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Section 363 Sales — An Increasingly Viable Tool For Bank Mergers & Acquisitions?

As bank holding companies (“BHCs”) navigate the current economic environment, often strugglingwith impaired balance sheets and increasing regulatory pressure to raise capital for their bank subsidiaries, the recent activity of Section 363 sales under Chapter 11 of the Bankruptcy Code (“363 sales”) may indicate that 363 sales are becoming an increasingly attractive option for bank-level recapitalizations and mergers.  In particular, three BHCs successfully sold subsidiary banks in 363 sale transactions during fourth quarter 2012.  The 363 sale method may be particularly attractive to BHCs that find traditional bank recapitalization attempts thwarted by the parent BHC’s debt overhang.

A primary impediment to successful bank recapitalizations and strategic M&A is the amount and type of debt carried at the BHC level, often in the form of a senior secured note to a correspondent lender, subordinated debt or trust preferred securities (“TruPS”).  Troubled Asset Relief Program ("TARP") securities, too, can be analogized to long-term debt in terms of some of their characteristics and the pressure they put on holding company liquidity. 

Be it a senior note, subordinated debt or TARP, the BHC can identify the holder of the note or security and attempt to negotiate a compromise on the instrument or conversion to equity, or both.  It is the TruPS instrument, however, that has proven most problematic in successfully accomplishing conventional recapitalization or M&A transactions.  For two decades, BHCs have issued TruPS mostly into conduits — collateralized debt obligations (“CDOs”).  These CDOs are legally documented with a trust indenture and administered by an institutional trustee (usually a large financial institution or trust company) that is charged with protecting the underlying bondholders.

These TruPS instruments trade in a market that lacks transparency or even significant direct communication between issuers and holders.  Because of the CDO structure, it is generally difficult or impossible to obtain the CDO trustee or underlying bondholders’ consent to restructure the TruPS debt.  The difficulty in obtaining bondholders consent poses a serious structural problem for a financial buyer who has a strong desire to recapitalize or acquire the bank under a BHC by injecting new equity in the holding company during a bank recapitalization.  The financial buyer’s new equity automatically stands behind the TruPS, an undesirable result for the new equity holder(s), because subordinated debt still has priority over equity in a liquidation of the holding company.  A healthy bank acting as a strategic buyer also is unlikely to want to assume the TruPS debt as part of the purchase price. In today’s market there simply is too great a difference between the franchise value of the bank subsidiary and the amount of TruPS (and other) debt that the buyer would need to assume.  The purchase price (including the assumed debt) would simply be unrealistic in this market. 

As a result, debt at the BHC level — especially in the form of TruPS held in CDOs — constitutes a significant obstacle to successful recapitalizations.  And when there have been acquisitions, there have been challenges.  In the 2012 acquisition of Bank Atlantic by BB&T, Bank Atlantic sold the Bank without the TruPS holder’s consent, resulting in litigation brought by the TruPS trustees.  The trustees won the case with the Delaware Court substantiating that their rights were violated by the transaction structure.  Similar priority and default issues arise from TARP securities, which are senior to common equity.

Section 363 sales offer a means of sidestepping the TruPS communications barrier and successfully recapitalizing a bank.  In a 363 sale, the BHC files a voluntary petition under Chapter 11 of the Bankruptcy Code and sells its subsidiary bank under the auspices of a bankruptcy court, most often on a pre-negotiated basis via an asset purchase agreement that provides some benefits to the buyer as a “stalking-horse”, or lead bidder.  These include reimbursement of expenses or a break-up fee payable from the proceeds of an alternative transaction if a higher bidder emerges. As required by the “stalking-horse” agreement, the bankruptcy court also approves procedures for the qualification of competing bids and bidders and for overbidding the stalking horse bid at an auction. By shaping the contours of the bidding procedures submitted to the bankruptcy court, the stalking horse has significant input into the process.  The bankruptcy court has the final authority to consider whether the procedures were followed and the terms of the final bid are fair and consistent with the Bankruptcy Code’s provisions dealing with the sale of assets and the assumption and assignment of executory contracts and unexpired leases.  While the bankruptcy court oversees the 363 sale process and has authority over the transaction, the transaction also remains subject to bank regulatory approvals.

In 2010, AmericanWest Bancorp successfully implemented a 363 sale of its subsidiary, AmericanWest Bank, marking the first use of the 363 sale method by a BHC.  AmericanWest’s success garnered much attention, but little replication.  In 2011, only two BHCs attempted to replicate the 363 sale strategy and only one succeeded.  Importantly, in the successful 363 sale of Jefferson Bank by Outsource Holdings, Inc., when TruPS holders sought appointment of a Chapter 11 trustee to obtain control of Outsource from its management, the bankruptcy court instead appointed an examiner to examine the fairness of the proposed transaction and adequacy of the marketing process.

In the fourth quarter of 2012, three BHCs successfully sold bank subsidiaries in 363 sales.  Premier Bank Holding Company sold Premier Bank, Big Sandy Holding Company sold Mile High Banks and First Place Financial Corporation sold First Place Bank.  The U.S. Treasury attempted to delay the First Place Bank proceedings in an effort to garner higher bids, but rather than delay the proceedings, the bankruptcy court facilitated the parties’ revision of the stalking-horse bid so that the process and terms of the bid satisfactorily accommodated some of Treasury’s concerns about the bid and the resulting value of its TARP securities. 

As demonstrated by the fate of Central Progressive Bank in 2011, struggling banks do not have time for delays in the judicially-approved market check provided by the 363 sale process.  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 363 sale is under way.  Although a bankruptcy court had approved bidding procedures for the section 363 sale of Central Progressive Bank by BHC Blossman Bankshares Inc. in 2011, the bank was placed under FDIC receivership just eleven days before the 363 sale auction was to commence.  This only heightens the importance of continued communications with their regulators by banks considering a 363 sale.

Bankruptcy proceedings can also be stigmatizing and the public may incorrectly equate bankruptcy at the BHC level with trouble at the bank level — although the bank itself is not in bankruptcy.  However, a well-planned public relations campaign can reduce or eliminate misunderstandings and negative associations related to the 363 sale — certainly a more favorable alternative than a FDIC receivership. 

While it is not yet clear whether 363 sales will become a frequently used tool in the bank M&A field, recent sales indicate the method’s increasing viability.  The publicity surrounding these sales could also lead to increased bidder interest and higher valuations, which could facilitate further transactions and reduce the opposition of TruPS holders and the Treasury.  In that vein, any such Chapter 11 filing also increases the level of communication with TruPS holders, now often third party funds that purchase these instruments at reduced market prices.  As such, a 363 sale may facilitate a much needed direct dialogue between issuers and holders, leading to a negotiated solution in the best interests of both parties — and approved by the bankruptcy court.

© 2014 Schiff Hardin LLP

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