Capital – Understanding It and Building It
ICBA Community Banking LIVE
March 1-5, 2015
Orlando, Florida
25697683 © Copyright 2015 – All Rights Reserved
54314498
Robert N. Flowers
Hunton & Williams LLP 1445 Ross Avenue, #3700
Dallas, Texas 75202
(214) 468-3324
Heather Archer Eastep
Hunton & Williams LLP 1751 Pinnacle Drive, #1700
McLean, Virginia 22102
(703) 714-7471
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Hunton & Williams LLP
• The Financial Institutions Corporate and Regulatory Group at Hunton & Williams LLP represents privately-held and publicly-traded commercial banks, community banks, thrifts, savings and loans, foreign banks and similar financial institutions, as well as holding companies and, from time to time, their officers, directors and shareholders. Our Financial Institutions Corporate and Regulatory Group provides effective counsel on a wide range of complex matters, including:
– Our Financial Institutions Corporate and Regulatory Group was #1 in overall M&A transactions for 2014. Over the past 14 years, the group has been involved in more M&A transactions than the next highest group, and has been #1 or #2 for all of those 14 years.
– In addition to M&A, the group is involved in new-entity charters, stock repurchases and splits, proxy contests, tender offers and ownership transitions.
– Regulatory counsel, including BSA/AML/KYC rules, Community Reinvestment Act, anti-money laundering, e-commerce, privacy, capital adequacy, UDAAP, Fair Lending, third party risk management, lending limits, compliance matters and a myriad of other Federal and state banking laws, rules and regulations.
– Nontraditional banking and finance activities, including insurance, securities brokerage and investment advisory services.
– Corporate matters such as capital offerings, employment matters, benefit matters, tax matters, real estate matters and litigation involving financial institutions.
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CAPITAL PLANNING
THE CAPITAL PLANNING PROCESS
Preparing Strategic Plan
Identifying and
Evaluating Risks
Setting and Assessing Capital Adequacy Goals That Relate to Strategic
Plan and Risks
Ensuring Integrity in the Internal Capital Planning
Process and Capital Adequacy Assessments
Maintaining a Strategy to Ensure Capital Adequacy
and Contingency Planning
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• Allows management to ensure that the bank has sufficient capital to support its Strategic Plan and effectively control the bank’s risk profile • Ensures that there is enough “fuel” in the tank to drive the
bank’s Strategic Plan and enable the bank to absorb risks that it may encounter
• Enables management to identify timing of capital needs to avoid “just in time” capital through the use of tolerances and triggers
• Provides management with reference points for capital alternatives and sources of capital
• Capital Plans are now being required of healthy banks as well as problem institutions
Purpose
Capital Plans
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• If regulatory examination shows bank in less than satisfactory condition, expect administrative action with Capital Plan requirement • Requirements to achieve and maintain elevated levels of leverage
and total capital • If ratios fall below minimums, take steps to restore ratios
• Prepare and submit Capital Plan and after regulatory approval of Capital Plan, implement Capital Plan • Show plans for immediate action to address capital situation –
shrink bank, sell branch, or raise identifiable capital • Be realistic, but not overly optimistic • Have quantifiable triggers to seek new capital, or take other action
to improve ratios
• Monitor bank performance against the Capital Plan and update Capital Plan as conditions change, but no less than annually
Problem Banks
Capital Plans
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• Bank regulators have communicated clear expectation for all banks, healthy or otherwise, to implement Capital Plans, especially for growing organizations
• Capital Plans should be prepared in ordinary course along with budget, Strategic Plan and Compliance Risk Management Plan
