Trust-preferred security
A trust-preferred security is a security possessing characteristics of both equity and debt. A company creates trust-preferred securities by creating a trust,
issuing debt to it, and then having it issue preferred stock to investors. Trust-preferred securities are generally issued by bank holding companies. The preferred stock securities issued by the trust are what are referred to as trust-preferred securities.
The security is a hybrid security with characteristics of both subordinated debt and preferred stock in that it is generally very long term, allows early redemption by the issuer, makes periodic fixed or variable interest payments, and matures at face value. In addition, trust preferred securities issued by bank holding companies will usually allow the deferral of interest payments for up to 5 years.
The principal advantages of these hybrid characteristics are favorable tax, accounting, and credit treatment. Trust preferred securities have an additional advantage over other types of hybrid securities, which is that if they are issued by a bank holding company, they will be treated as capital rather than as debt for regulatory purposes. This is why trust preferred securities are issued overwhelmingly by bank holding companies, even though any company can issue them. However, the Dodd-Frank Act changes this benefit.
Structure
The issuing company forms a Delaware trust and holds 100% of the common stock of the trust. The trust then issues preferred stock to investors. All of the proceeds from the issuance of preferred stock are paid to the company. In exchange, the company issues junior subordinated debt to the trust with essentially the same terms as the trust's preferred stock. All steps except the formation of the trust occur simultaneously. If the issuing company is a bank holding company, it will also usually guarantee the interest and maturity payments on the trust preferred stock.Advantages
Trust preferred securities are used by bank holding companies for their favorable tax, accounting, and regulatory capital treatments. Specifically, the subordinated debt securities are taxed like debt obligations by the IRS, so interest payments are deductible. Dividends on preferred stock, by comparison, are paid out of after-tax income. The company may therefore enjoy a significantly lower cost of funding.If issued by a bank holding company, they are treated as capital rather than liabilities under banking regulations, and may be treated as the highest quality capital if they have certain characteristics. Since the amount of liabilities that a banking institution may have is limited to some multiple of its capital, this regulatory treatment is highly favorable and is why the trust preferred structure is favored by bank holding companies.
To be eligible as Tier 1 capital, such instruments must provide for a minimum five-year consecutive deferral period on distributions to preferred shareholders. In addition, the intercompany loan must be subordinated to all subordinated debt and have the longest feasible maturity. The amount of these instruments, together with other cumulative preferred stock a bank holding company may include in Tier 1 capital, may constitute up to 25 percent of the sum of all core capital elements, including cumulative perpetual preferred stock and trust preferred stock. Non-financial companies are more likely to use less complex structures, such as issuing junior subordinated debt directly to the public.