Any bank holding company with trust preferred securities (“TRuPs”) outstanding and in need of capital in this stressed operating environment for banks has had its strategic options limited by a recent decision of the Delaware Chancery Court. The court’s opinion makes it more difficult to recapitalize a distressed bank by giving the TRuPs bondholders enhanced blocking power. This newsletter summarizes the recent court action, explains its implications for bank recapitalizations, and offers the strategic solution of a Bankruptcy Code Section 363 sale to address capital needs while reconciling the rights and remedies of TRuPs trustees and bondholders.
The February 27, 2012 decision of the Delaware Court of Chancery to permanently enjoin the proposed sale of the stock in a financially distressed bank as “substantially all of the assets” of a savings bank holding company in violation of several indentures for outstanding issues of TRuPS offers many lessons for boards of directors, CEOs, investment bankers and lawyers dealing with the recapitalization or sale of distressed banks. In re BankAtlantic Bancorp, Inc. Litigation, Slip. Op. Consol. C.A. No. 7068 VCL (Del. Ch. February 27, 2012). Vice Chancellor Laster held that the sale met both tests for a sale of substantially all of a corporation's assets. It met the quantitative test because the $306 million book value of the common stock in BankAtlantic, a federal savings bank (“Bank”) constituted approximately 90% of the $341 million book value of all assets of BankAtlantic Bancorp (“Holdco”) and the bank accounted for 69% of consolidated revenues and Holdco’s principal source of liquidity. The sale likewise met the qualitative test because Holdco’s public filings referred to itself as a “unitary savings bank holding company,” which was contractually bound not to compete with the buyer of Bank and owned no other subsidiaries other than a workout subsidiary to warehouse nonperforming assets. The plaintiffs were entitled to enjoin the transaction because the TRuPS trustees and holders would have been irreparably injured by the transfer of the Bank stock that left Holdco without sufficient liquid assets to pay the accelerated TRuPS.
The transaction and its context
The transaction culminated a series of efforts by Holdco to escape from $630 million in losses during 2008-2010 from commercial real estate loans in South Florida. Bank was blocked from paying dividends or upstreaming assets under a cease and desist order. Bank had raised some cash from a branch sale transaction in 2011 after a prior unsuccessful sales effort. Holdco tried unsuccessfully to raise equity capital and floated three partially subscribed rights offerings during 2009-2011. Holdco and its principals lost a summary judgment and a jury verdict for securities fraud in part of a class action about misstatement of loan losses. Finally, 11 issues of TRuPS, aggregating $25 million principal amount had been placed on interest deferral since early 2009. While Holdco was not formally insolvent or in capital violation under its cease and desist order, the accrual of deferred interest on the TRuPS increased the debt to $322 million by 2011 and a projected $368 million by 2013.
The court found that Holdco ran a sales process, but its controlling stockholders rejected every structure other than the transaction selected. One buyer expressed interest in a cash purchase of Bank for $158 million but cut its bid to $50 million after the securities fraud verdict was entered against Holdco. Instead, Holdco opted for a sale of its stock in Bank in an innovative transaction that involved no cash payment from the buyer, BB&T, other than a $10 million payment for a covenant not to compete from Holdco’s insiders. The transaction offered a 10% premium over deposits for the Bank stock, because BB&T would assume $3.4 billion in liabilities (principally to depositors) but only purchase $3.1 billion in assets. To adjust its balance sheet for closing, Bank planned to drop cash and nonperforming and criticized assets with a book value of $623.6 million into a new subsidiary named Retained Asset LLC (“Residco”). At closing, the membership interest in Residco would be distributed by Bank to Holdco. Residco was projected to generate $14 million in annual interest income, but Holdco’s annual expenses, including TRuPS interest, topped $30 million. To obtain regulatory approval, BB&T agreed to recapitalize Bank after closing with $538.8 million to fill the capital hole left by the creation of Residco and achieve a 6.84% ratio of tangible common equity to tangible assets).