• Capital Plan should reflect condition and plans of the bank, current and projected economic conditions and should work in tandem with the bank’s Strategic Plan and Compliance Risk Management Plan
• Capital Plan should contain: • Risk tolerances and triggers for additional capital or other
action to be taken • An assessment of interest rate risk and its impact on capital • An assessment of the impact of BASEL III on capital
• No “just-in-time” capital
Healthy Banks
Capital Plans
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• Capital alternatives and sources of funds • Details and timeframes • Tolerances and triggers • Three-year to five-year projections
• Projected key asset quality ratios • Include interest rate risk analysis and BASEL III analysis • Post-stress test estimates of potential losses and their impact on
ALLL
• Changes in business strategy or corporate structure • Consider BHC needs as well as bank needs • One size does not fit all – consider:
• Size of institution • Complexity of the institution • Risk profile of institution
Considerations
Capital Plans
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CAPITAL PLANNING
MANAGING TO THE BUFFER ZONES
Capital Ratios Phase-in Schedule
January 1 2015 2016 2017 2018 2019
Minimum Common Equity % 4.5 4.5 4.5 4.5 4.5
Capital Conservation Buffer % N/A 0.625 1.25 1.875 2.5
Common Equity with Capital Conservation
Buffer %
4.5
5.125
5.75
6.375
7.0
Minimum Tier 1 Capital % 6.0 6.0 6.0 6.0 6.0
Minimum Tier 1 Capital with Capital
Conservation Buffer %
N/A
6.625
7.25
7.785
8.5
Minimum Total Capital % 8.0 8.0 8.0 8.0 8.0
Minimum Total Capital with Capital
Conservation Buffer %
8.0
8.625
9.25
9.875
10.5
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CAPITAL PLANNING
MANAGING TO THE BUFFER ZONES
Prompt Corrective Action
(effective January 1, 2015)
Prompt
Corrective
Action
Categories and
Ratios
Tier 1 Leverage % Common Equity
Tier 1 RBC % Tier 1 RBC % Total RBC %
Well Capitalized ≥ 5.0 ≥ 6.5 ≥ 8.0 ≥ 10.0
Adequately
Capitalized
≥ 4.0
≥ 4.5
≥ 6.0
≥ 8.0
Undercapitalized < 4.0 < 4.5 < 6.0 < 8.0
Significantly
Undercapitalized
< 3.0
< 3.0
< 4.0
< 6.0
Critically
Undercapitalized
Tangible Equity/Total Assets ≤ 2%
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CAPITAL PLANNING
MANAGING TO THE BUFFER ZONES
Well-Capitalized Ratios vs. Buffer Zone Ratios
Common Equity Tier 1 RBC % Tier 1 RBC % Total RBC %
Well-Capitalized Ratios ≥ 6.5% ≥ 8.0% ≥ 10.0%
Buffer Zone Ratios ≥ 7.0% ≥ 8.5% ≥ 10.5%
BASEL III Minimum Ratios ≥ 4.5% ≥ 6.0% ≥ 8.0%
Size of Buffer 2.0% 2.0% 2.0%
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CAPITAL PLANNING
MANAGING TO THE BUFFER ZONES
Maximum Payout Amount as % of Eligible Retained Income
Size of Buffer
No Buffer Limit Greater than 2.5%
60% > 1.875% to 2.500%
40% > 1.250% to 1.875%
20% > 0.625% to 1.250%
0% ≤ 0.625%
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• The agencies define a discretionary bonus payment as a payment made to an executive officer of a banking organization or an individual with commensurate responsibilities within the organization, such as a head of a business line, when:
• The banking organization retains discretion as to the fact of the payment and as to the amount of the payment until the discretionary bonus is paid to the executive officer
• The amount paid is determined by the banking organization without prior promise to, or agreement with, the executive officer
• The executive officer has no contract right, express or implied, to the bonus payment
CAPITAL PLANNING
MANAGING TO THE BUFFER ZONES
Discretionary Bonuses
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• An executive officer is defined as a person who holds the title or, without regard to title, salary, or compensation, performs the function of one or more of the following positions:
• President
• Chief Executive Officer
• Chief Legal Officer
• Chief Lending Officer
• Chief Risk Officer
• Head of a major business line
• Other management staff that the board of directors of the banking organization deems to have equivalent responsibility
