EMTH - Profiles - Reprints of Articles by Partners/Assosciates




			I. INTRODUCTION A. Despite the levels of excess capital within the banking industry, bank and thrift institutions have recently flooded the capital markets with two types of hybrid securities--trust preferred and REIT preferred securities. B. Both forms of financings offer competitive advantages to bank and thrift holding companies (whether in stock or mutual form) and banks and thrifts (both stock and mutual). C. Both forms of financings represent an inexpensive form of core capital that can be used to (i) replace existing debt or equity (that is generally higher cost or not as favorably treated for regulatory capital purposes), (ii) leverage the institution’s balance sheet or (iii) finance either internal growth or external growth through acquisitions. II. ADVANTAGES OF TRUST PREFERRED SECURITIES AND REIT PREFERRED SECURITIES A. GENERAL 1. Cheaper than other forms of debt and equity -- Trust preferred securities are regarded as a true "hybrid" instrument that fits the tax definition for debt instruments and the bank regulatory capital definition for Tier I capital, while REIT preferred securities are tax deductible as a result of the REIT structure while also qualifying for Tier I capital treatment. Tax deductible Favorable regulatory capital treatment 2. Non-dilutive of existing common stock 3. No adverse impact on return on equity ("ROE") (Trust preferred securities and REIT preferred securities are not counted as equity for ROE calculations) 4. Consequently, trust preferred and securities REIT preferred securities can be used in transactions that are earnings accretive and which will enhance ROE: Common stock buy backs Replacing subordinated debt (Tier II capital) or (non-deductible) preferred stock Leveraging balance sheet without impacting capital ratios Also an alternative measure for raising capital for cash acquisitions or to downstream to subsidiary banks that need capital Enhance earnings through arbitrage (invest proceeds in investments yielding higher after-tax returns) B. TRUST PREFERRED SECURITIES 1. Historical perspective Texaco was the first issuer in 1993 Nonbanks have issued billions Rating agencies (and investors) view as "substantially" similar to perpetual preferred stock, while at same time payments were deductible Since Federal Reserve capital release in October 1996, discussed below, financial institutions have issued approximately $30 billion 2. Marketing perspective - well received and accepted in marketplace Spreads for trust preferreds appear attractive as compared to current spreads for both investment and non-investment grade 10-year and 30-year corporate bonds Two basic risk components of trust preferred securities credit risk of issuer non-credit risks -- duration, call and liquidity C. REIT PREFERRED SECURITIES 1. REIT preferred securities differ from trust preferred securities in that the financial institution (not the holding company) sets up a REIT (rather than a grantor trust), into which it injects real estate loans and mortgage-backed securities (and possibly other investments) in exchange for the proceeds of the REIT preferred stock offering and a common equity interest in the REIT. 2. Although these vehicles are more complicated than trust preferreds (because of the necessity to comply with the REIT rules), they provide a source for future continuing sales of loans and securities and a source of fees (advisory and servicing). 3. The financial institution must continue to feed the REIT with mortgage loans and securities as the original assets amortize and are paid off. 4. REIT preferreds create capital at the bank level. 5. In order to qualify for Tier 1 capital treatment, the REIT preferred is automatically exchangeable into preferred stock of the bank in the event that the bank’s capital position deteriorates (i.e., the leverage capital ratio falls below the "adequately capitalized" level). Consequently, the credit ratings of REIT preferred securities are closely tied to the rating of the sponsoring bank, regardless of the assets in the REIT. 6. The bank’s common equity interest in the REIT is typically much larger (generally 50%) than with the grantor trust in order to produce sufficient income to boost the REIT’s fixed-charge coverage ratio and improve its standing with the rating agencies. III. BASIS FOR FAVORABLE CAPITAL TREATMENT A. TRUST PREFERRED SECURITIES 1. Federal Reserve Board ("FRB") position - Trust Preferreds qualify as Tier I for up to 25% of Company's Tier I capital Long-term nature - 30 years Deeply subordinated to all of the holding company's other long-term debt Ability (within instrument) to defer dividend payments for up to five years Distributions on the interests are cumulative Outside preferred investors have no voting rights, except in the case of default (which does not include the 5 year deferral referenced above) Default permits preferred investors to appoint a trustee to take over the Trust, accelerate the debt and sue for collection 2. Subsidiary bank can utilize as much capital as is contributed to it as Tier 1 capital 3. Reasons for Positive Action by FRB: Federal Reserve action was taken because nonbank financial services competitors of bank holding companies were using tax-favored capital securities and receiving equity recognition for the instruments As an example, the Travelers Group alone registered $1 billion of trust preferred securities in the weeks before the Federal Reserve acted The pricing advantage on tax deductible issuances is substantial, amounting to as much as 300 basis points when compared to other preferred issues Foreign competing banks are allowed to have tax-favored capital Concern that trust holders could take over trust in default, accelerate debt and force holding company into bankruptcy was determined to be more theoretical than real -- if a 5 year payment deferral was needed, regulators would likely have taken over the financial institution. 