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Recapitalizing Banks Through Bankruptcy Sales

By: Robert L. Clarke and Justin M. Long

As holding companies with subsidiary financial institutions have faced increasing regulatory pressure, a number of strategic alternatives to alleviate capital concerns are being considered. One viable alternative may be voluntary bankruptcy protection for the holding company to effect the sale or recapitalization of a subsidiary bank. The bankruptcy process has been used in certain circumstances to provide an effective and efficient way to address debt issues and allow for the recapitalization of banks that might have otherwise required resolution by the FDIC.

One significant impediment to the ability of holding companies to raise equity or to complete the sale of a subsidiary financial institution is outstanding trust preferred securities issued by the holding company. From 1996 through the summer of 2008, many holding companies issued trust preferred securities, thinking that they could have their cake and eat it too. After all, trust preferred securities provided what amounted to 30 years of unsecured junior debt with low interest rates. Plus, the cake came with icing: debt counting as regulatory capital, interest payments being deductible for tax purposes and deferred for up to five years, and no dilution to shareholders.

Since the outset of the economic downturn, however, many holding companies have been forced to seek additional equity to bolster balance sheets and hold regulators at bay. Holding companies that are exploring strategic alternatives are finding that the obligations imposed by trust preferred securities are proving to be significant obstacles for potential buyers and investors.

While common shareholders may be willing to sell for a steep discount and take substantial dilution, the holders of debt and the holders of trust preferred securities have generally been openly hostile to taking a haircut. Additionally, because most trust preferred securities have been packaged into pools, it is often the case that the holders of such securities are difficult to identify and engage in negotiations. The ability of issuers of trust preferred securities to restructure the terms of such instruments has been limited, largely because many trustees of the pools have been unwilling to negotiate for fear of facing potential liability from the ultimate holders. Further, the terms of the outstanding debt or trust preferred securities generally provide that an issuer will not sell all or substantially all of its assets unless the debt is assumed by the successor, which impedes the ability to structure a transaction at the bank level.

One alternative to failure that boards of directors of bank holding companies with distressed bank subsidiaries have undertaken in the past and that is now garnering more attention is to seek voluntary bankruptcy protection and consummate a court-approved Section 363 sale of the subsidiary bank. This option only works when a bank has value in its core franchise and a buyer is willing to commit new capital above the purchase price immediately after the acquisition. This course of action was used by Surety Capital Corp. to effect the sale of its Fort Worth, Texas, based subsidiary, Surety Bank, in April 2008. More recently, in December 2010, AmericanWest Bancorp. Inc. effected a court-approved sale of its subsidiary, AmericanWest Bank, to investors backed by private equity for $6.5 million. The bankruptcy proceedings and actions leading to the above-referenced sales did not impact the day-to-day operations of the subsidiary banks.

AmericanWest was the parent bank holding company of AmericanWest Bank, a Washington state-chartered bank based in Spokane. From September 2002 to March 2007, AmericanWest issued approximately $40 million of trust preferred securities through four wholly owned trusts. AmericanWest initiated efforts to raise new capital beginning in 2008 in response to AmericanWest Bank’s significant losses incurred at that time. Potential equity investors with significant interest in recapitalizing the bank balked at the prospect of enhancing the standing of the trust preferred securities and AmericanWest reportedly did not expect to be successful in its efforts to repurchase or discount the outstanding trust preferred securities.

As a result, AmericanWest determined to sell AmericanWest Bank pursuant to Section 363 of the bankruptcy code to an investor identified during its ongoing efforts to recapitalize the bank. On Oct. 27, 2010, SKBHC Holdings LLC (a group of investors including private equity) entered into a purchase agreement with AmericanWest to acquire the capital stock of the bank and to serve as a “stalking horse” during the bankruptcy bidding process. AmericanWest filed for bankruptcy protection under Chapter 11 of the Bankruptcy Code the next day. Within a week of the filing, the bankruptcy court approved the bidding procedures described in the purchase agreement and pursuant to which the capital stock of the bank was openly marketed. No bid higher than that of SKBHC was submitted for the bank during the bidding process and regulatory approval for the Section 363 sale was received on Dec. 2, 2010. The transaction closed on Dec. 20, 2010, and thereafter AmericanWest Bank was recapitalized with approximately $185 million.

The AmericanWest transaction involved similar steps taken by Surety Capital Corp. in 2008. Surety Capital Corp. was a small bank holding company that issued subordinated debentures in 1998 maturing in 2008. The company began to face regulatory issues, including a consent order issued by the Office of the Comptroller of the Currency in 2004, which created significant obstacles for a sale or recapitalization of the company and led the company to consider a bankruptcy filing to allow for a Section 363 sale of its subsidiary bank. The company made its bankruptcy filing in January 2008, and on Feb. 8, 2008, Surety Capital Corp. entered into a purchase agreement with First Graham Delaware Corp., an existing bank holding company, which agreed to serve as the “stalking horse” during the bankruptcy bidding process. No higher bid was submitted pursuant to bidding procedures and Surety Bank was sold to First Graham on April 18, 2008, free and clear of all liens.

The boards of directors of holding companies must consider various factors in determining whether to seek bankruptcy protection, including its fiduciary duties to various stakeholders. Seeking bankruptcy protection has negative consequences for existing equity and debtholders. But, seeking bankruptcy protection as a means to recapitalize the bank may allow for a financial institution to avoid failure with far worse consequences for all debtholders and shareholders.

The bankruptcy strategy employed in the much-publicized AmericanWest transaction has the potential to allow holding companies to save subsidiary banks from failure. In addition, the prepackaged bankruptcy option also presents a possible alternative to save subsidiary banks should junior creditors try to stall a recapitalization or possible sale of the bank. The potential for either such action should cause holders of debt and trust preferred securities issued by financial holding companies (including trustees of pools) to soften what have generally been hard-line positions, which have in many cases resulted in their claims being made in an FDIC receivership and reaching a dead end without any satisfaction.

If bankruptcy is a workable option for the bank holding company as a method to save the subsidiary bank, such holders should be willing to consider discounts so as to avoid a holding company bankruptcy and, as a result, having their asset become completely worthless.

Robert L. Clarke is a senior partner and the founder of Bracewell & Giuliani LLP’s global financial services practice. He served as Comptroller of the Currency under Presidents Ronald Reagan and George H. W. Bush. Justin M. Long is an associate at Bracewell & Giuliani LLP. His practice focuses on matters involving corporate finance, mergers and acquisitions, and state and federal bank regulatory matters.

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