Schiff Hardin LLP May 21, 2012
Financial Institutions Alert

Bank Recapitalization Refresher

Although the market for bank and bank holding company recapitalizations remains challenging, several recapitalizations have recently been announced. While we hope that this points toward an increased level of activity and successes for institutions, the continued scarcity of announced deals is a reminder of the difficulties inherent to distressed bank recapitalizations. Recapitalizations present many unique and interrelated business, legal and strategic questions, and understanding how a decision on one issue may affect another equally important consideration is essential. We believe now is a great time to share some of the most material issues faced in our recent recapitalization experiences.

1. Regulatory Review and Participation. As any banker knows, if you are considering material changes to the structure or operations of your institution, discussing the proposal with your regulators early in the process is extremely important. In a recapitalization transaction, however, doing so early is essential. Just as important is presenting a recapitalization proposal that reflects a solid thought process and a plan that the regulators will view as cogent. Thoroughness, given the complexity of issues presented in any recapitalization, builds credibility with the regulators and makes a good use of their time, which is spread thin among a large number of distressed banks.

If an institution is currently considering engaging in a recapitalization, given today's environment, it is more likely than not that it is due to the institution needing capital and facing increasing regulatory review. As a result, the needs of the institution will be known to its regulators and there will have been an ongoing dialogue about the need for a capital solution. Once a viable recapitalization proposal has been formulated, taking that proposal to the regulators can have many benefits.

First, it will show the regulators that the institution is working proactively on finding a solution in a meaningful and material way. Second, if the regulators see any problems or impediments with the structure of the recapitalization proposal, the institution will be able to learn of the problems early in the process before too much time, money and effort is wasted. Third, to the extent new equityholders will be investing in the institution, identifying those individuals to the regulators early will allow them to raise any qualification impediments the proposed investors could face, including related to the Change in Bank Control Act and the Bank Holding Company Act.

Intelligence gathering is one of the most important benefits of taking your proposal to the regulators. You will learn about how the regulators view your institution, the risks they see in the balance sheet and whether they put your institution in a high risk or lesser risk category, all of which is important information for board and management decision-making.

It is also important to remember that both the institution looking for capital and the regulators are working toward the same goal - the recapitalization of the institution. Approaching the recapitalization process with your regulators in a collaborative manner can be an effective first step toward success.

2. Bank, Bank Holding Company or Both? There is one question that should be asked very early in any recapitalization: What is going to be recapitalized - the bank, the bank holding company or both? In most recapitalizations, the goal is to increase capital at the bank level. This can be accomplished by a capital injection directly into the bank, or a downstream of capital from the bank holding company following a capital injection into it.

The decision of which recapitalization structure to use can be complicated by many competing factors that need to be navigated. These factors can include: (1) the potential dilution to existing shareholders; (2) the amount and type of indebtedness at the bank and the bank holding company; (3) the restrictions provided for in indebtedness, TARP or trust preferred instruments; (4) the relative needs for capital at the bank and the bank holding company; and (5) tax considerations (which are discussed in more detail below).

It is important to analyze and assess each of these factors in a comprehensive manner very early in the process of a recapitalization. Determining how these factors interplay with each other, and understanding the rights of each stakeholder, will often times dictate the structure of the recapitalization. Getting the structure right can take months as you work through a "constraints analysis" with your professional advisers. What appears to be a simple and optimal structure on its face may, upon closer scrutiny, reveal complex tax, creditors' rights, stockholder consent, legal, regulatory and other issues. The structure will matter to the regulators, current stockholders and new investors. Developing the optimal structure and understanding the consequences is a process, and the result is only as good as the process used. Reorganizations can often times be very complicated puzzles to solve.

3. Insider Participation. Some recapitalizations include capital injections from existing shareholders, directors and/or officers. Often times, the participation by such individuals is because outside sources of capital are unavailable, or because the insiders are willing to invest on terms more favorable to the institution than are available elsewhere.

In each instance, it is important for the institution and the insiders to analyze and work through all potential fiduciary and conflict-of-interest issues. Documenting in the board's meeting minutes that all such issues were fully examined and considered under applicable law is very important in supporting the fairness of the recapitalization should a stakeholder of the institution seek to challenge it. Focusing on this issue early, so the process is not tainted by insider involvement or conflicts, is important.

4. Tax Considerations. If new or existing investors are injecting capital into the institution in exchange for voting equity in the institution, the preservation of the institution's deferred tax assets can become the dominant issue. Many institutions looking to engage in a recapitalization have significant tax losses from prior periods. These tax losses can be one of the most material assets, and a strategy to optimize their value is worthy of serious evaluation.

When new equity is issued to investors in connection with a recapitalization, to the extent that a "change in control" occurs under relevant tax laws, those deferred tax assets can be lost or severely impaired. As a result, structuring a recapitalization to ensure that an institution's deferred tax assets are retained can become the primary goal. There are techniques for deferred tax asset preservation, but they are complicated. Relying on professionals and their opinions has become common when deferred tax asset preservation is a goal of the transaction.

One difficulty that arises while ensuring these assets are retained is that it could require an investor to take non-voting, non-cumulative, perpetual preferred stock as consideration for all or part of its capital injection. Investors may view this type of security as being unattractive because of its limited rights and benefits, but it may be what is required in order to retain the institution's deferred tax assets. That form of instrument, however, can raise other issues in getting the recapitalization done, reflecting the common balancing of priorities necessary in these projects.

If you are a party to a potential recapitalization (whether it be a bank, bank holding company, lender, trust preferred holder, director, officer, shareholder or investor) and would like to discuss your situation with us, the members of Schiff Hardin's Financial Institutions Group are ready and willing to assist. We have helped our clients on numerous recapitalization transactions and are very experienced in how they work. We look forward to working with you.

ABOUT SCHIFF HARDIN LLP

Schiff Hardin LLP is a national law firm and its transactional capabilities help banks, bank holding companies, savings associations and other financial institutions raise capital, merge, acquire or be acquired, buy and sell assets, restructure and recapitalize. We combine our transactional know-how with regulatory experience, including experience of three former public company bank General Counsels who are senior members of our Financial Institutions Group. Their executive management and experience inside large financial institutions brings perspective to clients who have pressing business problems or want to seize market opportunities. We are proactive and bring comprehensive strategic legal solutions to our client's most pressing problems or strategic initiatives.