Banks have played a crucial role these last few months as the COVID-19 pandemic has swept across the world. Through Paycheck Protection Program loans, payment deferments, and other initiatives, banks have provided significant assistance to people and businesses of all types. The banking industry has worked incredibly hard, and bankers across the country should be proud.
Unfortunately, this good work does not make banks immune to the same pressures that have confronted many of America’s other businesses recently. That being the case, bank capital has become an increasingly hot topic as we’ve moved through the pandemic, particularly at the large bank level. Many national and super-regional banks made springtime decisions to suspend their stock repurchase programs. Recent Federal Reserve stress tests have brought about large bank dividend limitations, too.
Like the large banks, community banks also need to keep a close eye on their capital positions. There are several reasons a community bank might want or need more capital as we move forward. Some reasons relate to addressing problems, like shoring up credit losses or bracing for general uncertainty. Other reasons are more positive, including beefing up to position for an acquisition or other growth opportunity. Whatever the reason, it’s a good time to think about the steps your institution might take if a capital need were to arise.
Here are the basics of bank capital in today’s market:
Common Stock. Common stock is the most widely-utilized bank capital instrument. It is a gold standard of sorts, serving as “common equity tier 1 capital” and driving every major metric of the agencies’ capital adequacy standards. For many institutions seeking to raise capital, common stock is the first consideration. However, common stock is sometimes considered an “expensive” form of capital, and it can be dilutive of ownership percentages and earnings per share.
Preferred Stock. Next on the list is preferred stock. Preferred stock is a flexible instrument that can include not only dividend and liquidation preferences over common stock, but also special voting privileges, board representation, conversion features, and other unique rights. Generally speaking, preferred stock that is non-cumulative (i.e., the issuer’s dividend payment obligations do not accumulate if a scheduled payment is missed) and perpetual (i.e., the instrument has no maturity date) can qualify as “additional tier 1 capital,” and other types of preferred stock can qualify as tier 2 capital, all depending on the specific terms of the instrument. A careful look at the agencies’ capital criteria is a must for any proposed issuance of preferred stock.Notably, preferred stock was the mechanism the U.S. Treasury used to make most of its TARP Capital Purchase Program and Small Business Lending Fund investments during the late 2000s and early 2010s. If COVID-19 brings about new government programs to bolster bank capital, preferred stock may be part of the package again.
Subordinated Debt. Subordinated debt, which is senior to stock in a liquidation setting, is a relatively common capital alternative for banks. If its terms are right, it will count as tier 2 capital. If the issuer is a bank holding company, it can contribute the debt proceeds down to its subsidiary bank as tier 1 capital. For subordinated debt to count as tier 2 capital, the debt must (a) be subordinated to depositors and general creditors of the issuer, (b) be unsecured, (c) have a maturity of at least five years, (d) not be callable by the issuer during the first five years of its term, (e) not be subject to acceleration upon default, except in the event of a receivership or similar proceeding, and (f) not have a credit sensitive feature, such as a dividend or interest rate that is reset periodically based on the institution’s credit standing. In addition, at the beginning of each of the last five years of the life of a subordinated debt instrument, the amount that is eligible for tier 2 capital treatment is reduced by 20% of the original amount of the instrument, meaning that none of the subordinated debt will count as tier 2 capital in the final year of its term. The agencies’ capital adequacy standards contain certain other characteristics that subordinated debt must have to get tier 2 capital treatment, and issuing institutions should follow those standards carefully.
Senior Debt / Bank Holding Company Loans. As its name suggests, senior debt carries higher priority in liquidation than subordinated debt. Senior debt is almost always issued at the bank holding company level. Senior debt can be particularly useful to an institution with a “small” bank holding company, which generally means a holding company that has consolidated assets of $3 billion or less. A “small” bank holding company typically can incur senior debt and contribute the proceeds to its subsidiary bank in the form of tier 1 capital, without regard to the normal capital adequacy standards at the holding company level.
