guidelines, Moody’s lowered ratings for 40% of hybrids by one or two notches; and lowered ratings for 50% of hybrids by three to four notches This is MoFo 29 Moody’s revised guidelines Typical Regulatory Treatment Coupon Non-Payment Number of Notches below Adjusted BCA (Adj. BCA = BCA + Parental and/or Cooperative Support) Lower Tier 2 None Generally, will receive uplift from Adjusted BCA to BDR – 1 Hybrid Subordinated Debt Tier 2 and Tier 3 Mandatory, cumulative, subject to maturity extension Lower of BDR – 1 or Adjusted BCA + 2 Junior Subordinated Debt Upper Tier 2 Optional, cumulative Adjusted BCA - 1 or – 2 Dated Junior Subordinated Debt with Principal Writedown Upper Tier 2 Optional/mandatory, cumulative Adjusted BCA - 2 to – 4 Tier 1 Optional/mandatory, cumulative, non-cumulative, or non-cash cumulative (ACSM) settlement Adjusted BCA - 2 to – 4 Hybrid Subordination “Plain Vanilla” Subordinated Debt Preferred Securities Anchor point for hybrid ratings generally removes systemic support and will be based on banks’ intrinsic financial strength (the “adjusted baseline credit assessment”) This is MoFo 30 Regulatory Developments This is MoFo 31 ECB developments • EU Capital Requirements Directive (CRD) • • May 2009 amendments to the CRD • • • enacted Committee of European Banking Supervisors (CEBS) proposals for Hybrid Tier 1 eligibility criteria common definitions of hybrid capital instruments that could be regarded as “innovative” Tier 1 capital “principles” type criteria; important details missing The most important features of Hybrid Tier 1 Instruments are: 1. 2. 3. 4. • implements the Basel II Accord in the European Economic Area (EEA) Permanence Flexibility of payments Loss absorbency Mandatory conversion, (for eligibility beyond the 35% limit under the CRD amendments). CEBS launched a consultation which closed in September 2009 in conjunction with its proposals for more detailed guidelines for national bank supervisors in Europe This is MoFo 32 Permanence (1) Undated (or perpetual) instruments - may provide for a “moderate” incentive to redeem, arising not earlier than 10 years after issuance. • recommendations provide, where the incentive consists of (A) an interest rate “step-up” step-up capped at 100 basis points or 50% of the initial credit spread, less the swap spread between the initial index basis and the stepped-up index basis, (B) a principal stock settlement mechanism coupled with an issuer redemption (call option) conversion ratio capped at 150% of the conversion ratio at the date the hybrid instrument was issued, and (C) other incentives to be assessed by the relevant national bank supervisor case by case. This is MoFo 33 Permanence (cont’d) (2) Dated instruments must have minimum maturity of at least 30 years and may not provide for an incentive to redeem. (3) Both undated and dated instruments • • • • hybrids which are dated or contain an incentive to redeem - limited to an aggregate maximum of 15% of a bank’s Tier 1 capital. may contain an issuer call option exercisable after 5 years, but any redemption requires the prior consent of the competent authority • consent may be granted if the requesting bank’s financial condition and solvency are not affected consent to earlier redemption may be granted in the case of an unforeseen change in tax or regulatory treatment. as to dated instruments, consent must be withheld, or redemption suspended, if issuer non-compliant with its regulatory capital obligations. This is MoFo 34 Permanence (cont’d) • CEBS guidelines recommend issuer’s request for consent to be supported by: • a well-founded explanation of the reason therefor • current solvency data, including the capital position before and after redemption • a confirmation that the issuer will remain in compliance with all regulatory requirements after redemption • a 3-5 year plan for the development of such solvency data, evaluation of the issuer’s risks exposure and the sufficiency of the Tier 1 capital level to cover those risks, including in stressed circumstances. • if the relevant authority asks, a demonstration of its ability to re-access the hybrids market. • Consent must be refused where it would put issuer’s financial condition or solvency in material jeopardy in the foreseeable future and issuer must maintain sufficient capital buffers levels above the regulatory minimum. This is MoFo 35 Permanence (cont’d) (4) Repurchases (“buybacks”) - although CRD is silent as to “buybacks” of hybrid instruments, CEBS regards buybacks as equivalent to a call redemption, in economic and prudential terms • • May permit repurchases up to 5% of the relevant issuance for market-making purposes CEBS considering allowing repurchases, before 5 years and without replacement, in limited circumstances, so long as the repurchase improves solvency of