Trust-preferred creditors are starting to give deadbeat banks an unenviable choice: negotiate repayment or run the risk of forced liquidation.

Trapeza Capital Management, a New York investment firm, filed legal documents earlier this month to force FMB Bancshares in Lakeland, Ga., into involuntary bankruptcy. Trapeza, which manages a collateralized-debt obligation containing FMB's trust-preferred securities, says in its filing that it is owed $13.6 million in unpaid debt and interest.

FMB is the second lender to face involuntary bankruptcy over unpaid trust-preferred dividends, joining American Bancorp in St. Paul, Minn.

Other banks must take notice, industry observers say.

"Involuntary bankruptcies send a clear signal that doing nothing does not appear to be a good strategy," says Robert Klingler, a partner at Bryan Cave. "When you're in default and tell your creditors you can't do anything, you're asking for an involuntary bankruptcy."

American consented to a bankruptcy motion filed by two CDO managers last month and appears to be moving toward an auction of its bank. Such auctions, known as 363 sales, are the usual result of holding company bankruptcies.

Unlike American, the $566 million-asset FMB plans to fight. The company will file a motion to dismiss the bankruptcy petition, arguing that Trapeza doesn't have standing to sue, says Richard Cheatham, a lawyer at Troutman Sanders who represents FMB. He declined to discuss the case further.

Hundreds of community banks that issued trust-preferred securities early in the last decade began deferring payments on the securities during the financial crisis. Issuers can defer payment for up to five years, after which they are in default and the securities holders can demand full payment — or try to force a bankruptcy if payment is withheld. There are 230 banks in default on trust-preferred debt and 223 that are still deferring payments, according to Fitch Ratings.

A recent move by BNY Mellon, a major trust-preferred trustee, could make involuntary bankruptcies far more common. BNY Mellon said in May that it would let a group of investors in passively managed trust-preferred CDOs coordinate action against banks that are in default. The unnamed investors would shoulder the costs of suing defaulted banks and would indemnify BNY Mellon.

This could give banks an opening to negotiate repayment. Most trust preferreds are held in CDOs whose ownership is not transparent, making it impossible to negotiate a settlement. In many cases, the debt obligations are unmanaged, and trust-preferred issuers' only contact is with the CDO's trustee, which have been notoriously disinclined to negotiate given their possible legal liability.

BNY Mellon's move will likely make it easier for investors to sue defaulted banks, potentially setting off a wave of involuntary bankruptcies. In a research note, Fitch said BNY Mellon's announcement was "a positive step" for investors and "may improve the prospects for better recoveries on distressed" trust-preferred issuers.

It could also deal a major blow to distressed banks. With involuntary bankruptcies likely to become routine, many will be closely watching FMB's efforts to block the process.

Lawyers, by and large, don't like FMB's chances.

"Legal standing arguments can be made, but I think those have generally been ruled in favor of the creditors," Klingler says.

It's unclear how much negotiation took place between March 31, when FMB went into default, and June 9, when Trapeza filed its bankruptcy petition. Like American, FMB is under a Federal Reserve Board enforcement action that bars it from making trust-preferred payments. Through its lawyer, Michael Wilson of Hunton & Williams, Trapeza declined to comment.

What's puzzling about Trapeza's lawsuit is that FMB's poor financial condition means a bankruptcy sale is unlikely to give creditors anything close to a full return. American, by contrast, had a healthy and profitable bank.

FMB's Farmers & Merchants Bank just had its best quarterly result since the financial crisis, earning $890,000 in the first quarter. But the bank, which lost $35 million over the prior five years, is seriously undercapitalized, with a 2.84% Tier 1 leverage ratio.

"It's hard to expect any sort of recovery through a [bankruptcy] sale, so we're speculating that this is a negotiating tactic," says Alina Pak, a Fitch analyst. "If it makes the owners and management of the bank worse off, it could help the investors negotiate with other banks."

Another possibility is that the robust bidding in recent bankruptcy auctions has made Trapeza optimistic about a sale. In the latest bankruptcy auction, D.L. Evans Bancorp agreed to pay $10.1 million for Idaho Banking, or $7.5 million more than the opening bid. The recent auctions of 1st Mariner Bank, Metropolitan National Bank and Park Cities Bank also fetched strong prices.

"It used to be that the trust-preferred holders were opposed to the 363 process because early ones had very poor returns," says Joel Rappoport, a partner with Kilpatrick, Townsend & Stockton.

"Since then, we've had some auctions that were better than expected," Rappoport adds. "I think they're emboldened by those cases and I think they now like the 363 auction process."

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