January 7, 2014
Authored by: Robert Klingler
While we continue to emerge from the Great Recession, we are also approaching another cliff that could have significant ramifications for many community banks that continue to defer interest payments under their Trust Preferred securities. Under the terms of such Trust Preferred, issuers are generally allowed to defer interest payments for up to twenty consecutive quarters (or five years) without triggering a default. Many institutions began deferring interest payments about four and half years ago, both to preserve capital generally and in reaction to Federal Reserve Bank enforcement actions that limited the ability of banks to pay interest on the subordinated debt supporting the Trust Preferred. As we approach the end of the permitted five-year deferral period, we are now assisting a number of clients, on all sides of the equation, in addressing the ramifications of approaching, and potentially ultimately exceeding, the five-year deferral period.
One issue we have looked at is whether the Federal Reserve will permit a bank holding company subject to an enforcement action to bring its Trust Preferred current when failure to do so would result in default.
We’ve looked at the language in a number of agreements hoping that it would prohibit bank holding companies from paying interest only when such interest can be contractually deferred. Unfortunately, all the enforcement actions that we reviewed have a blanket prohibition on interest payments without regard to the permissibility of the deferral under the indenture. We understand that the Federal Reserve Banks are looking closely at the issue but have not yet provided any guidance as to the ultimate position on payment. In addition, most bank holding companies seeking to pay interest will need a dividend from their subsidiary bank to fund such payment; accordingly, the bank level regulator(s) will likely need to be involved as well.
A default, even with no further action by the trustee or holders of the Trust Preferred, likely eliminates the Tier 1 capital treatment, at least at the bank holding company level. Since such capital treatment only affects the holding company level, this should have little impact on bank capital levels and/or receiverships, but may offer the Federal Reserve Banks a compelling reason to allow holding company capital to be spent to bring Trust Preferred Securities current, as allowing to default would have a greater regulatory capital impact.
Another issue we have looked at is what reactions/limitations the Federal Reserve Banks might try to place on Trust Preferred holders in limiting their ability to force bankruptcy, and/or the attractiveness of doing so.
From a big picture perspective, while we believe the Federal Reserve Banks absolutely do not like bankruptcies, we are not aware of anything that would give the Federal Reserve the power to prevent a Trust Preferred holder from initiating a bankruptcy just like any other creditor. Either the FDIC or the Federal Reserve (or both), like any party in interest, could file a motion for the Bankruptcy Court to abstain or dismiss the case, asserting that the bankruptcy interferes with another pending proceeding elsewhere in a court more suited for the action. However, we think a Bankruptcy Court would be unlikely to abstain – the holding company has sufficient issues of its own (outside the bank regulatory environment) and would need to be resolved regardless of any bank regulatory action against subsidiary banks.
Regardless, bank regulators would certainly look to be very involved in overseeing and potentially exercising (or not exercising, as the case may be) approval authority over any plan, sale or other restructure that would result in a change in the control of the subsidiary bank (or the holding company itself, if we’re talking about something other than an eventual conversion to Chapter 7 and dissolution).
Because of their authority over the second part of this equation, which is really the part that gets the cash and/or other property of any value into the hands of the Trust Preferred holders, the institutional positions of the regulatory authorities could ultimately impact what strategies are seen as worth pursuing by the Trust Preferred holders. However, we wouldn’t want to predict what those regulatory positions may be (at least at the moment), beyond the Fed’s overarching scrutiny and skepticism of any complex corporate or financial structure.
We could certainly see the Trust Preferred holders forcing bankruptcies, if only for an effort to exact tribute from the banking regulators: “Either allow funds to go to the Holding Company, and we will forbear for a year, or we will push the holding company into bankruptcy, which will destabilize the bank and you will be forced to take it over, which will cost the FDIC much much more.” Not sure if this threat would work, but it could have some basic appeal to it.
Conversely, the institutional Trust Preferred holders, at least at present, likely do not have either the appetite or the ability to become bank holding companies, and that probably takes some bankruptcy restructuring options off of the table, at least in the more-underwater situations (to the extent that the way Trust Preferred has been largely pooled and chopped into CDOs hasn’t taken that off of the table already), but there could be some evolution there over the next couple of years, particularly as the subsidiary banks stabilize and start to regain some value.