4. No formal position taken by regulatory agencies on issuance of trust preferred securities by financial institutions at subsidiary level. At bank level, an unspecified amount of non-cumulative perpetual preferred stock can be used in Tier I capital calculations, but cumulative preferred stock will only count as Tier II capital for regulatory purposes A few banks have directly issued trust preferred securities (such as PNC and Corestates) 5. Rating Agency Perspective Consensus among rating agencies that trust preferred securities are generally rated the same as existing perpetual preferred stock Look at flexibility that the capital provides to the issuer Moody’s--treated as debt-like capital with no particular equity credit S&P--while viewing trust preferred securities as a weaker form of capital than perpetual preferred securities, the same treatment is afforded as with regular preferred stock B. REIT PREFERRED SECURITIES 1. REIT preferred securities qualify as Tier 1 capital for up to 25% of the bank’s Tier 1 capital 2. Bank regulators were concerned that in a REIT structure, valuable mortgage assets would be segregated to serve as a source of equity for the REIT investors and, consequently, such investors would have a preferential claim over depositors of the bank. 3. As a result, in exchange for Tier 1 capital treatment, the Office of Thrift Supervision ("OTS") requires that the operative legal documents for REITs provide that each REIT preferred share be exchangeable automatically for one newly issued preferred share of the parent bank if the OTS directs in writing that such an exchange shall occur because of any of the following: (i) the bank becomes "undercapitalized" under applicable regulations, (ii) the bank is placed into conservatorship or receivership or (iii) the OTS in its sole discretion, anticipates the bank becoming "undercapitalized" in the near term. Upon such an "Exchange Event," each holder of REIT preferred shares shall be unconditionally obligated to surrender to the bank all certificates representing the REIT preferred shares of such holder, and the bank is unconditionally obligated to issue to such holder in exchange an equal number of bank preferred shares. Holders of bank preferred shares would have the same dividend rights, liquidation preference, redemption options and other attributes as to the bank as holders of REIT preferred shares have as to the REIT. The bank preferred shares would rank on an equal basis in terms of dividend payments and liquidation preference with any then-outstanding shares of preferred stock of the bank. IV. STRUCTURE A. TRUST PREFERRED SECURITIES 1. How the Trust is Structured Holding company sets up a business trust (grantor trust) which owns all common equity and at least 3% of trust's total equity generally a Delaware business trust under Delaware Business Trust Act Trust issues trust preferred securities to third party investors Holding company issues subordinated debt to Trust simultaneously in exchange for loan of the proceeds of preferred issue. Terms of subordinated debt mirror image the trust preferred securities. Payments on the trust preferred securities are guaranteed by the parent company. Interest on subordinated debt is deductible expense for holding company but not taxable to trust, since earnings are passed through to stockholders, who pay tax on income. This is the tax benefit to the holding company. Guarantee is a relatively weak one -- payments are guaranteed only to extent the Trust is in possession of funds sufficient to pay investors. Other Features "Make Whole" features if tax law changes. 10 year call protection; premium call provisions in institutional private placements; no premium call provisions in retail public offerings 30-year term facilitates pricing and marketing off of 30 year U.S. Treasury bond. 2. Accounting Consolidation of balance sheet - holding company's common equity, interest and debt are eliminated, leaving preferred as form of minority interest - specifically, "Company Obligated Mandatorily Redeemable Preferred Securities of Subsidiary Trust." Consolidation of income statement - interest income and expense are eliminated and preferred dividends are treated as "minority interest" expense. More recently, many bankers prefer treating this as interest expense because transaction is essentially a financing Tax benefit shows up as a reduction in the tax provision 3. Tax Analysis - Based on Notice 94-47, 1994-1 CB 357 Unconditional promise to pay sum certain at fixed maturity date supports tax debt treatment. Also fact that pay-off is in cash. Whether holders have right to enforce payment of principal and interest. Whether holders are subordinate to general creditors, which supports equity treatment. However, widespread use of subordinated debt in these transactions suggests that this factor alone does not control. Whether holders can participate in management. Trust preferred holders do not vote or participate in management except in the event of default, suggesting debt treatment. Whether the issuer is thinly capitalized. Guarantee of holding company eliminates this concern and is an indicia of debt. Whether there is an identity between shareholders of holding company and holders of trust preferred securities. Usually this will not be the case. Supports debt treatment. Whether treated as debt or equity for non-tax purposes. With Tier 1 capital treatment for financial institutions, this supports equity treatment. Last factor unlikely to control since the same instrument could produce disparate treatment for non-financial issuers who don't need or seek regulatory treatment. Major focus on these "factors" seems to be length of maturity and whether payable in stock. 