Before a “small” bank holding company incurs debt, whether senior debt or subordinated debt, it should keep several things in mind. First, dividends from its subsidiary bank are the most likely source of repayment for its debt, and applicable law typically restricts a bank’s ability to pay dividends if its recent earnings (or its cumulative retained earnings) do not support the payments. Thus, holding company loans can become very problematic for distressed institutions. Second, a third-party lender might require a pledge of the subsidiary bank stock to secure the loan. A stock-secured loan can put additional pressure on an institution in a distressed situation. Third, a “small” bank holding company must comply with the Small Bank Holding Company Policy Statement at Appendix C of 12 C.F.R. Part 225, which itself includes leverage requirements, capital adequacy requirements, and dividend restrictions under certain circumstances.
As an institution evaluates these capital alternatives, it should carefully consider the following:
Organizational Documents. Before issuing stock, an institution should check its organizational documents. Most importantly, an institution’s articles of incorporation will speak to the classes of stock and the number of shares the institution is authorized to issue. If the institution does not have enough authorized but unissued shares of the desired class of stock, the institution generally will have to ask its shareholders to approve the issuance. Organizational documents might include other limitations or considerations, as well.
Debt instruments typically don’t give rise to organizational document considerations, but an institution should check its organizational documents for debt issuances, too. There’s always a chance an organizational document limits an institution’s ability to incur debt, reserves related rights to the shareholders, or imposes another type of limitation.
Securities Laws. An institution should be careful to comply with securities laws. Most notably, although the issuance of bank stock generally enjoys an exemption from registration under Section 3(a)(2) of the Securities Act of 1933, the issuance of bank holding company stock does not. A bank holding company needs a transaction-related exemption, such as a private placement exemption, to keep from having to register its securities with the Securities and Exchange Commission and/or state securities agencies. Private placement exemptions can come with size limitations, investor limitations, and restrictions on transferability of the stock, and it is vital that an issuing institution be aware of the issues.
Securities laws also come into play for certain types of debt issuances. In particular, widely marketed subordinated debt can involve significant securities law considerations. Before issuing any equity or debt instrument, an institution should be sure it understands the relevant securities laws.
Fairness Considerations. An institution should always be mindful of fairness considerations, especially if it issues equity or debt to a small group of people with heavy participation from board members. Transactions between an institution and its directors can invite scrutiny, particularly from shareholders. The Alabama Code provides certain protections to a corporation when the transaction is approved by its disinterested directors, when the transaction is approved by its shareholders, or when the transaction is “fair” to the corporation. An institution should navigate these issues carefully.
Contractual/Regulatory Limitations. An institution might be party to an agreement, or perhaps even subject to a regulatory limitation, that prohibits or limits debt or equity issuances. For example, if a bank holding company already has a loan, its loan documents might prohibit the incurrence of additional debt, including subordinated debt. Similarly, communications between an institution and its federal or state regulatory agency might require the institution to obtain agency consent prior to incurring debt. Of particular note for sales of voting stock (common or preferred) are the implications of the Change in Bank Control Act and similar state statutes, which can impact the timing and terms of a stock offering and require agency approval. An institution should review its contracts and records, and it should consider federal and state “control” rules, for these purposes.
There are many ways for a bank to raise capital, and this article covers only the basics. If your institution decides to go forward with a capital raise in the near future, we hope this information will be useful to you.
Charles Moore is a partner at Bradley law firm. His practice focuses on community banks and commercial lenders and borrowers. In his commercial finance work, Charles has had substantial experience in mortgage warehouse lending, mortgage servicing rights lending, real estate finance, bank holding company lending, syndicated lending, loan participation transactions, and Article 9 of the Uniform Commercial Code. In his community bank work, he has handled bank merger and acquisition transactions, Change in Bank Control Act matters, Bank Holding Company Act matters, formation and capital raising activities of banks and bank holding companies, and various other bank regulatory matters.