by contributor Andrew E. Jillson, Hunton & Williams | Published May 15, 2012 at 2:25 PM
In this current debt-laden economic environment, more than a few bank holding companies find themselves with impaired balance sheets while their subsidiary banks are in need of a recapitalization, a new owner or some other rescue. Developing a business solution for the subsidiary bank is no small task. But even when a promising solution is possible, creditors' claims against the holding company, including claims arising from trust preferred securities, can create a cloud on the subsidiary bank that may only be removed with the consent of those creditors. Unfortunately, obtaining this needed consent can be difficult or impossible, preventing the bank from being saved. Faced with that exact situation, and knowing that action is required to avoid a bank failure, holding companies are beginning to take the extraordinary step of filing Chapter 11 bankruptcy in order to enlist the Bankruptcy Code's powers to implement a rescue that otherwise would not occur.
In the past decade, many bank holding companies increased the Tier 1 capital of their subsidiary banks through the issuance of trust preferred securities. These subordinated debt securities provided needed capital to financial institutions and were attractive to investors due to their high yields. Although trust preferred securities are subordinate to senior debt, they preclude any merger or major transaction by the issuer or its subsidiary unless the trust preferred securities' obligations are assumed by the surviving entity. For the typical holding company, the high yields were offset by the long time to maturity and the ability as issuer to substitute payments in kind for cash interest payments, sometimes for extended periods of time. Finally, during the halcyon days of the financial markets, refinancing or redeeming the trust preferred securities was viewed as a realistic exit strategy should the need arise.
Unfortunately, with the financial collapse of 2008, these refinancing/redeeming exit strategies disappeared, PIKs only exacerbated stressed balance sheets, and subsidiary banks struggled to access needed additional capital. But because the trust preferred securities' instruments required that any mergers or substantial transactions include an assumption of the trust preferred securities' obligations, outside investors considering a major transaction were either scared away or required the holding company to obtain a waiver of the auto-assumption provision. Obtaining such consent can be difficult, because subordinated trust preferred securities holders are unlikely to be paid in full in such situations, and because such consent can require support from a majority or supermajority of all trust preferred securities holders, who may not even be identifiable. In sum, the market is deep with holding companies in need of help.
This needed help was sought from the bankruptcy court in the recent case of In re Outsource Holdings Inc., filed in the Northern District of Texas, Judge D. Michael Lynn presiding. To fully appreciate the significance of the Outsource case for holding companies overburdened with creditor obligations, a review of Outsource's facts helps.
In 2004, Outsource raised capital by issuing trust preferred securities. Eventually, its wholly owned bank, Jefferson Bank, was ordered by regulators to increase its capital. Prominent investment bank Keefe, Bruyette & Woods Inc. was retained to scour the market to find a transaction that would either recapitalize the bank or sell it outright. After over a year of effort, the best transaction found was a two-step transaction where MidSouth Bank would buy Jefferson Bank's branches and certain other assets, and First Bank & Trust would acquire the remaining Jefferson Bank assets from Outsource through a merger. By the winter of 2011, all indications pointed to obtaining the requisite regulatory approval so that the two-step transaction could be consummated.
Understandably, neither of these investors wanted to assume liability to Outsource creditors. Thus, obtaining consent from Outsource's creditors was necessary. Despite extensive efforts to gain that consent, it was not obtained. Closure of Jefferson Bank loomed.
Having no alternative, Outsource filed for Chapter 11 and immediately implemented a sale process under Section 363 of the Bankruptcy Code, which would preclude the trust preferred securities holders from asserting their claims against the new investors and assets being transferred to them. But rather than simply ask the bankruptcy court to approve the already negotiated transaction, Outsource instead proposed an auction process with the proposed merger with First Bank & Trust as the stalking-horse bid. Outsource also retained financial adviser Commerce Street Capital LLP to shop the stalking-horse bid in the marketplace with the hope that a better transaction would result. To induce First Bank & Trust to remain committed, Outsource proposed paying a breakup fee to the bidder if that offer was topped.
Unsatisfied, the trust preferred securities holders objected to the proposal and sought the appointment of a Chapter 11 trustee to wrest control of Outsource from its management. The request for a trustee was compromised by having an examiner appointed to examine the fairness of the proposed transaction and the adequacy of the marketing processes conducted both pre- and post-bankruptcy. Although the post-bankruptcy sale process generated interest from prospective purchasers, in the end no other investors submitted competing bids. At the hearing on the approval of the Section 363 motion, the examiner reported that the stalking-horse bid appeared fair and there was no other alternative.
By the time of sale hearing, the trust preferred securities holders were satisfied with the wisdom of the proposed transaction and did not oppose the Section 363 sale. From beginning to end, the Section 363 sale process in Outsource took 85 days, thereby averting the failure of Jefferson Bank.
Just as importantly, however, the transaction delivered to the Outsource bankruptcy estate value that provides a recovery not only for the senior debt but also to the subordinated trust preferred securities holders. The Outsource case shows that even when creditors start out at loggerheads, they can come together to maximize the recovery for the estate, and then reap the rewards that otherwise would be lost had the bank failed. The bankruptcy solution worked for Outsource and its creditors.
Bankruptcy will not stop regulatory action against the bank, and bankruptcy does not obviate the need for regulatory approval at the bank level. Obtaining regulatory and bankruptcy court approval takes time, as does finding an investor. Delays or lack of preparation in any of these areas can be fatal. At least one holding company has died on the bankruptcy court operating table due to regulatory action against its bank.
Yet these risks exist absent bankruptcy, and absent bankruptcy, or creditor consensus, these risks cannot be avoided. Indeed, failure is inevitable for a leveraged holding company if its bank assets will fail absent intervention. The only question is whether this process starts at the emergency room or at the morgue. If a feasible business solution can be found, then perhaps the patient can be saved. In such cases, drastic surgery such as Chapter 11 bankruptcy may be imperative to prevent avoidable losses to deposit insurers or creditors. Further, if the bank assets fail, then the holding company will find itself in the morgue, where its officers, directors, shareholders and creditors may be targeted by regulators, creditors, bankruptcy trustees and receivers. In short, there is no choice.
The outcome of cases such as Outsource has propelled formerly theoretical discussions and debate into the realm of reality. Now, in light of the result in Outsource, Chapter 11 provides a potential solution to the problem of overleveraged holding companies. Owners of banks should now realize that the tool of Section 363 under the Bankruptcy Code can be effective and worth considering when consensual resolution is not possible. And if Outsource is a guide, the Chapter 11 tool not only can save a bank, but it can benefit all parties.