CAPITAL PLANNING
MANAGING TO THE BUFFER ZONES
Discretionary Bonuses
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• Bank Capital Requirements • Generally higher ratios required • Very limited ability to use Tier 2 capital instruments
• BHC Capital Requirements • Lower leverage ratio requirements; all other ratios are
risk-based • BHC’s with less than $1 billion in total assets are
generally not subject to Federal Reserve capital adequacy guidelines on a consolidated basis
• Proceeds of additional capital, debt or Tier 2 capital raised at BHC level can be injected into the bank as common equity capital
BHC versus Bank Capital
Capital Plans
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Takeaways from BASEL III – capital surprises
Common equity is the
dominant form
Common equity must be
82.5% of Tier 1 risk-based
capital ratio
Minimum 5-year call right on
preferred and debt
New risk weighting rules
Manage to the buffered
ratios and not to PCA
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CAPITAL PLANNING - SAMPLE SOURCES OF CAPITAL
Common Stock
Subordinated Debt
KSOPs
IPOs
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CAPITAL
• Shareholder liquidity
• Refinance/replace existing debt/equity
• Increase Tier 1 capital
• Reduce outstanding trust preferred
• Pay off TARP or SBLF funds
• Pay off bank-stock loans
• Refinance existing subordinated debt
• Support internal growth consistent with Strategic Plan
• Shore up balance sheet to improve various measurement ratios
• Acquire another bank or branch acquisition
• Acquire a healthy institution that fits the Strategic Plan
• Acquire a troubled institution and inject additional capital
• Enter into the race to acquire a failed or failing institution by bolstering capital before the bid process
• Acquire a branch of a failing institution
• Engage in a merger of equals
Use of Proceeds
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• Stock offerings • General stock offerings • Rights offering to existing shareholders
followed by a general offering to customers and community residents
• Private placements to limited investors • Institutional investors and private equity
• Be prepared to negotiate hard on pricing • Be clear on need for a timing of liquidity event • Be aware of Bank Holding Company Act issues
and “control” thresholds (ownership below 9.99% and preferably lower)
Common Stock
CAPITAL PLANNING – SOURCES OF CAPITAL
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CAPITAL PLANNING – SOURCES OF CAPITAL
• Unsecured
• Ranking
• Senior to stock
• Senior to TRUPs
• Junior to senior indebtedness such as bank-stock loans
• Duration
• Rate
• Call features
• Conversion features
• Payment-in-kind features
Subordinated Debt
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CAPITAL PLANNING – SOURCES OF CAPITAL
• Tier 2 Capital at BHC level
• Must not be secured
• Must have no financial covenants
• Must have no guarantees
• Tier 1 Capital at Bank level
• Interest payments are deductible (unlike dividends)
• Non-dilutive to shareholders (absent conversion or PIK features)
• Preferred by retail investors (coupon clippers)
Advantages of Subordinated Debt
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CAPITAL PLANNING – SOURCES OF CAPITAL
• Tier 2 Capital at BHC level requires minimum 5-year call right (i.e., no redemption for 5 years after issuance)
• Amount treated as Tier 2 Capital decreases by 20% per year during last five years before maturity
• Typically requires higher interest rates for retail investors (as opposed to rates on bank-stock loans)
• Impact of interest and principal payments on cash flow
• Potential debt-to-equity ratio concerns at BHC level for BHCs with <$1 billion in total assets
Disadvantages of Subordinated Debt
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CAPITAL PLANNING – SOURCES OF CAPITAL
• Amend existing 401(k) Plan to add ESOP feature, or create a stand-alone ESOP
• Fund KSOP (or ESOP)
• One-time election right for 401(k) Plan participants
• Rollover IRAs (employees only, not outside directors)
