August 29, 2005
New Financial Product
Posted by Victor Fleischer

Investment Dealers' Digest (via NYT) describes Ecaps, the newest debt-equity hybrid from Lehman. 

The marketing / branding hook is that it should receive more equity credit from the rating agencies.  But is this really debt for tax purposes?

The article explains,

There are a few key differences between Ecaps and trust preferreds. Ecaps have a 60-year maturity, twice as long as the typical trust preferred. They also have mandatory deferral features, the key one being that if a pre-specified trigger is reached, the issuer is required immediately to issue either common stock or certain qualifying perpetual preferred stock to fund the distribution to Ecaps holders. By contrast, the deferral mechanism on trust preferreds is not mandatory, nor is there an equity issuance requirement. Finally, the deferral period on Ecaps is up to 12 years compared with the five on a traditional trust preferred.

These relatively subtle tweaks to the old trust preferred structure were enough to convince the ratings agencies that Ecaps are more equity-like. The difference is most striking at Moody's, which currently assigns zero equity credit to trust preferreds. Ecaps, however, receive 75% equity credit and 25% debt. The picture is similar but slightly more muddled at Standard & Poor's, where financials currently receive 100% equity credit for trust preferreds, which can account for up to 10% of total adjusted equity. Traditional preferreds are able to count for up to 25% of total equity in S&P's view, and Ecaps qualify to be included in this larger bucket. For nonfinancials, S&P assigns roughly 40% equity credit for trust preferreds, while Ecaps will receive 60% to 70%.

60 years, mandatory conversion into common or perpetual preferred ... I can see why the rating agencies would give some equity credit ... but won't the IRS see it the same way?  And since the IRS must see this gray-ish product in black or white, how sure are we that it will be debt for tax purposes?  I have not kept up with the newest debt-equity rulings, but it sure smells like equity to me. 

I am sure Lee Sheppard (Tax Notes) will be on this soon if she isn't already. 

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