issuer, but some concerns of national supervisors of permanence being compromised This is MoFo 36 Flexibility of Payments • Hybrid Tier 1 capital must give issuer ability to cancel, on a non-cumulative basis, interest/dividend (“coupon”) payments • National regulators may require cancellation of coupons based on issuer’s financial condition or solvency • Cancellation mandatory where issuer in breach of its regulatory capital requirements • Exemption available for hybrid containing an Alternative Coupon Satisfaction Mechanism (“ACSM” or alternative payment mechanism), i.e., permissible to issue shares in lieu of coupon payment but national regulators can impose conditions on such substitutions This is MoFo 37 Flexibility of Payments (cont’d) • CEBS guidance on dividend pushers/dividend stoppers (not addressed by CRD). • A “dividend pusher” requires the issuer to pay the hybrid coupon if it pays a dividend on its common stock; conversely, a “dividend stopper” prevents the issuer from paying a dividend on common stock unless it also pays the hybrid coupon. • According to CEBS, a dividend pusher is a permissible feature of Hybrid Tier 1 Capital, but must be waived if: • between the date of the coupon push and the date for payment, issuer breaches its regulatory capital requirements • the competent authority requires cancellation of the coupon based on financial condition/solvency concerns, or • the majority of the dividend on common stock is paid in shares, rather than cash This is MoFo 38 Flexibility of Payments (cont’d) • As regards a dividend stopper, CEBS has only noted it should not hinder recapitalisation CEBS regards an ACSM as acceptable only if it achieves the same economic result as a cancellation of the coupon (i.e., no decrease in capital), meaning that the deferred coupons must be satisfied without delay using newly issued shares up to an equivalent aggregate fair value (at a maximum) • • • • Hybrid holders must bear the risk that selling those shares may not yield the substituted coupon amount in full ACSM should not hinder recapitalisation, i.e., the issuer should be able to cancel the ACSM in order to absorb losses CEBS did not clarify whether issuer could sell the substituted shares on behalf of the hybrid holders and pay them the net cash proceeds - left up to the national supervisors. This is MoFo 39 Loss Absorbency • Under CRD, hybrids must be able to absorb losses both on a “going concern” basis and in a liquidation, and to count as Tier 1 capital, may be senior only to common stock and not have benefit of any guarantee or security. CEBS has stated that: • • • as to loss absorption on a “going concern” basis - the instrument must (A) help prevent insolvency and (B) not hinder recapitalisation • Preventing insolvency requires that (i) no redemption is permitted, (ii) the issuer can cancel the coupon, (iii) the hybrid holder cannot petition for the issuer’s insolvency and (iv) the hybrid instrument would not be taken into account in determining whether the issuer is insolvent. • of these, (iv) is arguably the most difficult to achieve where the insolvency test is based on the balance sheet - if instrument qualifies as “debt” under the relevant insolvency law, a mechanism for conversion into an equity instrument or write-down of principal (whether permanent or temporary) may work. the capacity of an instrument to absorb losses in a “liquidation” depends on the degree of subordination This is MoFo 40 Loss Absorbency (cont.) • In assessing whether an instrument renders a recapitalisation more likely, a balance must be struck between the hybrid holders’ and the potential new shareholders’ respective rights. • • • • mechanisms proposed by CEBS (again) are (i) a conversion into an equity instrument or (ii) a permanent or temporary write-down of principal, in each case to a meaningful extent (i.e., at least pari passu with shareholders), although it is unclear how a share can be “written down.” one or a combination of these mechanisms could be approved by a relevant competent authority. the mechanism(s) should take effect (A) immediately after losses cause a significant deterioration in financial condition/solvency and (B) before the share capital is exhausted. in practice the “trigger point” would occur when losses have significantly reduced retained earnings and other reserves, but before the issuer has breached any required solvency level. This is MoFo 41 Mandatory Conversion • Hybrids that do not convert into shares are limited to a maximum of 35% of the bank’s Tier 1 Capital Beyond the 35% limit the Hybrid Tier 1 Capital must be convertible into shares and the total Hybrid Tier 1 cannot exceed 50% • • • CEBS considers that there must be a mandatory conversion into equity in the event of the issuer’s breach of its required capital ratio and perhaps