Capital Understanding It and Building It

Capital Understanding It and Building It ICBA Community Banking LIVE March 1-5, 2015 Orlando, Florida Robert N. Flowers Hunton & Williams LLP 1445 Ross Avenue, #3700 Dallas, Texas 75202 (214) 468-3324 rflowers@hunton.com Heather Archer Eastep Hunton & Williams LLP 1751 Pinnacle Drive, #1700 McLean, Virginia 22102 (703) 714-7471 heastep@hunton.com Copyright 25697683 2015 All Rights Reserved 54314498

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. 2

CAPITAL PLANNING THE CAPITAL PLANNING PROCESS Preparing Strategic Plan Maintaining a Strategy to Ensure Capital Adequacy and Contingency Planning Identifying and Evaluating Risks Ensuring Integrity in the Internal Capital Planning Process and Capital Adequacy Assessments Setting and Assessing Capital Adequacy Goals That Relate to Strategic Plan and Risks 3

Capital Plans Purpose 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 4

Capital Plans Problem Banks 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 5

Capital Plans Healthy Banks 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 6

Capital Plans Considerations 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 7

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 8

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% 9

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% 10

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% 11

CAPITAL PLANNING MANAGING TO THE BUFFER ZONES Discretionary Bonuses 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 12

CAPITAL PLANNING MANAGING TO THE BUFFER ZONES Discretionary Bonuses 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 13

Capital Plans BHC versus Bank Capital 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 14

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 15

CAPITAL PLANNING - SAMPLE SOURCES OF CAPITAL Common Stock Subordinated Debt KSOPs IPOs 16

CAPITAL Use of Proceeds 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 17

CAPITAL PLANNING SOURCES OF CAPITAL Common Stock 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) 18

CAPITAL PLANNING SOURCES OF CAPITAL Subordinated Debt 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 19

CAPITAL PLANNING SOURCES OF CAPITAL Advantages of Subordinated Debt 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) 20

CAPITAL PLANNING SOURCES OF CAPITAL Disadvantages of Subordinated Debt 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 21

CAPITAL PLANNING SOURCES OF CAPITAL Overview of KSOP Transaction 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 22

CAPITAL PLANNING SOURCES OF CAPITAL - KSOPs Existing 401(k) Plan Amendment and Restatement to add ESOP Feature New KSOP (401(k) Plan with ESOP Feature 23

CAPITAL PLANNING SOURCES OF CAPITAL KSOP (FUNDING SOURCES) BHC ESOP Loan Bank Plan Contributions New KSOP (401(k) Plan with ESOP Feature 401(k) Participants Participant Election Right 24

CAPITAL PLANNING SOURCES OF CAPITAL KSOPS Considerations 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 25

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 26

CAPITAL PLANNING SOME NOTES ABOUT IPOs AS A SOURCE OF CAPITAL What is an IPO? 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 27

CAPITAL PLANS SOME NOTES ABOUT IPOs AS A SOURCE OF CAPITAL Some Advantages of an IPO 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 28

CAPITAL PLANS SOME NOTES ABOUT IPOs AS A SOURCE OF CAPITAL Some Advantages of an IPO 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 29

CAPITAL PLANS SOME NOTES ABOUT IPOs AS A SOURCE OF CAPITAL Some Disadvantages of an IPO 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 30

CAPITAL PLANS SOME NOTES ABOUT IPOs AS A SOURCE OF CAPITAL Some Disadvantages of an IPO? 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 31

CAPITAL PLANS SOME NOTES ABOUT IPOs AS A SOURCE OF CAPITAL So why do an IPO and become publicly-traded? 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 32

USE OF PROCEEDS - MERGERS OF EQUALS Bank A Stock (maybe some cash) Bank A $250 million in assets Bank B $150 million in assets Bank B Stock Resulting Bank AB $400 million in assets 33

USE OF PROCEEDS - MERGERS OF EQUALS Common Features 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 34

USE OF PROCEEDS - MERGERS OF EQUALS Considerations 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 35

USE OF PROCEEDS - MERGERS OF EQUALS Advantages 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 36

CAPITAL PLANS ALTERNATIVES TO RAISING CAPITAL MERGERS OF EQUALS Advantages (continued) 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 37

CAPITAL PLANS ALTERNATIVES TO RAISING CAPITAL MERGERS OF EQUALS Disadvantages 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 decisionmaking responsibility/authority at the senior management level and at the combined board of directors 38

USE OF PROCEEDS - MERGERS OF EQUALS Disadvantages (continued) 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 39

Questions? Robert N. Flowers Hunton & Williams LLP 1445 Ross Avenue, #3700 Dallas, Texas 75202 (214) 468-3324 rflowers@hunton.com Heather Archer Eastep Hunton & Williams LLP 1751 Pinnacle Drive, #1700 McLean, Virginia 22102 (703) 714-7471 heastep@hunton.com Copyright 2015