One of the most dramatic tools a lender can use in the collection of a loan is the involuntary bankruptcy case. It is dramatic because of the implications for both the debtor and the lender who files the case. If a bankruptcy court determine that the petitioning creditor has not met the statutory requirements it may require the creditor to pay the debtor’s costs and attorneys fees in defending the petition and if the court finds that the petition was filed in bad faith it can award compensatory and punitive damages. The consequences for the debtor are that if the creditor is successful, the debtor’s business and assets are now subject to disposition under a frameworks found in the Bankruptcy Code which may involve the appointment, at least initially, of a bankruptcy trustee to administer the debtor’s estate. Even if the debtor is successful in fighting off the petition it may suffer dramatic reputational risks that might affect its continued viability. Think of it then as the “nuclear” option.
This tool has now been used at least twice in connection with the enforcement by holders of Trust Preferred Securities (“TruPS”) against bank holding companies (“BHCs”). TruPS are hybrid securities that are included in regulatory tier 1 capital for BHCs and whose dividend payments are tax deductible for the issuer. In 1996 the Federal Reserve Board’s decided that TruPS could be used to meet a portion of BHCs’ tier 1 capital requirements. Following that decision many BHCs found these instruments attractive because of their tax-deductible status and because the increased leverage provided from their issuance can boost return on equity.
Smaller BHC’s typically did not bring TruPS to the market themselves, rather they were issued into a collateralized debt obligation (“CDO”) which in turn purchased TruPS from many different BHCs. According to Fitch since 2000 over 1,800 entities issued roughly $38 billion of TruPS that were purchased by CDO’s. In addition, many federally insured institutions held TruPS themselves once the banking regulators determined that TruPS were an acceptable investment.
One of the attributes of TruPS that led the Federal Reserve to grant them Tier 1 capital status was the ability of the BHC to defer dividends for up to five years. Many BHC’s took advantage of this feature during the economic downturn, some simply to be able to redirect cash flows where they were needed but others because they were operating under a regulatory enforcement actions which prevented the subsidiary bank from making dividend payments to the BHC to service the TruPS. Over the past five years or so the dividends have been accruing on the TruPS and the deferral period is coming to an end. Many BHC’s are still unable to service the dividends. Fitch estimates that there is $2.6 Billion of TruPS that will run out of their deferral period over the next several years.
Some of the BHCs in this situation have attempted to reach out to the holders of the TruPS in an effort to negotiate some sort of discount or a financial restructuring of the TruPS. This has proven very difficult to accomplish because the holders of the TruPS in many instances do not have the same priority position within the CDO. The FDIC has noted the difficulties that BHCs have had in attempting to work with the TruPS holders:
“The FDIC’s experience has been that the holders of TruPS have been an impediment to recapitalizations or sales of troubled banks. Potential investors in an open but troubled bank may need some reduction in claims from the TruPS holders to make a transaction feasible. However, there have been a number of occasions where, even when the common shareholders are poised to vote in favor of a transaction or sale (even one that results in significant dilution of equity), the trust preferred holders will not vote at all, or will not vote in favor of the transaction. One of the problems is that many trust preferred issues are in pools, which the holders say precludes voting on particular exchanges or discounts (e.g., BHC A offers to exchange its TruPS for common equity, or offers to redeem its TruPS at a specified discount). In some cases, the FDIC has found that downgraded TruPS are held by private equity investors who purchased the securities at a steep discount to par and may wish to hold out for a large “upside” in a transaction. In other cases, trustees of the TruPS will not vote for fear of litigation, or the percentage of TruPS holders needed to vote in favor may be very high.”
There is a current push by some of the banking advocacy groups to convince the federal banking regulators to allow banks and bank holding companies that are currently operating under a regulatory enforcement agreement more latitude in paying dividends from the bank subsidiary so as to allow it make a dividend payment on the TruPS. If the TruPS dividend payments were made current, the BHC could, if it so wished, generally then suspend dividends again for the next five years. So far the FDIC has shown little inclination to allow banks whose financial picture may be improving to make such a payment to thereby stave off the subsequent default by the BHC.
