Amidst the current wave of credit crisis-related securities lawsuits have been a noteworthy number of cases involving various classes of subordinated or preferred securities investors, as I previously noted here. In particular, and just in the past several weeks, plaintiffs’ lawyers have filed several securities class action lawsuits involving banks’ "trust preferred securities." As discussed below, these hybrid securities have particular characteristics that make them particularly sensitive to the current financial turmoil, which, in turn, suggest that there could be further litigation ahead involving these securities.
Trust preferred securities are hybrid securities that have characteristics of both equity and debt. Although any corporation could issue these securities, they have most popular with bank holding companies, due to a 1996 Federal Reserve Board opinion allowing the proceeds of a trust preferred offering to be treated as "Tier I" capital by the bank holding company. Under these Fed guidelines, up to 25% of a bank’s Tier I capital may be from funds raised through trust preferred securities offerings.
In anticipation of a trust preferred securities offering, the bank holding company creates a wholly-owned subsidiary organized as a trust. The holding company issues debt to the trust and the trust in turn issues securities to investors through an initial public offering. The holding company’s debt is the trust’s sole asset. In many instances, the trust preferred securities are traded on the public securities exchanges, with their own ticker symbol. The proceeds of the offering are transferred from the trust to the holding company, where the proceeds are treated as capital on the holding company’s balance sheet.
The advantage to the holding company from this transaction structure, in addition to the ability to reflect the transaction proceeds as regulatory capital, is that the holding company’s interest payments on the debt issued to the trust are tax deductible (unlike dividends on conventional preferred shares, which would come out of after-tax income).
Further background regarding trust preferred securities can be found here and here.
In recent years, these kinds of offerings were a popular way for bank holding companies to raise regulatory capital. According to a recent publication from the Federal Reserve Bank of Philadelphia (here), at the end of 2008, over 1,400 bank holding companies had approximately $148.8 billion in trust preferred securities outstanding. However, during 2008, there were relatively fewer of these offerings, as the market for these kinds of offerings "essentially dried up" due to "disruptions in the credit market."
Trust preferred securities offerings were an effective way for bank holding companies to bolster their regulatory capital when their financial performance was strong. However, when the holding company’s financial condition deteriorates and its regulatory capital declines, then, according to the Philadelphia Fed article, limitations the percentage of trust preferred securities that may be counted in regulatory capital and the restrictive covenants on the debt obligation "further exacerbate the institution’s financial problems and raise supervisory concerns."
In addition, concerns that the holding companies are more likely to defer interest payments on the securities as the economic crisis continues have resulted in ratings downgrades for the securities and significant declines in the valuation of the securities as well.
Given the combination of circumstances, it is hardly surprising that litigation involving these trust preferred securities has begun to appear. Just in the past few weeks, there have been several securities class action lawsuits brought on behalf of trust preferred securities investors who purchased their shares in the initial public offering of the securities.
For example, on May 4, 2009, a purported class action lawsuit was brought in the Northern District of Georgia on behalf of persons who purchased SunTrust Capital IX 7.875% Trust Preferred Securities of SunTrust Banks, in connection with the February 2008 initial public offering of the securities. The complaint (here) names as defendants SunTrust Banks; the trust itself; certain directors and officers of SunTrust; the offering underwriters; and PricewaterhouseCoopers.
The complaint alleges that there were material misrepresentations and omission in the offering documents in violation of the liability provisions of the ’33 Act. Among other things, the complaint alleges that:
(a) The Company’s assets, including loans and mortgage-related securities were impaired to a greater extent than the Company had disclosed; (b) Defendants failed to properly record losses for impaired assets; (c) The Company’s internal controls were inadequate to prevent the Company from improperly reporting its impaired assets; and (d) The Company’s capital base was not as well capitalized as it had represented.
Other recent actions involving trust preferred securities include the action brought on April 1, 2009 involving Regions Financial Corporation’s 8.875% Trust Preferred Securities of Regions Financing Capital Trust III, which issued securities in an April 2008 offering. Background regarding the case can be found here.
Three different recent securities lawsuits target separate trust preferred offerings involving Deutsche Bank. These filings involve actions commenced on February 24, 2009 (refer here); March 19, 2009 (refer here) and March 30, 2009 (refer here). Each of these actions relate to separate trust preferred securities offerings sponsored by Deutsche Bank.
Each of these cases are brought under the ’33 Act, and each names as defendants the bank holding company, the trust, the holding company’s directors and officers, the offering underwriters, and in many cases the auditor. Each of cases raises factual allegations similar to those raised in the SunTrust case.
Subject to the possible constraint noted below, it seems likely that there will be more of these kinds of lawsuits ahead. The trust preferred securities, which were offered to investors under different economic circumstances, are now beaten down as a result of the current financial turmoil. Each of the hundreds of separate offerings involved a distinct and discrete class of investors, which in turn gives plaintiffs’ lawyers a series of separate points of access from which to target specific troubled financial institutions, as the multiple separate lawsuits against Deutsche Bank demonstrate.
Each of the offering also affords a separate potential opportunity to assert claims under the ’33 Act. Bringing an action under the ’33 Act, rather than under the ’34 Act, avoids the need to satisfy the heightened standards for pleading scienter. In addition, the issuing entity is "strictly liable" under the ’33 Act for material misrepresentations and omissions.
The ’33 Act’s relatively short one year/three year statute of limitations (refer here) may provide some constraint on the offerings that plaintiffs’ lawyers might now attempt to target. On the other hand, the looming time limitations may simply spur a host of filings before time expires.
One final note is that the litigation possibilities arising from problems surrounding these securities are not limited just to the bank holding companies that initiated the trust preferred securities transactions. Investors who suffered losses because of interest payment defaults on trust preferred securities have also been hit with lawsuits. For example, the securities class action filed against RAIT Financial Trust (about which refer here) arose after American Home Mortgage defaulted on its trust preferred securities interest payments obligations, which meant the loss to RAIT of $95 million in revenue.
Investors alleged that RAIT had failed to disclose its exposure to American Home and to adequately reserve against the possibility of American Home’s nonpayment. As noted here, on December 22, 2008, the court granted in part and denied in part defendants’ motion to dismiss the RAIT plaintiffs’ complaint.
Shareholders Win Japanese Class Action: According to news reports (here), on May 21, 2009, shareholder plaintiffs won a 7.6 billion yen ($81 million) securities class action verdict against Takafume Horie, the founder of failed Internet company Livedoor, and other Livedoor executives. 3,340 individual and corporate shareholders had brought the action, which alleged that the defendants "used stock swaps and other dubious maneuvers to pad Livedoor’s books and inflate its share price."
Horie (who is popularly known as "Horiemon") is out on bail while he appeals his criminal conviction for securities fraud. Background regarding the fraud allegations can be found here.