Expert Byline: For community banks, capital raising is an art, not a science


Key issues in attracting capital stock investors to your community bank

By David Baris

It never has been easy for community banks to raise capital despite some recent improvement, but since 2007 it has been more difficult with a weak economy, regulatory excess and surprises, compliance costs, weak loan demand and financial setbacks. But there are ways for many community banks to significantly improve their chances to raise capital from investors.

A large majority of community banks won’t be able to raise capital by copying what large banks do. For many, the public capital markets are not open or not attractive. These are not conventional times, so it is necessary for community banks to think unconventionally in finding ways to sell their stock.

Unless your community bank is fortunate enough to have a committed group of deep pocket investors sitting around its board table or in its shareholder base, raising capital requires strategic thinking, serious consideration of regulatory attitudes and regulatory changes, and an honest assessment of your bank’s financial condition, business plan and prospects.

Where to begin

The beginning is very important. Your community bank will need strategic and capital plans formulated by management and the board of directors that identifies the reasons why capital is or is not needed now or in the foreseeable future.

A capital plan cannot stand alone. It needs a strategic plan to inform it. Why a bank needs capital and when it needs it is a decision based, in part, on the bank’s strategic plans, strategic focus and anticipation of the future.

A capital plan also involves an assessment of a bank’s current financial condition, its risks and its effectiveness in controlling risks. Stress testing can play an important role.

Such an effort requires focus, discipline and the involvement of the board of directors, management and others. Annual reviews are advised, and creating a corporate structure to support the effort might make sense. Your community bank should decide whether its full board should be devoted to strategic and capital planning or whether much of that work should be delegated to a board committee. The chief executive officer must be fully engaged for the process to work.

Telling a story

If your community bank’s capital plan calls for raising capital, the most important question that you should ask yourself is why should someone invest in your bank? What will you tell them?

Each bank has its own story. Through the development of your bank’s strategic plan, a story will emerge. Our clients who have been successful in raising capital have a story to tell their investors (a true story is essential for a lot of reasons), which have included supporting the development of a branch network, the strategic vision of new or current successful management, acquiring another bank or business, and continuing a successful strategy where retained earnings are not sufficient to support growth.

If your community bank’s capital plan calls for raising capital, the most important question that you should ask yourself is why should someone invest in your bank?

Regulatory considerations

Banks need to understand the capital adequacy rules and the bank examination process when considering a capital plan and capital raise. Your community bank will need to evaluate the impact of the newest capital rule, based on Basel III, which requires at least one new capital ratio based on common equity only, higher risk-weightings and a capital conservation buffer.

The form of capital your community bank may want to sell will also be affected by regulatory considerations. Basel III and the Dodd-Frank Act reinforce the strong regulatory preference for common equity.

Although bank holding companies with consolidated assets of $500 million or less are not subject to formal capital rules, Dodd-Frank requires bank holding companies to act as a “source of strength” to their subsidiary banks. Dodd-Frank directs the Federal Reserve to adopt rules. As of this writing, the Fed has not yet done so.

The audience

Who will be your community bank’s audience (prospective investors)? Your bank will need to decide who the audience will be before making the decision as to whom to make an offer to sell stock and how to do so.
For many community banks with assets of less than $500 million, their audience will be their bank’s board of directors, their shareholders and the members of their community. Tapping the public markets or going outside of a home market generally is not feasible.

The motivation of investors who are board members or shareholders is often fundamentally different than that of an institutional or out-of-area investor. Local investors are often motivated by the importance of a community bank to the well-being of the community. Others are more interested in the bottom line.

Different types of offerings

Your community bank will have a choice of different kinds of offerings. There are preemptive rights offerings, community offerings, around the table offerings and public/private offerings.

1. Preemptive rights offerings

These are offerings that grant a right to each shareholder to purchase at least enough shares to be able to maintain a pro rata interest in a bank, and allow the shareholder to avoid dilution, even if the price of the stock being offered is less than book value. These types of offerings provide an incentive for shareholders to invest for fear that if they don’t, their stock will be diluted.

There are variants of preemptive rights offerings, such as allowing shareholders to buy at a lower price than others who are not shareholders.

2. Community offerings

These are offerings that are made to members of the community served by the bank and normally include shareholders. The label has no legal significance but is simply a convenient way of describing one strategy that has often worked for community banks.

These offerings typically entail a public offering (see below for details) but can also be conducted on a private-placement basis.

Your community bank will enhance the likelihood of success by identifying ahead of time bank customers and individuals and businesses that the board and senior management know. Tapping the Rolodexes of your board members and officers can help develop a database from which to work once your bank initiates the offering.

