A Holding Company’s Options When Time Is Running Out

Hundreds of bank and thrift holding companies are facing potential default on debt they took on to fuel growth in their bank subsidiaries. Much of this debt was trust preferred securities (TruPS), which had the benefit of counting as regulatory capital for the holding company, as well as allowing companies to defer interest payments for 20 consecutive quarters. For banks and thrifts that may have grown aggressively and later suffered losses, regulators have imposed orders prohibiting the payment of dividends to their holding companies, and without cash flow from their subsidiaries, the holding companies have been unable to make payments on their debt. Now, the end of that five-year deferral period is nearing for many holding companies, and they are facing default. So what should a board do? Kilpatrick Townsend & Stockton LLP’s Joel Rappoport discusses the options for those holding companies.

What strategic options are available for holding companies approaching default?
Most holding companies in this situation will need to raise capital. Relying on earnings alone is unlikely to be enough to persuade regulators to allow a repayment of deferred interest. The best outcome usually will be to find investors to invest in the holding company, or even find a buyer for the holding company, as these strategies will preserve at least some value for stockholders. Anyone who invests directly in the holding company must be willing to take on the debt, because debt must be repaid before equity investors can get any return.

What if you cannot find an investor for the holding company?
If you have a high amount of debt that exceeds the bank’s capital, equity investors may be scared away because they don’t want to take on the debt. In that situation, you could consider selling your bank outright to another bank or investor group that will then recapitalize the bank. You also could try to negotiate a deal with your creditors to take less than what is owed.

What are the obstacles to these options?
It can be difficult to work out a settlement with creditors. First of all, you may have trouble finding someone to negotiate with. Often, the TruPS owner is a CDO, a collateralized debt obligation, which is an asset pool that issues bonds backed by the assets. Some of these pools are managed, and those managers can negotiate a settlement for the CDO. If the owner of your debt happens to be an unmanaged CDO, there is a cumbersome process to get the consent of bond holders to any debt restructuring. There also are tax rules that complicate the process of bringing in new owners or investors. Many banks and holding companies have deferred tax assets that can be very valuable. A major ownership change may mean that future owners do not get the full value of these tax assets. You should try to structure any transaction so as to preserve these tax benefits.

With trust preferred securities, debt covenants don’t allow a sale of bank, so holding companies have to file for bankruptcy because that is the only way a sale can be done. This is called a Section 363 sale, which is the Bankruptcy Code section that allows a debtor to sell assets, and for a bank holding company, the primary asset is the stock of its bank subsidiary. Essentially, it requires an auction so creditors can get the best possible recovery.

What actions will creditors take if and when holding companies default on their debt?
Until recently, creditors fought Section 363 transactions because the results were so poor. Early auctions yielded no competitive bidding and minimal recoveries for creditors. But recent 363 transactions have produced two or more competitive bidders, with much better results for creditors. Creditors now seem to be more comfortable with Section 363 transactions and, in two cases, have even tried to force holding companies to auction their banks by filing petitions for involuntary bankruptcy. When this happens, the holding company might be forced into bankruptcy before it is ready.

What should bank holding companies or buyers interested in them do?
I would say that buyers have an opportunity here to look at these bank holding companies that are under pressure to take action quickly. Holding company boards should explore options early and not wait until close to the end of your deferral period. By then it may be too late, and it may be out of your hands. You may lose the chance to control your destiny.

Forming a Game Plan for TruPS

9-5-14-bryan-cave.pngFor the past 15 years, trust preferred securities (TruPS) have constituted a significant percentage of the capital of many financial institutions, mostly bank holding companies. Their ubiquity, both as a source of capital and as a common investment for banks, made them a quiet constant for many financial institutions. Even in the chaos of the Great Recession, standard TruPS terms allowed for the deferral of interest payments for up to five years, easing institutions’ cash-flow burdens during those volatile times. However, with industry observers estimating that approximately $2.6 billion in deferred TruPS obligations will come due in the coming years, many institutions are now considering alternatives to avoid a potential default.

Unfortunately, many of the obstacles that caused institutions to commence the deferral period have not gone away, such as an enforcement action with the Federal Reserve that limits the ability to pay dividends or interest. It is unclear if regulators will relax these restrictions for companies facing a default.

So what happens if a financial institution defaults on its TruPS obligations? It is early in the cycle, but some data points are emerging. In two cases, TruPS interests have exercised the so-called nuclear option, and have moved to push the bank holding company into involuntary bankruptcy. While these cases have not yet been resolved, the bankruptcy process could result in the liquidation or sale of the companies’ subsidiary banks. Should these potential sales result in the realization of substantial value for creditors, it is likely that we will see more bankruptcy filings in the future.

Considering the high stakes of managing a potential TruPS default, directors must be fully engaged in charting a path for their financial institutions. While there may not be any silver bullets, a sound board process incorporates many of these components:

Consider potential conflicts of interest.
In a potential TruPS default scenario, the interests of a bank holding company and its subsidiary bank may diverge, particularly if a holding company bankruptcy looms. Allegations of conflict can undercut a board’s ability to rely on the business judgment rule in the event that decisions are later challenged. Boards should be sensitive to potential conflicts, and may want to consider using committees or other structures to ensure proper independence in decision-making.

Determine who owns your TruPS.
Because of the way in which many TruPS issuances were placed, their ownership structures can range from the very simple to the incredibly arcane, and identifying the decision-making authority among the holders and their interests can be difficult to determine and can vary widely. This can influence or preclude the institution’s ability to reach a negotiated settlement of their TruPS obligations.

