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Forming a Game Plan for TruPS

Forming a Game Plan for TruPS

November 14, 2014

Authored by: Ken Achenbach and Michael Shumaker

For the past 15 years, trust preferred securities (TruPS) have constituted a significant percentage of the capital of many financial institutions, mostly bank holding companies.Their ubiquity, both as a source of capital and as a common investment for banks, made them a quiet constant for many financial institutions. Even in the chaos of the Great Recession, standard TruPS terms allowed for the deferral of interest payments for up to five years, easing institutions’ cash-flow burdens during those volatile times. However, with industry observers estimating that approximately $2.6 billion in deferred TruPS obligations will come due in the coming years, many institutions are now considering alternatives to avoid a potential default.

Unfortunately, many of the obstacles that caused institutions to commence the deferral period have not gone away, such as an enforcement action with the Federal Reserve that limits the ability to pay dividends or interest. It is unclear if regulators will relax these restrictions for companies facing a default.

So what happens if a financial institution defaults on its TruPS obligations? It is early in the cycle, but some data points are emerging. In two cases, TruPS interests have exercised the so-called nuclear option, and have moved to push the bank holding company into involuntary bankruptcy. While these cases have not yet been resolved, the bankruptcy process could result in the liquidation or sale of the companies’ subsidiary banks. Should these potential sales result in the realization of substantial value for creditors, it is likely that we will see more bankruptcy filings in the future.

Considering the high stakes of managing a potential TruPS default, directors must be fully engaged in charting a path for their financial institutions. While there may not be any silver bullets, a sound board process incorporates many of these components:

Consider potential conflicts of interest.
In a potential TruPS default scenario, the interests of a bank holding company and its subsidiary bank may diverge, particularly if a holding company bankruptcy looms. Allegations of conflict can undercut a board’s ability to rely on the business judgment rule in the event that decisions are later challenged. Boards should be sensitive to potential conflicts, and may want to consider using committees or other structures to ensure proper independence in decision-making.

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Bankruptcy Judge Allows Involuntary Bankruptcy to Move Forward

On August 29, 2014, Judge John T. Laney, III, the Chief United States Bankruptcy Judge for the Middle District of Georgia, issued an order denying FMB Bancshares’ motion to dismiss the involuntary bankruptcy petition filed by its TruPS creditor, Trapeza CDO XII.  Among other conclusions, Judge Lacey found that the restrictions contained in FMB Bancshares’ written agreement with the Federal Reserve constituted a a restriction on the company’s ability to pay, rather than its legal duty to pay.  While detrimental to FMB Bancshares’ motion to dismiss, this conclusion should reinforce the ability of third parties to enter binding contractual arrangements with bank holding companies, which should be of great relief to those willing to lend to bank holding companies.

As reflected in the opinion and other court documents, FMB Bancshares issued $12 million in Trust Preferred Securities to Trapeza CDO XII in 2006.  Starting in March 30, 2009, FMB Bancshares elected to defer payments under its TruPS, and on March 30, 2014, FMB Bancshares exhausted the twenty consecutive quarter deferral period.  Trapeza has alleged that FMB Bancshares was non-responsive to Trapeza’s efforts to find an out-of-court solution, and declared the TruPS in default on April 7, 2014, causing an acceleration of all principal and interest.  On June 9, 2014, Trapeza filed an involuntary bankruptcy petition for FMB Bancshares, indicating that it believed an auction under Section 363 of the Bankruptcy Code would maximize its return.  On July 3, 2014, FMB Bancshares filed a motion to dismiss the bankruptcy petition, arguing (1) that Trapeza did not have the right (or standing) to institute an involuntary bankruptcy under the terms of the TruPS, (2) that FMB Bancshares was unable to pay because of its regulatory obligations with the Federal Reserve Bank of Atlanta, resulting in the debt being legally contingent, and (3) that the bankruptcy court was not the right venue for the disagreement.

In a 20-page opinion, Judge Laney succinctly rejected each of FMB Bancshares’ arguments.