Successful offerings, including community offerings, are more likely if the bank’s directors are investing significantly in the offering, sending a positive signal to investors.

3. Around the board table offerings

Sometimes the best source of new capital is a bank’s board of directors and other insiders. This is especially true when time is of the essence or the bank’s condition is precarious. However, there should be awareness of the insider character of the transaction. Therefore, it may be appropriate to retain an investment firm to determine whether the transaction and price for the shares being purchased by the board members are fair.

Forms and terms of capital

Deciding the form of capital and its terms will depend on regulatory definitions of required capital, the particular needs of the bank, the relative costs of each form of capital, and the practical considerations of who the prospective investors will be and whether the investment will be attractive to them.

The strong bias of the banking agencies is for common stock. The new Basel III-based rules require a minimum common stock ratio of at least 6.5 percent.

There are occasions where the use of more than one class of common stock may make sense—such as where control is sought to be maintained among a distinct group of shareholders, such as members of a founding family, where a class of common stock with higher voting rights may be desirable. Bank regulators often will look closely at such arrangements.

Generally, companies look to the safe harbor of the SEC’s Regulation D to determine if their offering will be public or nonpublic.

Preferred stock has several basic variations, the most favorable from a bank regulatory standpoint being noncumulative perpetual preferred stock because that has characteristics very similar to common stock.
Practically speaking, trust preferred securities—the major source of capital for holding companies of community banks from the mid-1990s through 2006—are history.

Banks with holding companies have alternative ways to raise capital. Rather than raising capital, a bank holding company can borrow from another bank or issue subordinated debt, then downstream proceeds to the bank as a contribution to capital or to purchase bank common stock.

Public versus nonpublic offerings

Banks and their parent companies may offer stock or debt either through a private placement or through a public offering. Public offerings are more costly and take longer to prepare, file registrations for, and obtain clearance from the SEC. Offerings by national banks or federal savings banks must be approved by the Office of the Comptroller of the Currency. State member and nonmember banks are not subject to registration requirements because the Federal Reserve and FDIC have not adopted those requirements.

Generally, companies look to the safe harbor of the SEC’s Regulation D to determine if their offering will be public or nonpublic.

Under Rule 506 of Regulation D, an offering where the investment is sold only to accredited investors or is sold to accredited investors plus up to 35 nonaccredited investors is considered nonpublic.

There are other exemptions from the registration requirements of federal law, but not necessarily state law. One sometimes used by community banks is an intrastate offering exemption where all of the investors or offerees are residents of the same state.

Our general advice is that if a bank can successfully raise capital without becoming a reporting company through nonpublic offerings, then it should do a nonpublic offering.

Working with underwriters

There are occasions where retention of an underwriter makes sense to assist a community bank or its parent company to raise capital.

There are two basic forms of underwriting—a firm commitment underwriting and a best-efforts underwriting.
In a firm commitment underwriting, the underwriter agrees that it will buy the securities from the company or bank, and it takes the risk that it will be unable to resell it to investors.

A best-efforts deal means that the underwriter will use its best efforts to find buyers for the securities, but it has no obligation to buy any of them for its own account or to take any resale risk.
Regardless of what kind of underwriting your community bank obtains, it is important to know who the underwriter’s customers are. Many brokers are geared more toward selling to institutional investors. Others have more of a focus on retail and individual investors. Who your stockholders are may affect the aftermarket as well as influence the direction and strategy of your community bank.

Alternatives to capital raising

There are a number of alternatives available to a bank that needs to improve its capital ratios other than raising capital. One obvious way is to earn net income and retain it as capital. Banks can manage their payment of cash dividends.

A bank’s holding company can borrow from another bank (typically pledging shares of the bank subsidiary), or sell subordinated debt, then downstream the proceeds to the bank as capital.

Capital ratios have a numerator and a denominator. The numerator is the capital and the denominator is the assets. Knowing this allows a bank to control its capital ratios by changing or managing its assets, both for the leverage and risk-based ratios.

Some of the nearly 80 bank mergers in which I have been involved in recent years are driven by capital needs. One bank needs capital to achieve its strategic objectives but finds that it cannot raise the capital to do so, while the other bank has the capacity to raise capital, or the two merged banks have an improved chance to attract capital.

David Baris ( is a partner at BuckleySandler LLP in Washington, D.C., a law firm that serves community banks throughout the United States. He has spent more than 30 years in practice assisting financial institutions on various corporate, securities and regulatory matters. He is also the executive director of the American Association of Bank Directors and serves on the Federal Bar Association Banking Law Executive Council.