One of Holdco’s investment banks called BB&T’s recapitalization the “purchase price” of the transaction, in effect satisfying the contingent liability that took the form of the amount of new capital necessary to meet ongoing capital requirements. Its other investment banker issued a fairness opinion that the book value of the membership interest in Residco was a fair purchase price. In either event, Holdco’s pro forma balance sheet after closing would improve by over $300 million and current deferred interest on the TRuPS would be paid. Holdco’s stock jumped 111% while one publicly traded issue of TRuPS rose 99.5% in value. Nevertheless, several TRuPS trustees and holders (including several activist secondary buyers) filed suit, perhaps because the transaction did not even generate cash sufficient to match Holdco’s prior offer to purchase the TRuPS for twenty cents on the dollar in early 2010.
What constitutes “substantially all of the assets” of a single bank holding company?
The plaintiffs successfully interrupted the transaction by enforcing a common “boilerplate” provision that appears in all of Holdco’s TRuPS indentures. The indentures allow acceleration of the TRuPS upon the sale of “substantially all of the assets” of Holdco unless the buyer assumes the indenture. Under established New York law, which each underwriter provided was to govern, the court applied both a “quantitative” and a “qualitative” test of what constitutes “substantially all of the assets.” Even if the seller retains assets making up most of its book value, the sale of the crown jewels of a company can trigger the qualitative test by fundamentally changing the nature or character of the seller’s business.
The court held that the transaction met both tests. The transaction satisfied the qualitative test because Holdco sold its sole banking subsidiary, which generated the dominant share of revenues, provided all of Holdco’s liquidity and cash flow and employed almost all of the employees of the combined enterprise. Holdco's business was fundamentally changed by the transaction because it was contractually bound not to compete with the buyer in the banking business. The court also found that the quantitative test was satisfied because the book value of the Bank stock (the $306 million) constituted 90% of the book value of Holdco’s assets ($341 million). The court rejected Holdco’s argument that the Bank stock had no value. Holdco argued that the book value of Residco (which was stripped out of Bank at closing) should be deducted from the book value of the Bank stock, leaving a “negative book value” of over $300 million. The court found this counter-intuitive because BB&T was buying the “good bank” and leaving behind the “bad bank.” Evidence of the positive value of Bank was the fairness opinion of one of Holdco’s investment bankers, which pointed out that BB&T thought that Bank’s franchise was worth enough to justify a $538.8 million post-closing investment to recapitalize it.
The court also rejected Holdco’s “valueless stock” argument because New York excluded the buyer's purchase price from the total assets of the seller in determining whether the seller sold “substantially all” of such assets. The court pointed to statements by Holdco's insiders that the membership interest in Residco was the “purchase price.” One of Holdco's investment bankers opined that Holdco received a fair price equal to 166% price-to-book ratio calculated by dividing the book value of Residco by the book value of the Bank stock ($607/306 million). Indeed, the court observed that no transaction would meet the “substantially all of the assets” test if the seller’s assets were grossed up by the purchase price paid.
Availability of Injunctive Relief
The court granted the plaintiffs’ request for a permanent injunction against the transaction because it held that they would be irreparably harmed. Even though the TRuPS would receive $39 million to pay down deferred interest, Holdco lacked the liquidity to pay the remaining $290 million that would be due on the acceleration of the TRuPS. Holdco would have had no assets to pay the TRuPS except a “fire sale” of the assets of Residco that would have been “suicide” according to Holdco’s principal stockholder. The court also believed that the $10 million to be paid to senior executives and shareholders in new severance and non-compete agreements violated the established liquidation rules giving creditors priority over shareholders. It also pointed to New York law holding that creditors are irreparably injured by transferring all collectible assets, which fundamentally shifts the risks that creditors agreed to assume.
The court rejected the view that an "untenable" status quo made the balance of hardships favor Holdco. While the court noted that there was a risk that Holdco would fail, it pointed to the fact that Holdco was not presently insolvent or in violation of its capital requirements, particularly because the TRuPS still counted as Tier I capital for Bank. It seemed particularly concerned with flaws in Holdco’s sales process whereby the controlling shareholder frustrated other alternatives to the transaction by misstatements to the board and the frustration of other bidders. Even though the only bid on the table offered just $50 million, the court believed that it might have been superior to the creditors if the TRuPS had been assumed. In essence, Holdco never made a case that such a transaction was impossible.