With regard to Trapeza’s standing to institute the involuntary bankruptcy filing, Judge Laney found that the terms of both the Indenture and Amended Trust Agreement provided Trapeza CDO, as the the holders of the Trust Preferred Securities, with broad powers to enforce their rights against FMB Bancshares directly following the event of default (the occurrence of which was conceded by FMB Bancshares).  Specifically, both the Indenture and Amended Trust Agreement provided, following an event of default, that any holder of TruPS had a contractual right to institute a suit or proceeding directly against FMB Bancshares for enforcement of payment.  Judge Laney found that  an involuntary bankruptcy case could be properly construed as a suit for enforcement of payment, noting that bankruptcy cases in other jurisdictions reached the same conclusion.

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TruPS on Your Mind? Let’s Talk About It on August 6th.

We are receiving quite a few calls regarding the recent activity surrounding trust preferred securities, including voluntary and involuntary bankruptcies, restructurings, acquisition opportunities, and potential personal liability of directors.  Given this level of interest, Bryan Cave attorneys will be presenting at the Georgia Bankers Association Trust Preferred Town Hall Meeting in Macon, Georgia on August 6, 2014.  A flyer and agenda for the event is linked here, and you can register by clicking here.  The town hall format of the event will allow for interaction with the presenters and with the other attendees.  We will share ideas that will benefit those who are looking for alternatives to work out their trust preferred obligations, those who hold trust preferred securities, and those looking to better understand the landscape to take advantage of opportunities.  We hope you will join us for this unique opportunity.

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TruPS and Involuntary Bankruptcy

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.

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Regulators Provide Creative Volcker Rule Fix for TruPS

In facing Congressional and industry backlash related to the effect of the Volcker Rule on TruPS CDOs, federal regulators were expected to choose between two options.  Door 1 was to provide an exemption for TruPS CDOs held by all institutions.  Door 2 was to provide an exemption only for TruPS CDOs held by banks with less than $15 billion in assets, consistent with the Collins Amendment to Dodd-Frank.

The regulators chose neither door, instead opening Door 3: the regulators have exempted TruPS CDOs for all institutions, so long as the TruPS CDO primarily holds TruPS of banks with less than $15 billion in assets.  It will likely take a few days for the full analysis to come in, but I would expect that this has the effect of exempting all TruPS CDOs, as the CDO structure was primarily used in conjunction with private offerings of TruPS by smaller financial institutions.

The Interim Final Rule, issued on January 14, 2014, adds a new Section __.16 to the Volcker Rule, effective on April 1, 2014 (the same effective date for the Volcker Rule generally).  Section __.16 provides that the “covered funds” prohibition of the Volcker Rule do not apply to investments in a CDO if:

  1. the CDO was established prior to May 19, 2010 (the grandfather date for Tier 1 treatment for TruPS);
  2. the bank reasonably believes the offering proceeds of the CDO were used to invest primarily in TruPS issued by banks with less than $15 billion in assets (the Collins Amendment threshold); and
  3. the bank acquired the TruPS CDO on or before December 10, 2013 (the date the final Volcker Rule was approved by the regulators).
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The Upcoming Trust Preferred Interest Deferral Cliff

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.

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Regulators Poised to Remove TRuPS CDOs from Volcker Rule Grasp

According to a story in the American Banker (subscription required), the federal banking regulators are looking at exempting all existing collateralized debt obligations backed by trust-preferred securities from compliance with the Volcker Rule.

From a technical perspective, it seems likely that the regulators would effect such an exemption by excluding the debt tranches of CDO’s backed by TRuPS from the definition of an “ownership interest” under the Volcker Rule, thereby allowing continued ownership by banking entities.  Whether the revision is limited to existing TRuPS CDO’s or all is likely largely irrelevant, as the elimination of preferred capital treatment for Trust Preferred securities has eliminated the creation of new TRuPS CDO’s.

