JOBS Act Presents Opportunity for Community Banks

On April 5, 2012, the Jumpstart Our Business Startups Act (“JOBS Act”) was signed into law in an attempt to reduce regulatory burdens on small businesses. The Act relaxes limits regarding the number of shareholders a company may have before it must register its securities with the Securities & Exchange Commission. For privately-held companies approaching the shareholder limit, the additional reporting requirements related to SEC registration can be particularly burdensome, without the benefits of access to capital markets and stock liquidity that being publicly traded offer. As a result, privately-held companies were compelled to undertake transactions such as reverse stock splits or share reclassifications to avoid triggering registration.

Since the JOBS Act became law, deregistration activity has been rising. According to a May 29, 2012 article on SNL Financial, approximately 60 banks had made the necessary filings to deregister their securities with additional filings expected. Most of these banks were relatively small, generally having total assets below $1 billion.

The JOBS Act increases the threshold for the number of shareholders that would require SEC registration from 500 to 2,000. Additionally, companies may terminate their existing registration by reducing the number of shareholders to fewer than 1,200 shareholders, relative to the former requirement of 300 shareholders. These rules offer opportunities for small, privately-held businesses, particularly for community banks which often have a relatively large base of local shareholders and demand for their stock within the local community.

The opportunity can present itself to community banks through two general scenarios:

• Scenario #1: A bank with 450 shareholders (or any other number below 500) desired to raise additional capital but under the previous shareholder limits was concerned an offering to new investors would cause the number of shareholders to exceed the 500 shareholder limit.
• Scenario #2: A bank with 1,500 shareholders (or any number greater than 500) that is not publicly traded would like to terminate its registration with the SEC.

For members of bank management contemplating taking action, several financial considerations unique to each scenario are discussed below. A number of legal considerations would arise as well, which are beyond the scope of this discussion.

Scenario #1

• If newly issued shares are sold at a discount to fair market value, the transaction will be dilutive to existing shareholders. In this circumstance, the capital raised will not be enough to offset the increase in the number of shares outstanding. While this is an important consideration for any situation, if the bank has an ESOP or other employee-incentive plan that invests in the bank’s stock, it is critically important. It would be prudent for management and the board of directors to commission a fairness opinion, or at the very least sound, well-reasoned third-party analysis used to set the offering price.
• Will the bank be able to deploy the new capital profitably, or is there potential to create excess capital? The ability to raise capital does not necessarily coincide with the need for capital. While bank management and the board of directors may feel more comfortable with a higher level of capital, given the current economic conditions and seemingly more stringent regulatory environment, capital that cannot be used to facilitate growth, meet regulatory capital expectations, and/or resolve outstanding asset quality issues may become excess in nature. This will diminish the bank’s return on equity and potentially depress net interest margin as the excess funds are invested in a low-yielding securities portfolio.
• If the bank pays regular dividends, will the additional funds required to maintain the current dollar amount of the dividend per share be available long-term? Many community bank shareholders have become accustomed to a certain level of dividend payouts in a given year, although in recent years many banks have had to curtail or suspend their dividends. Issuing a substantial number of new shares, such that the bank will struggle to maintain a similar dividend per share going forward, may, at the very least, result in some displeased shareholders.
• This option is not available to banks classified as S Corps under the U.S. Income Tax Code. The regulations limiting the number of shareholders in an S Corporation remain unchanged with a total shareholder limit of 100. However, the definition of what constitutes a “shareholder” differs between IRS and SEC regulations.

Scenario #2

• If redeemed shares are purchased at a premium to fair market value, the transaction will be dilutive to remaining shareholders. Similar to the issue discussed above (only in reverse), the number of shares redeemed will not offset the capital used to undertake the redemption. Again, it is imperative that management have a firm grasp of the appropriate price at which to redeem the shares, and in the case of employee benefit plans invested in bank stock, consider a fairness opinion. The cost savings realized by going private may bridge this gap.
• If the bank must undertake a “squeeze out” to reduce the number of shareholders below the threshold, there is the potential for shareholder lawsuits. On occasion, a sufficient number of shareholders may not voluntarily surrender their shares to achieve the goal of reducing the number of shareholders below the given threshold. In such circumstances, management may undertake what is termed a “squeeze out” transaction. This typically involves a forced redemption of a certain specified group of shareholders, generally defined as those owning a small number of shares. If these shareholders deem the price offered by the bank to be less than the shares’ fair value, they are entitled to legal action and potential compensation for additional amounts. It is critical in this case that management obtain a well-reasoned, third-party opinion of value.
• Does the bank have the financial capacity to redeem the shares? While a redemption and deregistration with the SEC may seem like a good idea, and particularly attractive to management who must deal with the added compliance burden, the benefit must be weighed against the potential alternative uses of the capital. For example, the use of capital to go private may hamper the bank’s ability to pursue an acquisition, unless the bank’s existing shareholders would be willing to commit additional capital. Further, the lack of a publicly traded acquisition “currency” may limit the bank’s attractiveness to potential sellers in stock transactions, as well as curtailing its ability to raise capital for cash transactions.
• How will the redemption be funded? Management has the option of funding the redemption using cash on hand at the holding company or dividends from the bank, issuing new stock to remaining shareholders, or obtaining a holding company loan from another bank. It is important to consider the pro forma impact of the financing decision on the future operations of the bank and bank holding company.

While the opportunity to eliminate the drawbacks associated with SEC registration is compelling, bank management should carefully consider all options and the associated consequences. Oftentimes, this will require a firm understanding of the bank’s financial strength, growth prospects, and stock price, under both the contemplated transaction and the status quo. Mercer Capital has wide ranging experience in assisting management with stock valuation for capital raises and redemptions, as well as performing pro forma analyses under varying scenarios. If you think we can be of assistance regarding these matters, we would welcome your inquiry.

Reprinted from Mercer Capital’s Bank Watch, June 2012