Davis Polk discusses Trust-Preferred Securities and Involuntary Bankruptcy

The involuntary chapter 11 bankruptcy filing of American Bancorporation (“American”), commenced by a group of distressed debt investors holding American’s trust-preferred securities (“TruPS”), was upheld by the U.S. Bankruptcy Court for the District of Minnesota pursuant to an order entered on May 27, 2014. This development highlights the use of involuntary bankruptcy as the latest strategy by TruPS holders to increase their leverage and recovery in distressed bank holding company situations.

Background

TruPS are deeply subordinated junior debentures issued to statutory trusts that in turn issue preferred securities. They were at one time a commonly used structure for financing bank holding companies because of their regulatory capital and tax advantages. In order to satisfy regulatory capital requirements, they included a safety valve permitting the issuing holding company unilaterally to defer interest payments for up to five years. This five-year period serves effectively as a standstill, allowing a distressed bank holding company a period of time to attempt to right its finances or effectuate a restructuring while its TruPS holders are forced to stand by. In 2008, American exercised its deferral option with respect to approximately $30 million in principal amount of outstanding TruPS. After American failed to repay the TruPS holders at the end of the deferral period in June 2013, ATP Management (“ATP”) – which manages securities tied to American’s TruPS – sued American in the U.S. District Court for the District of Minnesota. In April 2014, the court granted summary judgment in favor of American’s TruPS holders. Shortly thereafter, ATP and other managers moved to force American into involuntary bankruptcy proceedings. American ultimately consented to the filing and the Bankruptcy Court’s order upholding the filing was entered on May 27, officially commencing American’s chapter 11 process and likely setting the stage for a near-term bankruptcy auction of American’s bank subsidiary for the benefit of its creditors.

Involuntary Bankruptcy and Creditor Recoveries

The decision by American’s TruPS holders to force it into bankruptcy is a significant development and a new front in the campaign by distressed debt investors to gain footholds and leverage against distressed bank holding companies. In the past, some banks with extensive TruPS-related liabilities have voluntarily filed for bankruptcy protection, most often to effectuate prearranged sales and recapitalizations of their bank subsidiaries. Others have either negotiated discounted repayment schedules with TruPS holders or refinanced their debt via capital infusions. American is the first instance in which creditors have resorted to an involuntary bankruptcy petition to recover from a bank holding company. Section 303 of the Bankruptcy Code provides that, under certain circumstances, creditors can force a company into either chapter 7 or chapter 11. However, filing an involuntary bankruptcy petition subjects creditors to the risk of liability for costs, professional fees and damages if the debtor company is successful in challenging the filing. Additionally, even if an involuntary petition is upheld, costs of administering the case can reduce potential creditor recoveries as compared to an out-of-court solution. These costs can be exacerbated in a bank holding company filing by flight of bank depositors made skittish by the parent’s unplanned proceedings. Taken together, these factors make an involuntary bankruptcy filing a particularly aggressive option for creditors.

Future Implications

American’s involuntary bankruptcy filing signals the development of a potentially important new page in the playbook for distressed debt investors in the bank holding company sector. TruPS investors, which can see little to no recovery in the prearranged bank sale and recapitalization solutions often preferred by bank management and regulators, have sought ways to increase their leverage and recoveries, and the threat of an involuntary filing may prove useful in that regard. However, the long-term impact of this case and the efficacy of this strategy in future situations may hinge in large part on the outcome of American’s chapter 11 restructuring. If American’s bankruptcy is successful (for instance, if it ultimately sells its subsidiary bank at an attractive price), other such cases – or the threat of such cases – will likely follow. In any event, distressed debt investors’ willingness to employ this strategy should add incentive for distressed bank holding companies to formulate, negotiate and implement restructuring and recapitalization plans ahead of the expiry of their deferral periods. It is anticipated that the TruPS deferral period for a large number of community banks will expire by the end of 2015. As such, the outcome of American’s restructuring will likely serve as an important bellwether for other troubled community banks pursuing a restructuring or recapitalization.

The full and original memo was published by Davis Polk & Wardwell LLP on June 5, 2014, and is available here.