4. Other tax issues Because the trust is a pass thru entity for tax purposes, accrued interest or original issue discount is passed through to investors, even during a deferral period. (But likelihood of deferral is remote). If the debt instrument is distributed to holders, distribution likely is non-taxable and basis and holding periods would tack. Redemption of instruments would be taxable. 5. Treasury and Administration Proposals Would deny interest deductions for payments on instruments with more than specified term 1995 Balanced Budget proposal -- 20 years if not shown as debt on balance sheet FY 1997 Budget - same proposal FY 1998 Budget deny deduction where instrument has a weighted average maturity of more than 40 years, or where payable in stock of issuer also, treated as equity if maximum term greater than 15 years and not shown as debt on consolidated balance sheet. B. REIT PREFERRED SECURITIES 1. How the REIT is structured Determine form of organization Company vs. Trust State taxation -- some states impose franchise/income taxes on corporations but not on trusts Shareholder liability -- while shareholders are not responsible for debts/obligations of corporations, it is not as clear with respect to trusts Maryland trust statute provides specifically that trust shareholders are not liable for Trust’s debts/ obligations Corporate form offers more certainty while Trust form offers more flexibility Corporate statutes are specific while Trust statutes are broad and less specific Determine jurisdiction of incorporation -- Delaware vs. Maryland In recent years, Maryland has been primary jurisdiction for REIT incorporation Ability to use Maryland's flexible business corporation statute, which has more protective director/officer liability, indemnification and anti-takeover provisions than Delaware Maryland business corporation statute has been successfully tested in the courts, specifically with respect to its applicability to REITs No franchise tax in Maryland as there is in Delaware The operating bank or thrift (rather than the holding company) sets up the REIT Real estate loans and mortgage-backed and other securities are sold to the REIT in exchange for proceeds from preferred stock public offering and a common equity interest (solely held by the incorporating financial institution) in the REIT In addition to investing its assets in residential mortgage loans, commercial mortgage loans and mortgage-backed securities eligible to be held by REITs, cash, cash equivalents (including receivables) and government securities, a REIT may invest up to 20% of the total value of its portfolio in certain other assets. While the foregoing assets must constitute at least 75% of the value of the REIT's total assets under Section 856(c)(5)(A) of the Internal Revenue Code of 1986, as amended (the "Code"), up to 25% of the value of a REIT's total assets may be comprised of "non-mortgage-related securities" as defined in the Investment Company Act of 1940 (the "Investment Company Act"). Under the Investment Company Act, the term "security" is broadly defined to include, among other things, any note, stock, treasury stock, debenture, evidence of indebtedness, or certificate of interest or participation in any profit sharing agreement or a group or index of securities. The Code requires that the value of any one issuer's securities may not exceed 5% of the total assets of the REIT and the REIT may not own more than 10% of the voting securities of any one issuer. Dividends paid on REIT preferred securities are effectively deductible because a "qualified" REIT is not subject to federal and, in many cases, state taxation. REIT passes its earnings untaxed to shareholders, both common and preferred. Thus, dividends are paid with pre-tax dollars. 2. Accounting Upon consolidation of balance sheet, REIT's common equity and Bank's investment in subsidiary are eliminated REIT preferred stock is left on Bank's books as form of minority interest Upon consolidation of income statement, preferred dividends are minority interest expense. Tax benefit shows up as reduction in income tax expense. 3. Tax Analysis A REIT must be owned and organized and operated in such a manner as to qualify for taxation as a REIT under the Code. A company elects to be taxed as a REIT under Sections 856 through 860 of the Code and the applicable Treasury Regulations (the "REIT Requirements"), which are the requirements for qualifying as a REIT. The REIT Requirements are technical and complex. If a company qualifies for taxation as a REIT, it generally will not be subject to federal corporate income taxes on that portion of its ordinary income or capital gain that is currently distributed to stockholders. Such treatment substantially eliminates the federal "double taxation" on earnings (at the corporate and the stockholder levels) that generally results from investment in a corporation. The Code defines a REIT as a corporation, trust, or association (i) that is managed by one or more trustees or directors; (ii) the beneficial ownership of which is evidenced by transferable shares or by transferable certificates of beneficial interest; (iii) that would be taxable as a domestic corporation, but for the REIT Requirements; (iv) that is neither