also in other “emergency situations.” In addition, the competent authority should have the power to trigger the conversion if necessary, having regard to issuer’s financial condition/solvency (i.e., the same considerations as regards consents to call/redemption or a cancellation of coupons). This is MoFo 42 Basel Framework This is MoFo 43 Basel framework •In mid December, the BCBS announced far-reaching proposals for comment, which include changes to the components of capital; increases to the basic minimum Tier 1 and total risk-based capital rules; and a “capital buffer” concept that imposes a sliding scale of enhanced regulatory restrictions to pay dividends and bonuses if capital is not above the minimum. This is MoFo 44 Highlights of Basel framework •Emphasis on quality, consistency and transparency of the capital base •The definition of Tier 1 capital is moving closer to the definition of “tangible common equity” •Tier 1 (or going concern) capital must consist principally of common equity, plus retained earnings, net of regulatory adjustments, including deductions of intangible assets This is MoFo 45 Basel framework—Tier 1 changes •The proposal enumerates a list of 14 criteria to 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 •As a result of these criteria, certain instruments would no longer be considered included—for example, step-up instruments, cumulative preferred, and trust preferred This is MoFo 46 Regulatory adjustments •The proposals would harmonize regulatory adjustments, including adjustments for: • Minority interests, • Deferred tax assets, • Shortfall in reserves, • Goodwill & other intangibles, • Unrealized gains and losses • Investments in other financial institutions • Gains and losses due to changes in own credit risk This is MoFo 47 Tier 2 & Tier 3 •Tier 3 capital would be completely eliminated •Tier 2 (or gone concern) capital would be simplified by establishing a single set of eligibility criteria and eliminating all Tier 2 sub-categories •Upper and lower Tier 2 would be eliminated •Tier 2 capital would be required to be subordinated to depositors and general creditors, not secured, not guaranteed, having an original maturity of at least five years and callable by the issuer only after a minimum of five years This is MoFo 48 Contingent Capital This is MoFo 49 Contingent Capital • “A second kind of market discipline initiative is a requirement that large financial firms have specified forms of ‘contingent capital’…For example, a regularly issued special debt instrument that would convert to equity during times of financial distress could add market discipline both through the pricing of newly issued instruments and through the interests of current shareholders in avoiding dilution.” Fed Governor Daniel K. Tarullo at the Exchequer Club, Washington D.C. on October 21, 2009. This is MoFo 50 Lloyds Bank - November 23, 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 This is MoFo 51 Dodd Bill (Restoring American Financial Stability Act of 2009) §107 Enhanced Supervision and Prudential Standards for Specified Financial Companies (c) CONTINGENT CAPITAL.— (1) IN GENERAL.—The Agency shall promulgate regulations that require specified financial companies to maintain a minimum amount of long-term hybrid debt that is convertible to equity when— (A) a specified financial company fails to meet prudential standards established by the Agency; and (B) the Agency has determined that threats to United States financial system stability make such a conversion necessary. (2) FACTORS TO CONSIDER.—In establishing regulations under this subsection, the Agency shall consider— (A) an appropriate transition period for implementation of a conversion under this subsection; (B) the factors described in subsection (b)(3)(A); (C) capital requirements applicable to the specified financial company and its subsidiaries; and (D) any other factor that the Agency deems appropriate. This is MoFo 52 Wall Street Reform and Consumer Protection Act of 2009 (HR 4173) •House passed HR 4173 on December 11, 2009; no Senate action yet •Includes a section on “contingent capital” authorizing the Federal Reserve Board of Governors to issue regulations “that require a financial holding company to maintain a minimum amount of longterm 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.” This is MoFo 53 Contingent Capital – 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). This is MoFo 54 Selected Tax Issues (Cont.) 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…” • 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 This is MoFo 55 Selected Tax Issues (Cont.) 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 This is MoFo 56 Selected Tax Issues (Cont.) 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? This is MoFo 57 Predictions This is MoFo 58