Develop a decision tree for addressing the TruPS obligations.
Developing tiers of potential alternatives can lend structure to the process, and the short timeframe involved may require that initiatives be pursued simultaneously, on parallel paths. For example, if a potential capital raise proves unworkable, planning for a sale of the subsidiary bank as part of a voluntary bankruptcy, also known as a 363 sale, may prove to be the best alternative.

If possible, engage with the trustee, collateral manager, or TruPS holders.
While the parties may not be able to come to a resolution, attempting to have the conversation with interested parties, where possible, may head-off an involuntary bankruptcy filing, and in any case helps to build a record of the board’s diligence and proactive efforts to satisfy its creditors.

Review your D&O Insurance Policy.
The possibility of bankruptcy (whether voluntary or involuntary) raises a host of issues with respect to insurance coverage—new potential claimants enter the picture, the board’s ability to renew a policy in bankruptcy may be impaired, and the board’s decisions will be scrutinized. Ensuring upfront that your policy is framed to deal with the unique issues that can arise in bankruptcy (and to actually provide coverage for claims by the most likely claimants), regardless of whether you intend to end up there, is critical.

For directors, developing a proactive process for negotiating or settling the company’s TruPS obligations is far superior to adopting a passive approach in the face of a potential default. Even when attractive alternatives for an institution may be limited, evaluating and prioritizing those alternatives provides a framework within which the board can operate, and also allows directors to establish a record of diligence that is consistent with their duties.

What’s Sparking the Trend in Recent Section 363 Bank Sales?

11-4-13-Hovde.pngThe financial crisis left in its wake nearly 500 failed banks and 553 institutions remaining on the Federal Deposit Insurance Corp.’s problem bank list. Undoubtedly, the FDIC will seize some of those “problem” banks in the coming quarters as they fall below the critically undercapitalized leverage ratio of 2 percent. Yet, the financial crisis also left behind banks with sufficient capital whose holding companies are effectively bankrupt. In these unique situations, the holding company owns a valuable asset in the subsidiary bank, yet it may owe creditors—including Trust Preferred Securities (TruPS) holders—substantial sums. Such a scenario places directors and officers of the holding company in an uncomfortable position. Generally speaking, they cannot sell the bank out from underneath the holding company because debt covenants prohibit it or creditors would hold directors and officers personally liable for the debt. What can boards in these situations do to protect themselves and maximize value to stakeholders?

Fortunately, there are some options to consider:

  • With a long enough time horizon, continue to operate business as usual with the holding company slowly building up equity and paying off its debt;
  • Attempt a pre-packaged restructuring under Chapter 11 with creditors, many of whom could be disparate owners of the debt and difficult to organize; or
  • Explore a sale utilizing Section 363 of the Bankruptcy Code, selling the subsidiary bank in a court-supervised auction process designed to maximize proceeds to the holding company.

While every situation is unique—and these options are not exhaustive—Section 363 has become a useful tool for distressed bank holding companies to sell their bank franchises to acquirers free and clear of any liens and encumbrances. When a distressed holding company is unable to negotiate a pre-packaged reorganization with creditors under Chapter 11, then Section 363 may be an attractive alternative.

Since 2010, there have been roughly 15 examples of Section 363 sales in the banking industry, and seven of those transactions have been pursued in 2013, a significant uptick in prevalence from previous years. Recently, Capitol Bancorp, Inc. made news with its sale of four subsidiary banks to Talmer Bancorp, Inc., utilizing Section 363.

The pickup in 363 sales is not surprising. Six years after the credit crisis, several holding companies now hold TruPS debt in excess of their banking assets. According to SNL Financial, 30 holding companies were still deferring interest payments on TruPS as of August 30, 2013. While the number of companies deferring payments has decreased in recent years, there still remain those holding companies so far underwater that their TruPS holders are unlikely to receive deferred interest, let alone the face value of their debt. In these situations, a Section 363 sale of the bank subsidiary or subsidiaries may be the only viable strategic option for the holding company.

A Section 363 sale is similar to a traditional M&A process in which the bank asset is marketed for the highest price, although it involves several nuances, including a stalking horse bidder (i.e., a pre-selected acquirer of the bank with whom the holding company enters bankruptcy), a court-supervised auction with bidding increments designed to increase the price, large break-up fees, several court hearings and, as one might imagine, additional legal expense. Also, a 363 sale process is not without its own inherent risks.

In bankruptcy court, the debtor must demonstrate that the 363 sale was the best option for all stakeholders of the estate: enter the TruPS holders. Many TruPS holders of distressed institutions bought the paper for pennies on the dollar and have been waiting for the holding company to enter bankruptcy so they can argue for additional value. Indeed, many of the 363 bank sales announced thus far have involved objections by TruPS holders. The institutional investors who now own vast quantities of TruPS are very sophisticated, understand the bankruptcy process, and aren’t afraid to put up a fight while lining the pockets of well-heeled attorneys. Surely, they can be formidable adversaries to the friendly, neighborhood community bank in distress.

With the risk of litigation as a backdrop, directors and officers of holding companies with substantial TruPS obligations and a saleable bank asset should consider a Section 363 sale; however, it could be prudent to attempt to contact the TruPS holders ahead of time to see if a restructuring can be negotiated. While it may be unlikely that management will reach an agreement with TruPS holders—assuming they can be found—extending the olive branch should look better in court if they object to a bank sale.