BBX Capital Inc (BBXIA)

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Breaking the Trust Preferred Logjam

Not long ago, many banks viewed trust preferred securities (“TPS”) as inexpensive capital, and TPS are on the balance sheets of many bank holding companies today. Now, many of these same companies must raise capital and are finding their TPS an insurmountable impediment.

The reason for this is that TPS, which are considered debt, have priority over common stock upon liquidation. Investors will not invest new equity knowing that it eventually will be used to repay the TPS. This is particularly galling to sophisticated investors, the likely sources of new capital, who have no interest in “bailing out” debt holders. So prospective investors who might otherwise step up are sitting on the sidelines.

For particularly troubled bank holding companies, the failure to raise capital could lead to the failure of the bank subsidiary, leaving little or no value for TPS holders. Faced with thissituation, most debt holders would be motivated to negotiate a discounted payoff. Unfortunately, TPS are different, and negotiations often have proved impossible. To understand why, one must understand how TPS were sold.

To take advantage of a securities registration exemption, many TPS were sold to special purpose entities (“SPEs”) that own pools of assets, usually debt or preferred stocks that provide cash flows. These SPEs, in turn, issued bonds secured by their pools of assets. So, many TPS are owned by SPEs, which in turn have senior and junior bond holders.

Some SPEs have asset managers, who make investment decisions with respect to the SPEs assets. But many SPEs are unmanaged “static pools,” where investment decisions may be made only by the holders of the SPEs bonds. Each SPE has its own set of rules as to when and how decisions may be made. Often, in cases where a security is not in default, decisions must be reached unanimously by senior bond holders or by all bond holders, which is a practical impossibility. Indeed, many SPEs were structured with the intent of prohibiting negotiated settlements; those SPEs have no mechanism for reapportioning the cash flows of their bonds following an asset restructure.

As a result, many distressed bank holding companies seeking to negotiate with TPS holders have found there simply is no one to negotiate with, even in situations where negotiations are so clearly in the best interests of the TPS holders. Tender offers receive no response.

Avoiding bank failure is imperative. Thus, boards of directors who are unable to negotiate with TPS holders have sought ways to raise capital by forcing a reduced payout for TPS holders without their consent.

One approach, completed successfully in Washington in 2010, was the sale by a holding company of its ownership interest in its bank through a bankruptcy process. To do this, the holding company files for bankruptcy and at the same time enters into an agreement with a “stalking horse bidder” to sell the bank. Theholding company then auctions the bank under procedures approved by the bankruptcy court. The bank ultimately is sold to the highest bidder, which likely is the stalking horse bidder. Upon closing, the proceeds from the sale of the bank go to the TPS holders, and the winning bidder recapitalizes the bank.

This type of transaction carries the risk of a run on the bank, as customers may think the holding company bankruptcy means the bank too has failed. For this reason, a well thought out public relations campaign is essential. The holding company should seek court approval for as short an auction process as possible.

A second way to recapitalize a bank without negotiating with TPS holders would be to raise capital at the bank level by selling bank equity to investors. Such a transaction also poses risks,in that if a sufficient ownership interest in the bank is sold it could amount to a breach of the TPS covenant against a sale of all or substantially all of the holding company’s assets unlessthe buyer assumes the TPS obligations. A careful reading of the exact wording of the TPS covenants would be required.

Relief may be on the horizon. Some SP bond holders recently have begun to organize, and there are investors who have acquired TPSwho are willing to negotiate, so it may now be possible to negotiate with at least some TPS holders. This raises the intriguing possibility of a mutually negotiated settlement amongthe holding company, investors and some TPS holders. The negotiated settlement could be enforced against all TPS holders through a prepackaged bankruptcy. The settlement might even give the TPS holders an equity stake in the recapitalized bank, which would be an opportunity to recover in the future some of their lost value.

One thing is certain – TPS will continue to be an impediment to bank holding companies who need to recapitalize their bank subsidiaries, and so long as TPS holders are unwilling or unable to negotiate, companies will continue to seek creative solutions to break the logjam, even if it means deliberately breaching TPScovenants.

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http://media.straffordpub.com/products/fdics-expanded-role-in-bank-holding-company-insolvencies-2012-07-26/reference-material.pdf