An arrangement between a Maryland bank on the mend and an investor could serve as model for banks looking to move past the Troubled Asset Relief Program.

Delmar Bancorp (DBCP) agreed last week to sell Kenneth Lehman a 40% stake in itself in exchange for $6 million in cash and the cancellation of 5,000 shares of preferred stock he received through a Tarp auction. Lehman, who successfully bid on more than half of Delmar's Tarp shares earlier this year, also agreed to waive his rights to roughly $600,000 in unpaid dividends.

Tarp conversions have happened occasionally between the Treasury Department and participants. But this deal's structure, which also gives Lehman a say in how Delmar disposes of certain assets, could draw attention from other banks if the parties can make the marriage work, industry sources say.

"It is an interesting and pragmatic approach that allows the bank to hopefully survive and grow, while letting the investor realize value," says Walter Todd 3rd, a portfolio manager at Greenwood Capital Associates in South Carolina. "If it works out over the next six to 12 months, it could serve as a framework for other deals."

On paper, the deal makes sense for Delmar and Lehman, industry experts say. Lehman is set to receive roughly $11.6 million of common stock for an investment that may only cost him $9.7 million. (Lehman bought preferred stock with a face value of $5 million in a Treasury auction that featured a 39% discount.)

For Delmar, the deal value of $3.57 a share is a modest 6.3% discount from where the stock closed before the exchange was announced. That's a respectable showing for a bank that remains under regulatory orders and earned a mere $301,000 through the first half of this year, industry experts say.

A number of looming capital concerns may have also spurred Delmar to accept the deal even though its bank had a healthy Tier 1 capital ratio of 8.93% at June 30. The $432 million-asset company, which was already behind on Tarp dividends, would see its payout rate spike from 5% to 9% at the end of next year. The exchange also allows Delmar to build tangible common equity.

"This was about more than just the dividend increase," says Edward Thomas, Delmar's president and chief executive. "We haven't been paying on Lehman's preferred shares, period, even at the 5% level. And the regulators see common equity as the most desirable type of capital."

Delmar's desire to boost tangible common equity could, in part, be a by-product of Basel III, says Chip MacDonald, a partner at Jones Day in Atlanta. "Though the effective time for banks is some time away, bankers realize that everyone will need Tier 1 common equity, and Tarp doesn't qualify," he says.

Lehman's willingness to add a cash infusion likely served as the deal's carrot, adds Robert Klingler, a partner at Bryan Cave in Atlanta. "Having the additional capital is still useful these days," he says.

For Lehman, the investment represented an opportunity to build value by helping management confront lingering credit issues head on.

"I look [to invest in] companies that have a history of strong earnings," says Lehman, who expects to complete the transaction by Dec. 31. Delmar "had a leaky tire during the recession … but the wheels didn't fall off. They just need a little bit of tangible common [equity] to fix their situation."

Delmar's issues largely stem from getting "bogged down in real estate," Thomas says. Nonaccrual loans and foreclosed assets made up 3.1% of total assets at March 31, according to the Federal Deposit Insurance Corp.

The arrangement with Lehman also includes an asset resolution plan that requires Delmar to accelerate the disposition of certain assets. Lehman would not confirm the amount of assets involved, though he says the total would be fewer than the $50 million earmarked under a similar arrangement he has with First Capital (FCVA) in Glen Allen, Va. (Lehman bought a 40% stake in First Capital last year.)

Lehman confirmed that Delmar's asset resolution plan caps after-tax credit-related charges at $6 million, an amount equal to his cash infusion. Purging assets "is an important part of putting the legacy issues behind them so that the strong earnings capability of the bank is no longer obscured," says Lehman, who has a similar arrangement with First Capital.

Lehman "wants normalized earnings as quickly as possible and we think 2014 will afford us with that opportunity," says Thomas, who declined to discuss the specific terms of Delmar's agreement. "We had already made great headway with our legacy issues."

Several factors could deter other banks and investors from pursuing similar deals, industry observers say. Delmar is still operating under an April 2012 consent order with the FDIC, which applies to any institution-affiliated parties, including Lehman, MacDonald says. Such exposure raises the amount of risk Lehman is taking on if Delmar, which is also operating under a June 12 written agreement with the Federal Reserve Board, hits a rough patch.

The transaction with Lehman will also be highly dilutive to Delmar's existing shareholders. The company plans to increase shares outstanding by 67%, to 8 million, before issuing stock to Lehman, Thomas says. "It was a huge decision for our board because we've had an extremely diverse ownership and this deal significantly concentrates ownership," he says.

Still, recapitalizing by converting Tarp securities is less dilutive than selling more stock to an existing common shareholder who would "only be willing to do it at a lower per share price," Klingler says. By working with Lehman, Delmar also removed a preferred shareholder who would be entitled to a payout at par, which benefits common shareholders, he adds.

Tax implications could deter a bank from swapping out common stock for Tarp shares. Ownership changes can prevent banks from tapping into certain accounting benefits, including those tied to deferred tax assets, MacDonald says.

A number of banks have been able to reclaim deferred tax assets in recent quarters, and doing so has provided a boost to earnings and capital levels. Only dire cases, such as the one involving Metropolitan Bank Group in Chicago, include investors who are willing to give up DTAs to save the bank.

There are also other options for banks looking to buy out holders of Tarp shares. BNC Bancorp (BNCN) in High Point, N.C., borrowed $30 million earlier this year to buy out investors who successfully bid on Treasury auctions.

As for Lehman, he says there could be more opportunities for him to convert Tarp shares into common stock. Lehman says he "infrequently" participates in Treasury auctions, limits his bidding to one company per session and typically buys large blocks when available.

Delmar's management team and board have more work to do; 13 other investors successfully bid on Tarp shares with a face value of roughly $4 million. The company, which is intent on preserving capital, did not bid on its own shares. "We've had a lot of board discussions about the next step for the remaining preferred holders," Thomas says.

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