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Legal Issues as Community Banks Embrace Subdebt

on Thursday, 16 July 2015 in Banking Update

Subordinated debt instruments are making a comeback, with private offerings and pooled investments gaining favor among a number of bankers in the Midwest.

As bankers consider whether subordinated debt is the right way to boost their balance sheets, there are at least three major legal issues to consider before making an offering:

  • First, does the instrument qualify for capital treatment under Federal Reserve and FDIC rules? There are a number of boxes that need to be checked to ensure an offering will qualify for Tier 2 capital treatment under Federal Reserve rules, such as subordination requirements, the elimination of common acceleration provisions, minimum maturity periods and the absence of other provisions designed to protect debtholders.
  • Second, does the offering comply with federal and state securities laws? To qualify for an exemption under the securities laws, it is common to limit a subdebt offering to accredited investors only. However, even under those circumstances, it is important to provide full and fair disclosure to prospective investors to ensure that the offering is eligible for an exemption.
  • Finally, will the subdebt be sold to a pool? The aggregation of community banks’ subdebt into pools that will be sold to institutional buyers bears a striking resemblance to the pools of trust-preferred securities that proved so challenging to deal with during the last financial crisis. If your company’s subdebt will be issued to a pool, it is important to understand the legal mechanisms that will be available and with whom you will be dealing if there is an event that causes a payment to be missed.

Strong demand from individual investors and institutional buyers alike are driving the resurgence in subdebt offerings. Currently bearing typical interest rates of between six and eight percent, subordinated debt provides an opportunity for investors to find yields in a challenging rate environment.

And after years of worrying about whether community banks would survive the economic downturn, investors appear to be willing to tolerate the higher risks of subordinated debt, which falls behind senior debt but ahead of equity instruments in a bankruptcy.

The benefits of subordinated debt for issuers are significant. First, it doesn’t dilute existing shareholders as occurs in any issuance of common stock. Second, and perhaps even more important, interest payments on the debt are tax deductible, unlike dividends. Finally, the proceeds, which are considered Tier 2 capital at the bank holding company level, are treated as Tier 1 capital when injected into a subsidiary bank.

Jonathan J. Wegner

1700 Farnam Street | Suite 1500 | Omaha, NE 68102 | 402.344.0500