Investors Fight Back Against Trust-Preferred Loophole

A group of investment funds is aiming to cut off a risky path out of bankruptcy for troubled banks.

Lenders that default on trust-preferred debt usually have no choice but to file for bankruptcy, then sell their bank to pay the parent company's debts. Recently, however, several lenders have tried the unusual — and legally uncertain — strategy of recapitalizing or selling their banks separate from their holding companies, leaving the parent, and its debt, behind.

Investors left holding debt in these hollowed-out companies are taking aggressive legal action to collect on their investment and, perhaps, make sure other banks don't try the same thing.

First Southern Bank in Georgia was sued last month over a stock sale that effectively freed it from its debt-saddled holding company. Arvest Bank in Arkansas was sued in September for buying a bank without taking its parent's trust-preferred debt. And a group of creditors is considering legal action against Beneficial State Bancorp in California over a deal in which it bought a controlling stake in an Oregon bank and left its trust-preferreds behind.

What's unusual about the lawsuits is their wide scope. In addition to the banks, the litigation targets executives, shareholders and the advisers who worked on the deals. The argument is that everyone involved — buyers, sellers and consultants — should be held responsible for taking part in transactions designed to work around the bankruptcy process.

"These are basically creative ways that people came up with to avoid paying their debts," said John Scannell, chief operating officer of the hedge fund Hildene Capital Management, a major trust-preferred holder. "All we're asking is for the bankruptcy process to be respected."

Creditors have warmed up to the bankruptcy process after several recent bankruptcy sales, including First Mariner Bank in Baltimore and Metropolitan Bank in Arkansas, delivered excellent returns. Some investors have even started pushing holding companies into involuntary bankruptcy over trust-preferred securities to force an auction.

The unorthodox deals arranged by First Southern and Arvest allowed the banks to slip out of creditors' hands and avoid bankruptcy. Now, investors are trying to make sure that other banks don't follow their lead. With 236 banks in default and 186 nearing the end of their five-year deferral period as of mid-November, according to Fitch Ratings, the lawsuits could have wide resonance in the banking industry.

Scannell criticized these bankruptcy alternatives for lacking transparency and circumventing the established procedure of liquidation followed by an auction. He argued that investors could eventually lose confidence in the banking system if more banks resort to unusual strategies to avoid paying creditors.

Hildene filed a lawsuit against Arvest Bank in September, claiming its rights were violated by a 2012 transaction in which Arvest bought Union Bank in Missouri without taking on the trust-preferred debt of Bannister Bancshares, Union's parent company.

Bannister later dissolved, leaving Hildene with no way to recoup the $25 million in trust-preferred debt it says it's owed. Hildene's lawsuit, filed in the U.S. District Court for Connecticut, called the sale a "scheme" to avoid paying Bannister's debt, while criticizing Arvest's "outrageous conduct in knowingly and willfully procuring a breach" of the trust-preferred agreement.

The $14 billion-asset Arvest is owned by the Walton family, which also owns Wal-Mart. It did not respond to a request for comment.

Bankers on the other side of the lawsuits argue that their banks would have failed, and everybody would have been wiped out, had they not made unorthodox deals. When the Federal Deposit Insurance Corp. seizes a bank, its parent's trust-preferred creditors often come away empty handed.

"For any bank on the point of failure, the responsibility of the board and the CEO is to protect the institution," said William Hughes, chief executive of First Southern Bank in Patterson, Ga. "To try to save a bank is not conniving or self-serving."

Hughes is being sued by a Cayman Islands investment vehicle over a capital raise last year that diluted First Southern's holding company. At the time of the raise, First Southern was extremely undercapitalized, which, along with the overhang of trust-preferred debt, made raising money through a conventional sale impossible, Hughes said. He said the bank not even have enough cash to file for bankruptcy.

Instead, Hughes came up with a plan to raise money by issuing stock directly from the bank unit, which reduced the holding company's ownership stake in the bank from 100% to less than 1%. He was sued last month, along with two First Southern directors, its adviser, and the investors — unnamed, but listed in the lawsuit as "John Does 1-50"- who bought stock in the capital raise.

The plaintiff, U.S. Capital Funding VI, a collateralized-debt obligation controlled by offshore law firm Maples & Calder, said in its litigation that the capital raise violated its trust-preferred agreement. The lawsuit was filed in the U.S. District Court for the southern district of Georgia.

U.S. Capital Funding holds more than $3 million in trust-preferred debt issued by Patterson Bankshares, which had been the $86 million-asset First Southern's parent company until it was dissolved last year by state regulators.

Efforts to reach U.S. Capital Funding IV for comment were unsuccessful.

The lawsuit claims Hughes and the directors orchestrated the sale to protect their jobs and avoid the humiliation — and potential legal liability — of having the bank seized by the FDIC.

The defendants "took steps with the express intent to preserve for their own benefit and others the only asset available to satisfy the [trust-preferred] repayment obligation by transferring the value of that asset … to stockholders of the bank," the lawsuit claims.

Hughes disagrees, arguing that the capital raise cost all the holding company's investors their entire stakes, and that a bankruptcy sale would not have brought a return for the debtholders because the bank had a negative value.

"We were looking at the whole picture, and we were not trying to devise a scheme to defraud anybody," he said.

Albina Community Bancorp in Portland, Ore., used a similar deal structure last year when it sold a 90% stake in its bank unit to Beneficial State Bancorp in Oakland, Calif. Albina's management has said that the deal — a direct sale of stock in the bank, bypassing the parent company — was the only way to save the bank, which was under a regulatory order and near failure. The stock sale diluted the holding company's ownership of the bank, which drew loud objections from the companies that own the parent's $6 million in trust-preferred debt.

Albina filed for bankruptcy in September. Now Beneficial, which bought the bank's stock, could be in for legal challenges. Last month, Hildene won the approval of the other trust-preferred investors to hire lawyers and "take appropriate legal action" over the recapitalization, according to the ballot seeking authorization for Hildene's proposal. That could include action against Beneficial, the ballot said.

Kat Taylor, Beneficial's CEO, did not respond to a request for comment. The bank is co-owned by Taylor and her husband, Tom Steyer, the billionaire founder of hedge fund Farallon Capital Management.

The specific wording of the trust-preferred agreements will determine whether the lawsuits against Arvest and First Southern will succeed. Neither company has filed responses to the lawsuits, so it is not yet clear what legal strategy they will take. The legal resolution is likely to take months, if not longer.

For now, the lawsuits could discourage other banks from following the lead of First Southern and Albina.

Lee Bradley, managing partner of Community Capital Advisors in Georgia, said he thinks the trust-preferred holders are trying to scare bankers to stay in line. Community Capital was named a defendant in U.S. Capital Funding's suit over First Southern's capital raise. The lawsuit claims that, by helping First Southern with its capital raise, Community Capital interfered with the debtholders' contractual rights.

"The lawsuit is a clear intimidation shot for everybody, from the shareholders and the CEO to the advisor," Bradley said.

Bradley denies that his company did anything wrong. He said he thinks that the alternative to the capital raise — failure — would have been worse for the bank and no better the trust-preferred investors.

"The bank was going to fail, and that's the only asset the holding company had," Bradley said. "So the trust-preferred holders wouldn't have gotten anything that way — unless the FDIC was going to pay them."