Next Generation Hybrid Securities by Anna Pinedo
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May 2006, Vol. 10 No. 5 © Thomson/West Legalworks Next Generation Hybrid Securities By Anna Pinedo Anna Pinedo ([email protected]) is a partner specializing in securities and derivatives in the New York offi ce of Morrison & Foerster LLP. Much of the material in this article was developed for a conference on hybrid securities at IN THIS ISSUE: Morrison & Foerster LLP. Morrison & Foerster partners Thomas A. Humphreys and Oliver Ireland presented with Barbara J. Havlicek, Vice President, Chair, Next Generation Hybrid Securities New Instruments Committee, Moody’s Investors Service, and Scott Sprinzen, By Anna Pinedo.............................................. .1 Financial Institutions Group, Standard & Poor’s. Introduction Hybrid securities, or securities that have some equity characteristics © 2006 Thomson/West Legalworks. This publication and some debt characteristics, have been popular for over a decade. was created to provide you with accurate and Hybrid securities lie somewhere along the equity-debt continuum,1 authoritative information concerning the subject matter covered, however it may not necessarily have but where exactly, is the subject of great debate. In fact, over its life, been prepared by persons licensed to practice law in a hybrid security may exhibit different proportions of equity-like or a particular jurisdiction. The publisher is not engaged debt-like traits—sliding along the continuum. in rendering legal or other professional advice, and this publication is not a substitute for the advice Hybrid securities include certain classes of preferred stock, trust of an attorney. If you require legal or other expert preferred securities, and convertible debt securities. Issuers like hybrid advice, you should seek the services of a competent securities because these instruments often receive favorable treatment attorney or other professional. by ratings agencies and regulators when they analyze an issuer’s capital For authorization to photocopy, please contact structure. Many hybrids also provide a lower after-tax cost of capital the Copyright Clearance Center at 222 Rosewood for issuers. Drive, Danvers, MA 01923, USA (978) 750-8400; fax (978) 646-8600 or West’s Copyright Services Ratings agencies recently changed their methodologies for analyzing at 610 Opperman Drive, Eagan, MN 55123, fax hybrid securities,2 creating defi ned “baskets” based on the “equity-like” (651)687-7551. Please outline the specifi c material or “debt-like” content of a security. Under the basket approach, a hybrid involved, the number of copies you wish to distribute security meeting specifi c criteria will qualify for a specifi ed percentage of and the purpose or format of the use. equity treatment. This change, which provides additional clarity relating For subscription information, please contact the to the amount of “equity credit” awarded in evaluating an issuer’s publisher at: capital structure in connection with the issuance of a hybrid security, [email protected] was a catalyst for new product development. Product structuring groups around Wall Street set out to build a better hybrid security. What are the key elements of a better hybrid security? A better hybrid security: • qualifies for favorable equity treatment; • allows issuers to make tax-deductible payments; and • qualifies as Tier 1 capital for bank holding companies. This article discusses the principal structuring considerations relating to hybrid securities. The article does not address accounting issues, which often may be signifi cant. ARTICLE REPRINT © 2006 Thomson/West Legalworks 2 The Measuring Stick pay a sum certain on demand or at a fi xed maturity date that is in the reasonably foreseeable future; (b) whether holders The benefi ts of a hybrid security depend on its “equity- of the instruments possess the right to enforce the payment like” or “debt-like” characteristics. From a ratings agency of principal and interest; (c) whether the rights of the holders perspective, the more equity-like the hybrid, generally, the of the instruments are subordinate to the rights of general more favorable the treatment. From a tax perspective, the creditors; (d) whether the instruments give the holders the more debt-like the hybrid, generally, the more favorable the right to participate in the management of the issuer; (e) tax treatment the issuer can obtain. This poses an interesting whether the issuer is thinly capitalized; (f) whether there is conundrum. identity between holders of the instruments and stockholders In thinking about how to structure a security to meet these of the issuer; (g) the label placed upon the instruments by seemingly contradictory objectives, it is helpful to identify the the parties; and (h) whether the instruments are intended to core elements of common equity (which Standard & Poor’s be treated as debt or equity for non-tax purposes, including 4 refers to as “the paradigm equity”3) and the core elements of regulatory, rating agency, or fi nancial accounting purposes.” debt. Both