In a number of instances some of the TruPS holders have decided to move forward aggressively to assert their rights with the idea of essentially forcing the sale of the subsidiary bank by initiating an involuntary bankruptcy case for the BHC. Under the Bankruptcy Code, an involuntary bankruptcy case can be commenced by one creditor if the debtor has fewer than 12 creditors. The creditor’s claim must not be contingent in nature and aggregate at least $10,000 in excess of any value of any assets securing the claim. Further, the claim must not be the subject of a “bona fide” dispute and the creditor must show that the debtor was generally not paying its debts when they came due. If the creditor meets these tests then the bankruptcy court will generally approve the filing and appoint a trustee to administer the case. In the case of a BHC involuntary case the petitioning creditor will have already selected the party it seeks to have appointed as trustee, usually a firm that deals with company restructuring.
The first use of an involuntary bankruptcy filing against a BHC involved American Bancorporation in Mendota Heights, Minn (“AB”). AB first exercised its ability to defer dividends on its TruPS in 2008. When the deferral period ended in 2013, ATP Management (Alesco Preferred Funding XV Ltd. and Alesco Preferred Funding XVI Ltd.) sued AB on behalf of the TruPS holders and obtained a judgment in federal district court for approximately $40 million on TruPS which had a principal balance of approximately $30 million. The most recent filing was initiated by Trapeza Capital Management, LLC (Trapeza CDO XII, Ltd) against FMB Bancshares, Inc. located in Lakeland, Georgia. FMB had also been taking advantage of the option to defer dividend payments and had reached the end of its deferral period in 2014.
The AB case has been converted to a Chapter 11 proceeding. The advantage to the BHC of converting the case to one under Chapter 11 is that it maintains some control over the process as opposed to having the bankruptcy case driven by a bankruptcy trustee. Regardless, the ultimate outcome will be the same, the subsidiary bank of the BHC will be put up for sale and the proceeds will be upstreamed to the BHC for distribution to claimants. Theoretically it is possible that there could be sufficient proceeds available to pay all of the TruPS plus make a distribution to the shareholders. While the value of the subsidiary bank can vary pretty dramatically from institution to institution it is probably unlikely that the shareholders will receive any sort of distribution in a forced sale type of situation. It is also not altogether clear that there will always be a buyer waiting in the wings. The practical issue for any buyer being the capital position of the subsidiary bank, its non-performing loans and how much it will take to fully recapitalize the bank. It is possible that a BHC could offer the bank for sale and there be no offers. In such an instance the TruPS holders, after having expended a great deal of time and expense, could seek to dismiss the involuntary bankruptcy case. Another alternative is to allow their debt to be converted to equity in the BHC. As the new owners of the BHC they would then face the issue of whether they should inject new capital into the bank subsidiary in order to create some longer term value. In addition to the pure financial analysis they would also have to deal with the regulatory headaches that flow from a change in control.
The calculus for whether to file an involuntary bankruptcy case and whether it is really in the TruPS holders best interest is a fairly complicated one, matched in its challenges by the one faced by BHCs of whether they should preempt such action by filing a voluntary Chapter 11 case. Both decisions involve estimates of valuation and expenses as well as an economic analysis of whether any particular bank franchise has value to an outside investor and the value of any other assets owned by the BHC. The legal issues involved are also complicated as they touch on meeting the requirements of the Bankruptcy Code as well as evaluating possible legal claims and defenses among all of the parties involved. The calculations, of necessity, require a multi-pronged team of bankruptcy, bank regulatory lawyers and investment bankers. While it is unclear at this stage whether out-of-court restructurings of the TruPS will actually be possible based upon their oftentimes complicated structure, BHC management should seek advice at an early stage of how to approach the TruPS holders and find out what may be possible. They may find that a continuing dialogue will result in some sort of financial accommodation. Likewise, trustees for TruPS must find a way to balance the demand of TruPS holders with pragmatic steps to maximize recoveries on the TruPS.
Our experience has been that an ongoing dialogue between the BHC and the trustee for the TruPS holders where both parties explore all of the options available to them will at least leave open the option of some sort of accommodation. Clearly, this is not always the case whether due to intransigence by either side to the equation or some other cause but we find that at least attempting to have the conversation is a valuable tool for preventing precipitous action.