As previewed by the regulators’ late Christmas gift, the regulators are considering limiting the relief to banking entities with less than $15 billion in total assets.  Without getting into the merits of whether its appropriate to treat TRuPS CDO investments differently based on the size of the institution with the investment, it seems that limiting the relief to banking entities with less than $15 billion could also limit the effectiveness of such relief.  To the extent larger financial institutions still need to dispose of their TRuPS CDO investments (by July 2015, but potentially earlier in light of accounting treatment), it could still unsettle TRuPS CDO markets, widening market losses for community banks.  While not impacting regulatory capital levels, this could still represent a GAAP hit for community banks that seems inconsistent with the Collins amendment and the regulators general statements that the Volcker Rule is not intended to impact community banks.

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Banking Regulators Agree to (Re)Examine TRuPS CDOs and the Volcker Rule

In a late Christmas present (or perhaps it was just delayed in delivery), the federal banking agencies and the SEC (although apparently not the Commodity Future Trading Commission) announced they would be reviewing whether it would be appropriate to exempt CDOs backed by Trust Preferred Securities from the Volcker Rule’s ban on covered funds.

The agencies have stated that they intend to address the matter no later than January 15, 2014, and believe that, consistent with GAAP, any actions taken in January 2014 should be effective in addressing year-end financial statements so long as such actions are taken before the issuance of such financial statements.

In the statement released by the regulators, the agencies emphasize the grandfathering of TRuPS provided by the Dodd-Frank Act for institutions with consolidated assets of less than $15 billion, and suggest that action to revise the Volcker Rule may be appropriate  to avoid “consequences that are inconsistent with the relief Congress intended to provide community banking organizations.”  Whether this foreshadow only partial relief of the impact of the Volcker Rule on CDOs backed by TRuPs, namely only to those institutions with less than $15 billion in total consolidated assets, remains to be seen.

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Ambiguity Regarding TRuPS CDOs and the Volcker Rule

On December 19, 2013, the Federal Reserve, FDIC and OCC issued an Interagency FAQ Regarding Collateralized Debt Obligations Backed by Trust Preferred Securities under the Final Volcker Rule.  While roundly criticized by most trade associations and others following the industry as constituting “Frequently Asked Questions Without Answers,” the FAQ does provide additional potential insight on whether banks will ultimately need to dispose of their investments in CDOs backed by TRuPS portfolios (as well as other CDOs).

The greatest weakness in the FAQ, and a generally nasty side-effect of issuing final Volcker Rules shortly before calendar (and thus fiscal) year-ends, is whether accounting firms will force institutions to recognize unrealized market losses, based on an inability to hold the investment to maturity.  This question will ultimately be answered by the accounting firms, although still subject to second guessing by the banking regulators.  The tone and style of the December 19, 2013 FAQ suggests that the regulators are continuing to explore the issue, and intend to take advantage of the delayed compliance deadline of July 2015, to reach more conclusive determinations.  Whether this ambiguity is sufficient for institutions to appropriately determine they maintain the requisite intent to hold the securities through maturity will be a judgement call for institutions and their accountants.

Without providing definitive answers, the FAQ does indicate that the banking regulators do not believe that bank investments in CDOs backed by TRuPS portfolios are universally prohibited by the final Volcker Rule.  Rather, they point to two specific areas for further analysis in determining the Volcker Rule’s applicability to any particular investment.

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Volcker Rule Adds Another Nail in TRUPs’ Coffin

On December 10, 2013, the final Volcker Rule was adopted by the federal banking regulators, the SEC, and the CFTC to implement Section 619 of the Dodd-Frank Act.  The Volcker Rule generally prohibits banking entities from engaging in “proprietary trading” and making investments and conducting certain other activities with “private equity funds and hedge funds.”

One unintended consequence appears to be the treatment of Collateralized Debt Obligations (CDOs) backed by Trust Preferred Securities (TRUPs) as “covered funds” under the Volcker Rule.  As a covered fund, banking entities of all sizes will no longer be able to own TRUPs CDOs as of July 21, 2015.  Moreover, because of this obligation to divest by July 21, 2015, banks are no longer able to say they will hold such investments to maturity and therefore will not be able to split out their other than temporary impairment between credit losses and market losses.  Any market losses in the CDO security (which is currently reflected only in other comprehensive income) will be reported as a loss through Tier 1 capital.  Banks holding TRUPs-backed CDO’s are encouraged to reach out to their accountants to discuss the potential accounting impact.

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