a financial institution nor an insurance company subject to certain provisions of the Code; (v) the beneficial ownership of which is held by 100 or more persons; (vi) not more than 50% in value of the outstanding stock of which is owned, directly or indirectly, by five or fewer individuals at any time during the last half of each taxable year; and (vii) meets certain other tests, described below, regarding the nature of its income and assets. The Code provides that conditions (i) through (iv), inclusive, must be met during the entire taxable year and that condition (v) must be met during at least 335 days of a taxable year of 12 months, or during a proportionate part of a taxable year of less than 12 months. Conditions (v) and (vi) will not apply until after the first taxable year for which an election is made to be taxed as a REIT. In order to maintain qualification as a REIT, a company must annually satisfy certain gross income requirements. First, at least 75% of a company's gross income (excluding gross income from prohibited transactions) for each taxable year must be derived directly or indirectly from investments relating to real property or mortgages on real property or certain other types of gross income. Second, at least 95% of the company's gross income for each taxable year must be derived from such real property investments and from dividends, interest and gain from the sale or other disposition of stock or securities and certain other types of gross income. At the close of each quarter of each taxable year, a company must satisfy three tests relating to the nature of its assets. First, at least 75% of the value of the company's total assets must be represented by real estate assets, cash, cash items and government securities. Second, not more than 25% of the company's total assets may be represented by securities other than those in the 75% asset class. Third, of the investments included in the 25% asset class, the value of any one issuer's securities owned by the company may not exceed 5% of the value of the company's total assets and the company may not own more than 10% of any one issuer's outstanding voting securities. In order to be treated as a REIT, a company is required to distribute dividends (other than capital gain dividends) to its stockholders in an amount at least equal to (A) the sum of (i) 95% of a company's "REIT taxable income" (computed without regard to the dividends paid deduction and a company's net capital gain) plus (ii) 95% of the net income, if any, from foreclosure property in excess of the special tax on income from foreclosure property, minus (B) the sum of certain items of noncash income. Such distributions must be paid in the taxable year to which they relate or in the following taxable year if declared before the company timely files its tax return for such year and if paid on or before the first regular dividend payment after such declaration. To the extent that the company does not distribute (or is not treated as having distributed) all of its net capital gain or distributes (or is treated as having distributed) at least 95%, but less than 100% of its "REIT taxable income," as adjusted, it will be subject to tax thereon at regular ordinary and capital gains corporate tax rates, as the case may be. "REIT taxable income" is the taxable income of a REIT, which generally is computed in the same fashion as the taxable income of any corporation, except that (i) certain deductions are not available, such as the deduction for dividends received, (ii) it may deduct dividends paid (or deemed paid) during the taxable year, (iii) net capital gains and losses are excluded and (iv) certain other adjustments are made. As long as a company qualifies as a REIT, distributions to United States stockholders up to the amount of a company's current or accumulated earnings and profits (and not designated as capital gains dividends) will be taken into account as ordinary income and will not be eligible for the dividends-received deduction for corporations. Distributions that are designated by a company as capital gain dividends will be treated as long-term capital gain (to the extent they do not exceed the company's actual net capital gain) for the taxable year without regard to the period for which the stockholder has held its stock. 4. REIT Benefits In general, the following benefits may be realized in connection with the formation of a REIT and issuance of REIT preferred securities: As noted, a portion of the REIT preferred shares can qualify as core/Tier 1 capital of the financial institution under relevant regulatory capital guidelines if properly structured. The dividends paid on the REIT preferred shares will be deductible by the REIT for income tax purposes as a result of the REIT's qualification as a REIT The financial institution will receive new funds after giving effect to the financial institution's expense of purchasing the REIT's common stock and additional capital contributions. The financial institution will be entitled to receive annual advisory and servicing fees and annual dividends in respect of the common stock The financial institution as servicer for the REIT will also be entitled to retain any late payment charges, prepayment fees or penalties and assumption fees and conversion fees collected in connection with the mortgage loans serviced. In addition, the financial institution will receive any benefit derived from interest earned on collected principal and interest payments between the date of collection and the date of remittance to the REIT and from interest earned on tax and insurance escrow funds with respect to mortgage loans