A Holding Company’s Options When Time Is Running Out

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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

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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.

Raising Capital in a Difficult Environment

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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.

Debentures
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.

PIPEs
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.

Summary
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.