• Ongoing match or discretionary contribution by BHC or Bank
• Leveraged
Overview of KSOP Transaction
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CAPITAL PLANNING – SOURCES OF CAPITAL
- KSOPs
Existing 401(k) Plan
New KSOP (401(k) Plan with ESOP Feature
Amendment and Restatement to
add ESOP Feature
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CAPITAL PLANNING – SOURCES OF CAPITAL – KSOP (FUNDING SOURCES)
BHC
New KSOP (401(k) Plan with ESOP
Feature Bank
401(k) Participants
ESOP Loan
Plan Contributions
Participant
Election Right
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CAPITAL PLANNING – SOURCES OF CAPITAL – KSOPS
• Prototype plan versus self-designed plan
• Limitations on election right
• Benefits of an ESOP and a Subchapter S BHC or Bank
• Appraisal requirements
• ERISA issues
• Fiduciary duties
• Inside/outside trustees
• Third-party administrators
• Bank Holding Company Act issues
Considerations
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CAPITAL PLANNING - SOURCES OF CAPITAL
ISSUES TO CONSIDER IN A CAPITAL OFFERING
Nature of securities offered
Nature of purchasers
Corporate Governance
Issues Exemptions
Pricing Minimum
investment
Sweeteners (warrants,
convertibility) Offering period
Placement agent Supplementation
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CAPITAL PLANNING – SOME NOTES ABOUT IPOs AS A SOURCE OF CAPITAL
• An “initial public offering”
• Register with the SEC
• Become a publicly-traded company
• A company that has the privilege of having its shares traded on a national securities exchange
• A company that files reports with the Securities and Exchange Commission
What is an IPO?
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CAPITAL PLANS – SOME NOTES ABOUT IPOs AS A SOURCE OF CAPITAL
• Potentially greater access to capital markets and financial flexibility
• Raising capital on more attractive terms
• Publicly-traded securities typically trade at a higher multiple than privately-traded securities
• Eases burden on Company to plan for liquidity events of significant shareholders
• Expands and improves acquisition alternatives
• Finance acquisitions through issuance of publicly traded stock as acquisition currency
• Conserves cash
• Provides incentive for retained managers of acquired company
Some Advantages of an IPO
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CAPITAL PLANS – SOME NOTES ABOUT IPOs AS A SOURCE OF CAPITAL
• Facilitates better alignment of director, officer and shareholder interests
• Assists in the recruitment and retention of directors and employees
• Provides a means of providing compensation without using cash
• Provides the potential for considerable upside potential to employees
• Enhanced corporate governance
• More transparency on corporate governance matters
• More robust system of investor relations
Some Advantages of an IPO
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CAPITAL PLANS – SOME NOTES ABOUT IPOs AS A SOURCE OF CAPITAL
• Can be an expensive means of securing capital
• Commissions and expense allowances of underwriters
• Auditing fees, internal control systems & legal fees
• Audit and D&O insurance fees
• Costs of implementing SEC and exchange required corporate governance systems
• Increased exposure to litigation and liability
• Federal securities laws (insider trading, anti-fraud, etc.)
• Shareholders as a new corporate constituency: corporate governance, shareholder proposals, proxy contests
• Disgruntled shareholders; derivative suits
Some Disadvantages of an IPO
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CAPITAL PLANS – SOME NOTES ABOUT IPOs AS A SOURCE OF CAPITAL
• Limitations on management flexibility
• Manage to quarterly earnings growth
• Impact of market on price of stock – can’t control market
• Required public disclosure of information
• Magnitude and volume of required disclosures may obscure important business developments
• Securities laws may require disclosure of sensitive trade or proprietary information
• Securities laws may force disclosure of information at strategically undesirable times
Some Disadvantages of an IPO?
