Making the Tough Call on Trust Preferred Securities

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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.

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.