The 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.