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A Guide to Trust Preferred Securities
Trust preferred securities, or TruPS, have been a topic of much recent conversation. Those conversations have largely focused on the application of the Volcker Rule, added by Section 619 of the Dodd Frank Act, to collateralized debt obligations (CDOs) backed by TruPS. However, there are other TruPS issues that do not involve the Volcker Rule but which merit discussion, and this article will primarily focus on these issues. Readers interested in the Volcker Rule can read the banking agencies interim final rule, which for the Federal Reserve Board will be codified in 12 U.S.C. Part 248 (Regulation VV). The Boards website also has other guidance and testimony related to the Volcker Rule.
Background on TruPS
The amount of TruPS, together with other cumulative preferred stock that a BHC could include in Tier 1 capital, was limited to 25 percent of Tier 1. To be eligible as Tier 1 capital, the following conditions had to be satisfied:
Given the capital treatment announced in the press release, TruPS presented BHCs with a way to raise capital without diluting existing shareholders. TruPS also provided BHCs with favorable tax treatment in that TruPS dividend payments are tax deductible for the issuers, unlike dividends paid on preferred stock. A final benefit to using TruPS is that the collateralized debt obligations (CDOs) could be issued under SEC Rule 144A, which allowed TruPS CDOs to be unregistered when issued to qualified institutional buyers (QIB) through a broker‐dealer and permitted CDO issuers and trustees to provide very limited disclosures.
TruPS are issued by a special purpose subsidiary of the parent BHC. The TruPS proceeds are loaned by the special purpose subsidiary to the BHC pursuant to a long-term, deeply subordinated note. Loan payments by the BHC to the SPS are used to make the dividends payments to TruPS investors. This exhibit depicts the entities involved and the flow of funds is contained below.
Where CDOs are involved, the investors in the diagram above would be replaced by pooling entities. These entities form trusts to hold pooled TruPS issuances and then issue CDO securities backed by the TruPS to market investors, which have included private-equity firms and financial institutions. Early on, smaller BHCs did not typically issue TruPS directly to investors, so the CDO arrangement has expanded to such BHCs the ability to utilize TruPS to raise additional capital.
TruPS benefits foster expansion
In the Sixth District, by 2007, there were 223 BHCs reporting $5.9 billion of outstanding TruPS. The high point for the amount issued by Sixth District BHCs was 2008, during which the total amount issued was $6.9 billion. Similar to the aggregate trend, the number of Sixth District entities with TruPS outstanding, as well as the amount of TruPS outstanding, has been declining. As of December 31, 2013, the number of Sixth District BHCs reporting TruPS has fallen to 152, and the dollar amount outstanding is now $2.6 billion. Table 2 shows the total number of Sixth District BHCs reporting TruPS, including the dollar amount outstanding, annually from 2007 through 2013:
One issue facing BHCs currently deferring TruPS payments is the potential default on their TruPS. As a result of the impact of the financial crisis, a number of BHCs exercised their 20-quarter option to defer payments to TruPS investors. Deferrals were largely driven by the condition of the bank and parent BHC and by provisions contained in enforcement actions by financial institution regulators. During the deferral period, TruPS payments continue to accrue on a cumulative basis. At the end of the deferral period, a single catch-up payment equal to the total amount of deferred payments is required. Depending on the amount of TruPS issued and the applicable terms, the amount of the catch-up payment could be significant and may exceed an organizations available resources and ability to pay in full.
Table 3 shows that two BHCs—out of 5,674 total BHCs—were deferring $395 million of TruPS in 2007. By 2012, 168 BHCs were deferring a total of $2.4 billion of TruPS.
For the Sixth District, no BHCs were deferring TruPS in 2007 and 2008. However, by 2012, there were 60 BHCs deferring $551 million of TruPS. As of the end of the fourth quarter of 2013, there are 49 BHCs deferring approximately $403 million of TruPS (see table 4).
BHCs facing a potential default on their TruPS have taken a number of actions. Some have sold their depository subsidiaries to acquiring holding companies prior to the expiration of the deferral period. Some BHCs have obtained regulatory approval to make TruPS payments. (In an 8-K filing dated February 26, 2014, Oakland, Md.-based First United Corp. reported that it received approval from the Federal Reserve System to terminate the interest deferral periods with respect to an aggregate of $30.9 million of its junior subordinated debentures issued to First United Statutory Trust I and First United Statutory Trust II, and an aggregate of $10.8 million of TPS debentures issued to First United Statutory Trust III.)
