"Ticking TRUPs" Threaten BHCs
This article was published in the November issue of Western Independent Bankers CFO & Finance Digest.
Trust preferred securities (TRUPs), the highbred security that counted as Tier 1 regulatory capital but generated tax deductible interest payments, were a favored source of capital for community banks. When the financial crisis hit, many bank holding companies (BHCs) with troubled bank subsidiaries exercised the right to defer interest payments on their outstanding TRUPs for up to five years. Interest continued to accrue during the deferral period, but the deferral was not a default and there was nothing that the TRUPs holder could do but wait. Many deferral periods that began late in 2009 and early 2010 are about to expire. TRUPs holders − long shackled by contractual stand still covenants – are about to be unleashed to exercise their creditor rights against the troubled BHCs that issues the TRUPs.
Deferred Interest Becomes Due and Payable
In most cases, the five years of deferred interest on the TRUPs becomes due and payable in full when the deferral period ends. If the accrued interest is not paid, then the TRUPs holders may declare a default, accelerate the principal and demand immediate repayment of all principal and accrued interest on the TRUPs. The trustee for the unpaid TRUPs has all the rights of an unsecured creditor, may obtain a judgment against the BHC and can force the BHC (but not its subsidiary bank) into bankruptcy, which has already happened to at least three BHCs.
Dividends from Subsidiary Bank
The obvious solution is for the BHC to pay all accrued interest on the TRUPs when the deferral period ends (after which a new five-year deferred period could begin). In many cases, however, the BHC may not have millions of dollars of liquid assets available to pay the accrued interest. The BHC may be dependent upon dividends from its subsidiary bank to make the interest payment due on the TRUPs. All of the accrued and unpaid interest may, in effect, be capital of the subsidiary bank (because during the deferral period, dividends were not paid by the bank to the BHC to pay the interest on the TRUPs). This retention of capital strengthened the subsidiary bank, helping it recover from the financial crisis. The subsidiary bank may no longer be in a troubled condition, but in many cases it will not have excess capital sufficient to pay an extraordinary dividend and remain well capitalized. The OCC and FDIC may be unwilling to approve an extraordinary dividend from the bank to the holding company. Also, the Federal Reserve may not permit a troubled BHC to pay the accrued interest due on the TRUPs.
Proceeds of Stock Offering
Some BHCs may raise funds to repay TRUPs accrued interest by issuing new common stock. Convertible preferred stock is preferred by some private equity funds. A stock offering will usually dilute existing shareholders, but is generally preferable to a default on the TRUPs.
If the BHC and/or subsidiary bank are still in a troubled condition, regulators may prohibit the BHC from using the proceeds of a stock offering to pay the TRUPs interest. The Federal Reserve could direct a troubled BHC to retain such proceeds to be a source of strength to the subsidiary bank. In one instance, the Federal Reserve permitted a BHC to issue stock with proceeds placed in escrow and used by the escrow agent (not the BHC) to pay the TRUPs accrued interest. The Federal Reserve has indicated that structure may not be permitted in the future.
Merger with Acquiror
Another alternative is for the BHC to sell by merging with a financially stronger BHC. In that case, TRUPs indentures generally require that the buyer assume all the obligations of the seller under the TRUPs. TRUPs holders have been unwilling in most cases to negotiate any discount with the buyer. The result is a lower price for the selling BHC’s shareholders. In most cases, the TRUPs indenture prohibits the BHC from selling or merging its subsidiary bank unless the acquiring bank and BHC assume all the seller's TRUPs obligations.
Downsizing the Bank
TRUPs indentures generally do not prohibit the subsidiary bank from selling its assets or branches. A bank may raise capital by selling deposits and branches, shrinking its balance sheet and increasing its regulatory capital ratios. If the downsized bank remains viable and well capitalized, banking regulators may approve a dividend of any resulting excess capital to the BHC.
Section 363 Sale in Bankruptcy
If a BHC cannot receive dividends from its subsidiary bank, use proceeds from a stock offering or merge with another BHC, then the BHC must consider a holding company bankruptcy as a possible solution. If the subsidiary bank is viable, but the BHC is illiquid, then the debtor BHC may engage in a Section 363 sale (named after the bankruptcy code section authorizing such sales) of its subsidiary bank. Under bankruptcy court supervision, the BHC may sell the stock of its subsidiary bank free and clear of the BHC’s debts (including the TRUPs). Proceeds from the sale of the bank stock are then distributed according to the bankruptcy code:
- First, to any secured bank stock lender
- Second, to unsecured creditors, including TRUPs
- Third, to any preferred stockholders
- Fourth, any remainder to the common stockholders.
Holders of defaulted TRUPs may initiate an involuntary bankruptcy, but strategically, the BHC may want to file a voluntary bankruptcy. This is more likely to result in a favorable sales price for the subsidiary bank. The debtor BHC can pre-arrange for a stalking horse acquiror to submit a reasonable and competitive bid to purchase the stock of the subsidiary bank. Creditors, shareholders and third parties are then given a limited amount of time to top the stalking horse bid for the bank stock, usually in a bankruptcy court auction. The highest bidder purchases the stock of the bank, and receives a bankruptcy court order that it acquired the stock free and clear of all liens and claims of third parties (including the TRUPs).
Section 382 Recapitalization in Bankruptcy
A BHC with significant net operating losses (NOLs) may pursue a Section 382 bankruptcy transaction. In this complex tax-driven transaction, the debtor BHC retains and recapitalizes its subsidiary bank, cleans the BHC balance sheet and preserves the economic value of its NOLs. Under bankruptcy court supervision, the BHC converts the TRUPs and other BHC debt into equity (in which the existing common shareholders are severely diluted or wiped out). The BHC then raises new equity from investors, which must constitute less than 50 percent of total equity. The reorganized and debt free BHC then operates the recapitalized subsidiary bank and uses its NOLs to shelter income and increase capital and value until the BHC and bank are subsequently sold.
Troubled BHCs and healthy but illiquid BHCs that have TRUPs deferral periods about to expire face unique problems. There are various ways to address such problems, but careful advanced planning is required. BHCs that do not have a plan to deal with their maturing TRUPs may lose control to the TRUPs trustee and the bankruptcy court.