serviced by them 5. Additional REIT Considerations Ongoing management requirement - fee generation for serving as advisor Must comply with complicated ongoing REIT qualification rules Need to continue to feed REIT with mortgages as loans and mortgage-backed securities amortize and are paid off Creation of capital at bank level could make holding company's access to capital for cash acquisitions more difficult Same beneficial characteristics as trust preferred securities Can be used by those financial institutions not in a holding company structure and mutual holding companies Can be used as an alternative source of funding for assets that cannot be pledged to Federal Home Loan Banks Permanent source of capital since instruments can be of perpetual duration V. THE MARKETING OF TRUST PREFERRED SECURITIES A. PUBLIC VS. PRIVATE ISSUANCES 1. Private Placements Initially, all issuances of trust preferred securities were conducted as private placements, due to the urgency created by the pending tax legislation. The purchasers have been primarily institutional buyers such as high yield bond funds, insurance companies, money managers and other bank and thrift holding companies. Pricing and terms 200 to 300 basis points over 30-year Treasury Call premiums 10-years of call protection Semi-annual interest payments Registration rights File registration statement for exchange offer or shelf registration within 150-days Registration statement declared effective within 180 days Exchange offer -- offer to exchange identical trust preferred securities which are fully registered Shelf registration Penalty if registration statement not filed or declared effective within time-frame -- additional 25 basis points of interest 2. Public Offerings Lower cost -- yields are generally lower than private transactions No call premiums Often distributed to retail purchasers as opposed to institutional buyers Quarterly interest payments Financial information is generally incorporated by reference VI. THE PUBLICLY TRADED REITS FORMED BY FINANCIAL INSTITUTIONS A. LIMITED NUMBER OF TRANSACTIONS TO DATE 1. Chase Manhattan, New York -- September 1996 Only bank holding company issuance $500 million transaction Trades on New York Stock Exchange All residential mortgages 2. Chevy Chase, Maryland -- November 1996 $150 million transaction Trades on New York Stock Exchange All residential mortgages 3. California Federal, California -- January 1996 $450 million transaction Trades on New York Stock Exchange All residential mortgages 4. D&N Financial, Michigan -- July 1997 $27.5 million transaction Trades on Nasdaq First to introduce commercial mortgages as well as residential mortgages 5. People’s Preferred Capital Corporation, California -- September 1997 $35.6 million transaction Trades on Nasdaq First privately-owned bank to establish a public REIT subsidiary First to use an outside servicer for portions of the loan portfolio B. TERMS 1. In general, these issues have had at least five years of call protection; some transactions have 10 years of call protection and have imposed redemption premiums. 2. Early redemption permitted for "Tax Events," which result in dividends paid by the REIT not being fully deductible for federal income tax purposes or the REIT having to pay more than a de minimis amount of taxes as a result of dividends paid by the REIT. 3. No voting by REIT preferred shareholders unless dividends shall not have been paid for specified number of periods, in which case REIT preferred holders can elect additional directors until dividends have been paid or set aside for specified period of time. C. LEGAL ISSUES 1. Thrift institutions are required to seek prior approval or non-objection to the establishment of an operating subsidiary from the OTS and the FDIC. 2. Thrift institutions will want to obtain confirmation of continued applicability of favored Tier 1 capital treatment provided OTS requirements are followed as originally outlined in writing by the OTS in the Chevy Chase transaction. 3. Because of the OTS requirement of having the requisite corporate documents in place for an "Automatic Exchange" of REIT preferred shares for bank preferred shares under the adverse circumstances referenced above, the thrift institution as a potential issuer of future securities will have to file an Offering Circular with the OTS on Form OC under 12 C.F.R. § 563g. This is in addition to the Registration Statement on Form S-11 filed by the REIT with the Securities and Exchange Commission. The Offering Circular with respect to the thrift institution is included as an appendix to the REIT prospectus. For public reporting thrift institutions, the information required can be incorporated by reference from public filings. 4. Because of the inter-relationship between the REIT and its parent company, care must be taken and proper corporate formalities followed to preserve the integrity of the two independent companies. Need for certain REIT directors to be independent from those persons who serve also in certain capacities with the financial institution. The REIT's incorporating documents should reference that certain actions may not be taken without the approval of a majority of the Independent Directors. Examples could include: Issuance of additional preferred shares Incurrence of debt in excess of specified levels Acquisition of assets other than as set forth in the REIT Operating Plan Termination or modification of operative agreements governing the REIT Terminating the REIT’s status as a REIT REIT Operations Policy and Conflict of Interest Policy Separate agreements with respect to purchase of assets, servicing and advisory arrangements