Moody’s and Standard & Poor’s identify several The IRS Notice further states that “[n]o particular factor characteristics associated with “pure equity,” including no is conclusive in making the determination of whether an maturity, no ongoing payments that could trigger a default instrument constitutes debt or equity. The weight given to if unpaid, and loss absorption for all creditors. For example, any factor depends upon all the facts and circumstances and common stock has no fi xed repayment obligation or term. the overall effect of an instrument’s debt and equity features In contrast, debt usually has fi xed payments and a stated must be taken into account.”5 maturity. An issuer can elect to not pay dividends on its For tax purposes, the analysis focuses on the rights of common stock, but non-payment of principal or interest on the holders of the hybrid security as compared to the rights a debt security generally will constitute an event of default. of the issuer’s other security holders. In contrast, the ratings Finally, common stock provides “loss absorption” for an agency analysis for equity credit purposes focuses more on issuer, meaning that common stockholders are the last class the effect of the security on the issuer’s capital structure and of security holders to receive distributions in a liquidation. cash fl ows. The equity credit that is afforded to a hybrid By contrast, debt holders have a right to receive payments security may change over the life of the security, but the tax prior to equity holders. In evaluating a hybrid security, both characterization will remain the same. Moody’s and Standard & Poor’s consider whether, how, and the extent to which, the features of a hybrid security replicate Rating Agency Treatment these characteristics associated with common equity. As discussed above, hybrid securities receive varying The most common hybrid securities are preferred degrees of “equity content” from ratings agencies based on securities with additional features designed to achieve their features and their anticipated effect on the issuer’s capital enhanced economics or other effi ciencies. As a general structure. Ratings agencies will limit the overall amount of matter, preferred stock is issued directly by an issuer. traditional hybrids to which they give equity treatment when Preferred stock may entitle the holder to a dividend, subject considered relative to the issuer’s overall capital structure, but to declaration by the issuer, and may entitle the holder to in general, ratings agencies like hybrids because they have some voting rights. As with common stock, non-payment some of the loss-absorbing features associated with common of a preferred stock dividend will not trigger an event of equity securities. To varying degrees, hybrid securities may default. However, non-payment may breach a covenant provide “cushion” within an issuer’s capital structure in or other contractual undertaking by the issuer. Dividend bankruptcy or upon the occurrence of other adverse events. payments may be cumulative, or non-cumulative. Preferred Ratings agencies also consider the effect of the hybrid security stock may be convertible, at the option of the issuer or on the issuer’s cash fl ows. The analysis of the hybrid security the holder or mandatorily upon the occurrence of certain is separate and distinct from the rating agency analysis of the events. While senior to common stock in liquidation, issuer’s overall credit rating. preferred stock provides some measure of loss absorption in a bankruptcy or other degraded fi nancial situation. In its Tool Kit, Moody’s has a continuum of fi ve baskets, from the A basket, which is 0% equity and 100% debt, at From a tax perspective, the issuer of a hybrid security one extreme, to the E basket, which is 100% equity and wants a tax deduction for the associated dividends or coupon payments. A tax deduction will be available if the security is 0% debt, at the other extreme. The A basket would include determined to be debt for tax purposes. Whether a security dated subordinated debt (with maturity of less than 49 is debt or equity for tax purposes depends on a careful years). The E basket encompasses instruments having fi ve evaluation of the facts and circumstances and is not subject characteristics: mandatory convertible; convertible within to a bright-line test. three years; subordinated debt, preferred or senior, with accelerated conversion; optional deferral; and cumulative In 1994, the Internal Revenue Service set forth the fol- coupon. In order to assign a hybrid security to a basket, lowing list of non-exclusive debt-equity factors: “(a) whether Moody’s assesses the instrument’s equity-like characteristics there is an unconditional promise on the part of the issuer to (measured against the no maturity, no ongoing payments, © 2006 Thomson/West Legalworks. This publication was created to provide you with accurate and authoritative information concerning the subject matter Wall Street Lawyer covered, however it may not necessarily have been prepared by persons licensed to practice law in a particular jurisdiction.