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CAPITAL PLANS – SOME NOTES ABOUT IPOs AS A SOURCE OF CAPITAL
• General thoughts:
• M&A environment (current and projected)
• Regulatory environment
• Publicly-traded stock as a viable form of currency
• “Ideal” IPO candidates:
• Strategic Plan calls for acquisitive transactions in the short and near term (especially “serial” acquirors)
• Total assets of $750 million to $1.0 billion (or more)
• Growing assets organically, but outstripping ability to augment capital needs through earnings
• Target capital raise of at least $35 million to justify costs
So why do an IPO and become publicly-traded?
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Bank A $250 million in assets
Bank B $150 million in assets
Bank A Stock (maybe some cash)
Bank B Stock
Resulting Bank AB $400 million in assets
USE OF PROCEEDS - MERGERS OF EQUALS
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• Somewhat similar-sized healthy or substantially healthy banks
• Neither bank initially dominates the combined senior management team and both sides have board representation
• Form of consideration is typically common stock, not cash (or at least a combination thereof)
• Typically no “premium” is paid because a merger of equals is not an “acquisition,” but rather a “financial combination”
• Negotiating atmosphere is typically friendly and low key
Common Features
USE OF PROCEEDS - MERGERS OF EQUALS
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• The nonfinancial (“social issues”) are extremely important
• Heavy discussions/negotiations should be performed, early on, to resolve the many social barriers to consummating a transaction of this sort
• Compromises will absolutely be necessary if:
• Neither shareholder group will own 100% of the combined company
• One shareholder group will likely become the “minority” shareholders
• Decision-making at the board and senior management levels will be shared
• Some prospective merger-of-equals transactions are not consummated due to unresolvable problems in this area
• CEO “chemistry” is a most vital social issue
Considerations
USE OF PROCEEDS - MERGERS OF EQUALS
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• Avoids premature cash-out of investment associated with an outright sale – sellers receive stock in “acquiring” bank
• Preserves independent institution in existing markets
• Conserves equity capital and enhances debt capacity for “acquiring” bank
• Increases access to alternative forms of financing
• Can increase the marketability/liquidity of shares by increasing the number of shareholders, and possibly enhance the market price per share
• Improves senior management depth
Advantages
USE OF PROCEEDS - MERGERS OF EQUALS
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• Only limited amounts of earnings and equity per share dilution are typically incurred, as compared to an acquisition at a competitive purchase price level (no “premium” price is paid by either party)
• Significant opportunities for economics of scale/merger savings are usually available through reduction in duplicate operations/staffs, thereby materially enhancing combined shareholder value (without having to “sell out”)
• Scale also provides economic means to afford compliance costs related to Dodd-Frank and other pronouncements that Washington is pumping out
• Diversification of trade area economic/customer base concentrations
Advantages (continued)
CAPITAL PLANS ALTERNATIVES TO RAISING CAPITAL – MERGERS OF EQUALS
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• Difficult form of transaction to close, typically due to problems in resolving the many social issues
• The merger partners must be willing to dilute existing shareholder ownership percentages (from 100% to something less)
• The merger partners must be willing to share decision-making responsibility/authority at the senior management level and at the combined board of directors
Disadvantages
CAPITAL PLANS ALTERNATIVES TO RAISING CAPITAL – MERGERS OF EQUALS
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• Significant organizational, operational, and producer integration of the merger partners, while very common in this type of transaction, is never easy (people frequently do not embrace significant change willingly)
• The corporate cultures of the merger partners may be substantially different, requiring a major effort to re-orient the combined company in a unified direction
• Some layoff of the combined company’s staff may be necessary in order to achieve the potential shareholder value enhancements available
Disadvantages (continued)
USE OF PROCEEDS - MERGERS OF EQUALS
Questions?
© Copyright 2015
Robert N. Flowers
Hunton & Williams LLP 1445 Ross Avenue, #3700
Dallas, Texas 75202
(214) 468-3324
Heather Archer Eastep
Hunton & Williams LLP 1751 Pinnacle Drive, #1700
McLean, Virginia 22102
(703) 714-7471
