U.S. structure mimics income trusts

(October 15, 2004) If Canadian investors had a hard time understanding income trusts, wait until they see what’s heading to our markets from the U.S.

Because U.S. law does not allow the “pass-through” trusts which Canadian income trusts are built upon, investment bankers seeking the same benefits were forced to create a whole new corporate structure. What they came up with were income deposit securities (IDS), enhanced income securities (EIS) and income participating securities (IPS).

All three of these products are essentially the same, according to Edwin Maynard, partner with Paul Weiss LLP and American representative on the OSC’s Securities Advisory Committee. The standout difference between the IPS and the other two is that it is traded exclusively in Canada and is not considered foreign content by the CRA.

Maynard was speaking at the Strategy Institute’s Income Securities conference on Thursday, and told the audience the American market is at “an exquisite moment of uncertainty” where no one is quite sure how the income security market will play out. In contrast, the Canadian investment community has been onboard with income trusts since the 1990s, with the bursting tech-bubble causing a near stampede in 2000 and 2001.

The IDS/IPS structure provides investors with one share of common stock in the company, fused to one unit of senior subordinated debt. These two constituent parts of each IDS unit can be split after 45 days and recombined at any time. This structure gives the IDS unit-holder the rights of a shareholder and the protection of being a creditor.

The IDS unit itself is traded in the same fashion as a trust unit, but neither the stock nor the debt can be listed on the stock exchange individually. This may change in the future to allow the severed stock to trade freely. While the stock and debt are not listed, the underwriters must guarantee to make a market for each, should the investor opt to split the unit. The debt component typically matures in 12 or 15 years.

On top of these IDS units, the company must issue 10% of its debt on a stand-alone basis, with these “bachelor bonds” carrying the same terms as the IDS unit’s debt component. These bonds cannot be combined with common stock split off from the IDS unit.

There is also a second class of equity, or “spinster stock”, which is issued to the operating company’s pre-IPO equity holders, typically management and private equity sponsors. This maintains their equity stake without the conflict of also becoming debt-holders, as they would be with the IDS unit. But in some of the proposed deals, a provision has been made to allow conversion of these shares to IDS units after a holding period. This is generally two years for a minimum of 10% and one year for the balance.

There is some concern that the entire instrument could be deemed as “equity” by the IRS, which would mean a loss of the deductibility for interest payments. So far, the IRS has not issued a ruling on this, but Maynard says the top accounting firms in the U.S. have all “signed off on the structure.”

Another challenge facing these structures comes from the SEC, which will not allow the company to use historic earnings to set initial dividend levels. Registrants must include one year of earnings projections to support their proposed dividend level and show the “minimum EBITDA” required to support the stated payout.

The deals have faced close regulatory scrutiny compared to traditional equity listings, with the SEC making 11 amendments to one filing, versus the average of three for typical equity deals. They have also spent more time on the filings, taking 10 months to complete some, versus the usual three to five months.

In the U.S. there have been about 20 IDS/EIS deals filed with the SEC, with two completed and two pulled.

So far, the deals have headed to the AMEX stock exchange, but Maynard foresees the NYSE and NASDAQ taking steps to take some of that market share as the IDS/EIS gains acceptance.

Due to their fairly complicated structure, IDS offerings have mostly been gobbled up by institutional investors, with retail buyers typically making up 25-40% of the offering. That stands in stark contrast to the trust market in Canada, which has been driven by the retail investor while institutions have largely stood on the sidelines.

The IPS is a Canadian-listed version of the IDS, landing north of the border because the IPO would not be able to reach the $300-million threshold needed to attract the attention of U.S. institutional investors.

The arrangement may strike some as odd, however, considering the uproar in 2003 over the northward cash flow from U.S.-based business income trusts.

Filed by Steven Lamb, Advisor.ca, steven.lamb@advisor.rogers.com

(10/15/04)

Steven Lamb