Making the Tough Call on Trust Preferred Securities

In recent months, three bank holding companies in or nearing default on the payment of deferred interest on trust preferred securities have elected to sell their institutions under Section 363 of the U.S. Bankruptcy Code. While this certainly must have been a difficult step to have taken, it does suggest that the boards of directors of these companies are making appropriate, though wrenching, choices to protect their bank subsidiaries, the communities they serve and the FDIC insurance fund. However, there are many similarly situated companies that are delaying taking their medicine, and these companies may be placing their banks at risk.

Before the onset of the economic crisis, many institutions, seeing growth opportunities ahead, established trust subsidiaries that issued trust preferred securities. The trust subsidiaries used the proceeds to purchase subordinated debt from their holding companies, which then contributed the proceeds to their bank subsidiaries to increase capital to support anticipated growth. In order to treat the subordinated debt as capital, the instruments were required to permit issuers to defer the payment of interest for up to 20 consecutive quarters.

When the economy soured, many of these holding companies had to exercise their deferral options. Most holding companies in this predicament now have regulatory agreements that prohibit the payment of dividends by their bank subsidiaries and the payment of interest on trust preferred securities without approval. These companies are now nearing, or in some cases have already reached, the end of their 20-quarter deferral periods and are in danger of defaulting.

There are remedies available for these companies, although many of them are difficult to accomplish or could be unpalatable. Most desirable is obtaining regulatory approval to pay a dividend from the bank and use the proceeds to pay deferred interest on the trust preferred securities. Before granting approval, regulators will want to see a reliable earnings stream and sufficient remaining capital at the bank.

Other remedies are less appealing. A company may seek to raise capital. However, it can be difficult for troubled institutions, especially smaller community banks, to raise capital from institutional investors, and a capital raise is also likely to be highly dilutive to existing stockholders.

Other companies may find themselves forced to seek a merger partner with the resources to assume the company’s obligations under its trust preferred securities. While eliminating default risk, a merger results in the loss of independence.

Companies also may seek to negotiate a resolution with creditors. This is extremely difficult, if not impossible, to accomplish, given that most trust preferred securities are held by special purpose entities, many of which are not actively managed.

When all else fails, creditors can be forced to accept a sale of the bank under Section 363, an action that often will achieve little or no value for stockholders.

It is natural for boards of directors to resist diluting or wiping out stockholders or surrendering their independence. However, the consequences of failing to act can be severe. Regulators are keenly aware when bank holding companies are nearing default and will strongly pressure their boards of directors to take action. And once a company is in default, creditors can act to recover their principal and may even act in ways that may not seem economically rational but make sense to them if they are more concerned about their entire portfolio of companies than they are about any single company. Indeed, we have seen two situations where creditors have filed petitions for involuntary bankruptcy.

Even where boards of directors decide to act, it can take time to accomplish any transaction, so it is critical to act sufficiently in advance of the default date. Once default occurs, if creditors choose to take action unilaterally, boards of directors could lose control of their destinies, and key decisions may end up in the hands of creditors or judges. These types of disputes can harm a bank’s reputation and, in extreme cases, create liquidity risk.

So for companies with a default date looming, it is critical to accept reality and then plan and act well in advance of the default date. The action may be difficult to accept, but in the long run it might be the best thing for the bank and its customers.

Raising Capital in a Difficult Environment

1-31-14-Hunton.pngIn this environment, bankers can be excused for a fixation on capital. The demise of trust preferred (“TRUPs”) pools means there is no longer “just in time capital.” Regulators have demanded higher capital levels for troubled institutions, and new rules under the global agreement known as Basel III are set to go into place for community banks in January of 2015. Accordingly, bankers need to plan for their capital needs.

The following are some options for raising capital.

Bank Stock Loan
Bank holding companies (BHCs) of more than $500 million in total assets will generally be required to maintain a leverage ratio of 5 percent, a Tier 1 capital to risk-weighted assets ratio of 6 percent and a total capital to risk-weighted assets ratio of 10 percent, all on a consolidated basis. Basel III increases the total risk based capital ratio, including a new conservation buffer, and will add a common equity risk-based ratio, starting Jan 1, 2015. Bank holding companies below $500 million in assets are subject to a leverage limitation (essentially, the company must have a ratio of 100 percent debt to holding company equity) and a requirement that a subsidiary bank remains well capitalized. Dodd-Frank phases in quantitative capital requirements for savings and loan holding companies regardless of whether they have $500 million in assets or not.

All BHCs can borrow funds and contribute such funds into their banks as capital. BHCs of less than $500 million in total assets need mainly to stay within the debt-to-equity limits. Obviously, interest on bank stock debt is tax deductible.

For larger BHCs (those subject to consolidated capital guidelines), the Federal Reserve generally provides that subordinated debentures with an average weighted maturity of at least five years count as Tier 2 capital. These debentures are also an option for any size BHC looking for an interest-only alternative. Subordinated debentures must be unsecured. There are also other technical requirements to count as Tier 2 capital.

Preferred Stock
Dividends paid by a BHC on preferred stock are not tax deductible. Preferred stock must be noncumulative to qualify as Tier 1 capital, in other words, it doesn’t pay the holder any unpaid dividends retroactively. Consequently, a BHC may be able to justify the higher cost as compared to debt if necessary to improve the BHC’s leverage or Tier 1 risk-based capital ratios. Cumulative preferred stock is Tier 2 capital.

Common Stock
Common stock is obviously the cheapest form of capital, but also the most dilutive, to shareholders.

Private Offering
There are a number of options for an offering of securities. The JOBS Act regulations allow broad marketability of offerings solely to accredited investors. A BHC can engage in a nonpublic offering for up to 35 accredited investors or an offering which is otherwise exempt from registration. For instance, the BHC can engage in an exempt offering under Rule 144A to qualified institutional buyers (QIBs), which allows subsequent resales of the securities when resold to QIBs. This can mitigate the embedded marketability discount on securities sold in private placements.

Public Offering
To the extent that the BHC is public and it anticipates making frequent offerings of its securities, it may decide to file a shelf registration under Rule 415. A shelf registration covers securities that are not necessarily sold in a single discrete offering immediately upon effectiveness, but rather a number of tranches sold over time or on a continuous basis. With a shelf registration in place, the BHC has increased flexibility to raise money without the need of further Securities and Exchange Commission (SEC) clearance. There is also a considerable saving in paperwork, as only a prospectus supplement need be filed with the SEC.

Rights Offering
A BHC may consider a rights offering to existing shareholders as a means to raise additional capital. The rights offering could either be registered with the SEC or, if an exemption from registration were available, as a private offering. In a rights offering, the BHC allows existing shareholders to purchase their pro rata share of the securities offered.

In a PIPE offering, which stands for private investment in public equity, a public company issues securities in a private placement to selected accredited investors, normally QIBs or other institutional accredited investors. As a part of the securities purchase, the issuer agrees to file a resale registration statement covering the resale of the securities within a period of time following the closing. This allows the holders of the securities to gain liquidity while allowing the issuer to receive the capital without the delay of an SEC registration process.

Our expectation is that the most likely source of funding for most is a retail offering either with or without an investment banker. Nonetheless, in light of the rebounding capital market, offerings in a 144A or in a public offering are increasingly available.