The Financial Accounting Standards Board is pushing for companies to count their trust preferred securities as debt on balance sheets, a move that could significantly shift the debt ratios of some companies and lead to potential covenant defaults. FASB is taking aim at the mezzanine section of the balance sheet as part of its equities and liabilities project, and trust preferreds typically reside there.
FASB has completed an exposure draft on the project and has summarized the comment letters, stating it will come out with a final decision regarding trust preferred securities in the second quarter, according to Corporate Financing Week, an LMW sister publication. While FASB has floated this move before, many bankers are bracing for the worst as balance sheet issues come front and center in the wake of Enron. "It could wipe out the trust preferred market," said Jeff Seidel, director of convertible research at Credit Suisse First Boston. Companies issue trust preferreds because of their equity treatment for regulatory and capital purposes, and for the tax deductibility of their interest payments. If, because of an accounting change, the ratings agencies don't give the trust preferred structure the equity treatment they currently enjoy, it would wipe out any reason for issuing them, said Seidel.
The change would also affect a company's debt-to-equity ratio and could trigger certain covenants, forcing companies to renegotiate their loan agreements with creditors. For companies on shaky financial ground, renegotiating these covenants could be the start of a bigger restructuring demanded by the creditors, said Jim Harrington, an accounting specialist at PricewaterhouseCoopers. "The bankers or bondholders could see this as an opportunity to force the companies to fully restructure under much less-friendly terms," he said.
From a bankruptcy perspective, a change in the way the company accounts for trust preferreds will only be significant if the move is accompanied by a legal change in the way these obligations are interpreted, said Henry Miller, co-head of restructuring at Dresdner Kleinwort Wasserstein. Trust preferred bondholders are only senior to common shareholders and if there is no change to that status than it is a "non-event," he said. "So what if the ratios change? You just get together with the banks or bondholders and renegotiate the covenants."
Ratings agencies have different approaches to how much equity treatment to give the structure, and the FASB move will more clearly mark the securities as debt, noted one accounting professional. Tim Blake, member of Moody's Investors Service's new instruments committee, said he "felt vindicated" by the potential FASB move because Moody's has always considered the structure as subordinated debt to the parent company.