During the last few years, a number of BHCs facing default have chosen to file for bankruptcy protection and pursue a "363 sale" of the subsidiary bank under Section 363 of the Bankruptcy Code, 12 U.S.C. § 363. (Section 363 of the Bankruptcy Code governs sales of a debtors assets outside of the ordinary course of business, such as a BHCs sale of its banking subsidiary.) In 2010, there was a single 363 sale; in 2013 there were seven 363 sales. A search of the internet reveals that 363 sales have received increased publicity and media coverage and are topics of regular discussion by attorneys, accountants, and trade groups with the industry. The 363 sale process actually begins prior to bankruptcy, with a BHCs pre-selection of a lead bidder interested in acquiring the subsidiary bank. This bidder assumes the lead in establishing a floor price for the debtors asset and prepares a form asset-purchase agreement and terms, which can be shopped around to other potential bidders once the bankruptcy action is filed and the auction process moves forward. Such a bidder is known as a "stalking horse" bidder.
The 363 sale process is not without its pitfalls, however. In a number of cases, TruPS investors have challenged the 363 sales; in particular, the agreements and deals with stalking horse bidders. TruPS investors are interested in getting the most money for the bank subsidiary in an attempt to maximize the recovery of their investment and seek to delay quick sales to stalking horse bidders. In 2012, the U.S. Treasury, owner of preferred stock of First Place Financial as part of the money the holding company received in the course of the Troubled Asset Relief Program (TARP), sought to delay the 363 sale proceedings of First Place Financial. The delay was based upon the position that the protections afforded the stalking horse bidder were excessive and that the bid process was not structured to produce bids higher than the stalking horse bid.
Faced with a challenge that could delay the sale of the bank subsidiary, the bankruptcy court facilitated the parties revision of the stalking horse bid to address the Treasurys concerns. As this case demonstrates, the 363 process can be challenged, delay in the process is a possibility, and—if there is TARP outstanding—the Treasury Department may become actively involved from the creditor side and further increase the potential for delay.
Delay in the bankruptcy case, particularly the 363 sale, is a significant risk for BHCs and their subsidiary banks. Throughout bankruptcy proceedings, the subsidiary bank remains subject to regulatory capital and other requirements, and bank regulators maintain the authority to seize a bank even when a BHC has filed for bankruptcy protection and a 363 sale is under way. Severely weak or distressed banks may not have enough time to survive any delay in the 363 sale process, such as those that can result from challenges and objections by unsatisfied creditors.
The above risk is best demonstrated by the 2011 case of Central Progressive Bank. Although a bankruptcy court had approved bidding procedures for the section 363 sale of the bank, it was placed into FDIC receivership just 11 days before the 363 sale auction was to commence. Similarly, while the bankruptcy court oversees the 363 sale process and has authority over the transaction, the transaction also remains subject to bank regulatory authority, including the filing of applications or notices.
Another Texas case demonstrates a pitfall for TruPS investors. In that case, two TruPS investors challenged a 363 sale as unreasonably restrictive and not designed to produce a value maximizing offer. The two investors also did not agree with the bid protection, essentially a break-up fee, in favor of the stalking horse bidder of $1.23 million, or about 17 percent of the total bid amount. The two investors were owed approximately $34 million and argued that the approved auction process provided virtually no recovery for unsecured creditors of the debtors' estates. In this case, the creditors lost the case over the bidding process and realized a big loss on their investments. This case demonstrates a peril facing TruPS investors - the potential loss of some or all of their investment. According to the FDIC, more than 300 FDIC-insured institutions reported investments in TRUP CDOs in their September 30, 2010, Call Reports, and most of the investments were in mezzanine classes.
Another risk has recently emerged, but instead of being a risk for banks that have purchased CDOs backed by TruPS, it is a risk facing the directors and officers of such entities. On May 20, 2013, the FDIC sued eight former officers and directors of Vantus Bank for $58 million. The FDIC accused the defendants of negligence, gross negligence and breach of fiduciary duty for allegedly using $65 million in bank funds—120 percent of its core capital—to purchase "high-risk, collateralized debt obligations backed by trust preferred securities without due diligence and in disregard and ignorance of regulatory guidance about the risks and limits on purchases of such securities." It will be interesting to see the outcome of this case and if additional actions are filed based upon TruPS purchases that were made by other failed institutions.
Considering pitfalls and possibilities
By Alan Faircloth, director of examinations and senior counsel in the Atlanta Feds supervision and regulation division