Two weeks after the decision in the BankAtlantic litigation, BB&T and Holdco revised the transaction to include the assumption of the TRuPS. BB&T protected its investment, however, by its simultaneous acquisition of a 95% preferred membership interest in an LLC to be formed to hold $424 million in loans and $17 million in real estate and associated deposits, escrows, rights, obligations, loss reserves and claims (presumably the bulk of the assets that BB&T previously agreed to leave behind in Residco). BB&T’s preferred interest will terminate when it receives a preferred amount of distributions equal to the additional $285 million investment that it made by assuming the TRuPS indentures. Finally, BB&T received Holdco’s guaranty of the preferred amount of distributions. The legal fees of the TRuPS trustees in the BankAtlantic litigation will be paid from the transaction. In sum, the TRuPS holders received exactly what they wanted.
The BankAtlantic litigation shows a number of developments in the distressed, open-bank arena:
- The terms of TRuPS indentures can impede an open-bank sale even if the sale improves the holding company balance sheet, pays deferred interest and offers the prospect of full payment to creditors and value to shareholders. Most distressed bank situations do not offer such advantages to holding company creditors and shareholders.
- TRuPS holders have become better organized and are able to persuade or direct trustees to take legal action to contest transactions. The ruling in the BankAtlantic litigation will encourage more aggressive litigation in the future.
- Analogous events of default allow acceleration of secured and unsecured bank loans to bank holding companies.
- Courts will closely scrutinize the marketing process where a seller restricts bidders to a structure that benefits insiders and does not allow all bidders reasonable due diligence.
- Non-bankruptcy courts may not give much weight to the difficult regulatory and economic environment for open-bank sales of financially distressed banks.
- To be persuasive, the investment bankers’ fairness opinions must pass the common-sense test, even in a transaction that positively benefits creditors.
Would a Bankruptcy Court have approved the Original Transaction as a Section 363 Sale of Holdco’s stock in Bank?
The court’s ruling suggests that Holdco may have had a more favorable outcome if it had structured the original transaction to close in a Section 363 sale of assets in a Chapter 11 proceeding. See Fisher, J.M., Bankruptcy Sales to Facilitate Open-Bank Recapitalizations, Pratt’s Journal of Bankruptcy Law (January 2011) at 64. Bankruptcy courts are more familiar with the practical exigencies of selling financially distressed businesses, a point that the Chancery Court discounted. These include the need for a speedy sale and the fact that creditors may have to wait to be paid and be satisfied with a partial payment of their claims. In essence, the BB&T bid could have been signed up with the contingency that the bankruptcy court (i) approve bidding procedures setting a marketing period for higher and better bids for a reasonable but brief period after the bankruptcy and giving BB&T a breakup fee as compensation for being the stalking horse, (ii) allow other bidders to compete against the price and structure of the stalking horse bid so long as the other bidder had comparable financial qualifications, due diligence and financing contingencies, if any, and comparable ability to obtain regulatory approval, and (iii) approve the sale to the highest and best bid based on the values received by Holdco’s creditors with due regard to the urgent risk of regulatory action.
A bankruptcy would involve several key differences in the judicial process:
- The existence of a default and acceleration under the TRuPS indentures would be irrelevant because the automatic stay prohibits the TRuPS trustees from exercising remedies.
- Bankruptcy courts are comfortable with a stalking horse process, particularly where there has been substantial pre-bankruptcy marketing.
- All constituencies, including TRuPS and shareholders, have input into the judicial process approving bidding procedures that test the stalking horse bid and ultimate fairness of the value provided to holding company stakeholders.
- Bankruptcy courts are accustomed to considering valuation testimony as well as treating the judicially approved auction result as the “market” value.
- The $626 million value of the Residco membership interest would have been considered a substantial purchase price to be balanced against the investment banker’s valuation of the BankAtlantic stock. The “book value” of the Bank stock likely would have been viewed as inflated, in light of the value of Residco and the large investment that BB&T was required to make to recapitalize Bank after closing.
- A fair auction process and the protections afforded a buyer under Section 363 might have induced competitive bidding by the other interested party and likely captured the proposed noncompete payment from BBT to insiders for the benefit of creditors.
- The holding company could have taken its time, protected by the automatic stay or a discharge, in working out the nonperforming assets in Residco.
- The holding company might have been able to preserve valuable tax attributes through a plan of reorganization.
Even though the matter appears to be settled, the BankAtlantic decision suggests a change in the landscape for the open-bank sale of a financially distressed bank and a possible detour through bankruptcy that can level the playing field for all stakeholders.© 2013 Schiff Hardin LLP