Making the Tough Call on Trust Preferred Securities

October 26th, 2015

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.

jrappoport

Joel Rappoport is a partner on the Financial Institutions Team in the Washington, D.C., office of Kilpatrick Townsend & Storckton LLP.