[Federal Register Volume 59, Number 112 (Monday, June 13, 1994)]
[Unknown Section]
[Page 0]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 94-14006]
[[Page Unknown]]
[Federal Register: June 13, 1994]
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FEDERAL DEPOSIT INSURANCE CORPORATION
Mutual-to-Stock Conversions of State Nonmember Savings Banks
AGENCY: Federal Deposit Insurance Corporation (FDIC).
ACTION: Notice; request for comments.
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SUMMARY: As previously indicated in Congressional testimony and in
public statements, the FDIC has been at work on a fundamental review of
the process by which mutual thrifts convert to stock form. This request
for comments reflects that study. The intended effect of this notice is
to obtain comments on the suggested approach to resolving fundamental
concerns about the current mutual-to-stock conversion process.
DATES: Written comments must be received by the FDIC on or before
August 12, 1994.
ADDRESSES: Written comments shall be addressed to the Office of the
Executive Secretary, Federal Deposit Insurance Corporation, 550 17th
Street NW., Washington, DC 20429. Comments may be hand-delivered to
room F-400, 1776 F Street, NW., Washington, DC, on business days
between 8:30 a.m. and 5 p.m. (FAX number: (202) 898-3838). Comments
will be available for inspection in room 7118, 550 17th Street, NW.,
Washington, DC between 9 a.m. and 4:30 p.m. on business days.
FOR FURTHER INFORMATION CONTACT: Robert H. Hartheimer, Acting Director,
Division of Resolutions (202/898-8789), John G. Finneran, Jr., Acting
Deputy General Counsel, Legal Division (202/898-3766), Robert F.
Miailovich, Associate Director, Division of Supervision (202/898-6918),
Robert W. Walsh, Manager, Planning and Program Development Section,
Division of Supervision (202/898-6911), Joseph A. DiNuzzo, Counsel,
Legal Division (202/898-7349), Federal Deposit Insurance Corporation,
Washington, DC 20429.
SUPPLEMENTARY INFORMATION:
Historical Background
Mutual savings institutions were founded to fill gaps in the
market--and for a social purpose. Commercial banks have not always
welcomed retail customers as either depositors or borrowers. Mutual
savings banks were in many respects charitable organizations designed
to encourage and facilitate thrift on the part of urban wage-earners.
Their trustees were self-perpetuating groups of leading citizens, some
of whom may have contributed the capital to establish the bank in the
first place, who took no fees and did no business with the bank.
Savings and loan associations were essentially cooperatives. One became
a ``member'' in order to save--in order eventually to borrow the money
to build a home. There were limitations on the ability to withdraw
one's funds. The right to be the next borrower, when enough funds had
accumulated, was often decided by lot. Trustees were elected by the
members--and in the early days members were required to attend meetings
and take their turn as officers. The notion of ``self-help'' motivated
both sorts of formations. At one time, people spoke of the spread of
these institutions as a ``movement.''
As a legacy of that tradition, today there are approximately 1,100
mutuals in the United States. (Ten years ago there were about 2,500,
five years ago 1,775.) From time to time, one or another of them
desires to convert to stock form. It may be that they need more
capital--in some cases on an urgent basis. It may be that they see
expansion opportunities and need a currency (stock) with which to
acquire. For many small institutions, it makes sense to join a larger
organization, and they often need to convert to be able to do so. Based
on our own research and analysis, as well as published cases, there is
also little question that some institutions have converted primarily to
enrich those who controlled them.
The existing form of transaction by which both federal and state
mutuals convert was developed by the Federal Home Loan Bank Board
(``FHLBB'') in 1974. What happens, essentially, is that the mutual
sells itself, for cash, to whoever buys its newly issued stock. Various
categories of potential purchasers get priority. In general, depositors
stand at the head of the line. To the extent depositors and others with
priority rights do not subscribe for stock, an attempt is made to sell
it locally. If stock is still left over, it is sold to investors with
no particular connection to the converting institution.
The FHLBB was conscious, when it first wrote rules for conversions,
that there might be value to the right to subscribe for stock in a
conversion. For example, if a mutual with $100 million of net worth
raised only $20 million of new capital in converting, whoever got to
buy the stock would have a claim on $120 million of net worth. In such
a situation, the stock would almost certainly be worth much more than
the buyers had paid for it. For about a year, in the early '70s, the
FHLBB took the view that rights to buy stock in a converting
institution should be distributed to its depositors, who could either
exercise and become owners or sell the rights for their intrinsic
value.
The FHLBB subsequently abandoned this approach, however, primarily
out of concern that depositors would shift funds from association to
association, hoping to capture the intrinsic value of the rights when
the conversion occurred--and on a scale that could be destabilizing. At
the same time, it adopted the current approach, which included an
``appraisal'' requirement, providing that a converting institution
issue and sell its capital stock at a total price equal to the
estimated pro forma value of such stock in the converted institution.
Because of moratoria imposed in 1973 and 1974, the existing form of
transaction was not tested in great numbers until the '80s. At that
point, it worked quite well, because many converting institutions had
little net worth or economic value, and the market was extremely wary
even of those that did. Depositors and other investors who subscribed
for stock got securities with a market value approximately equal to
what they paid for them.
Problems With the Existing Process
In the last two-plus years, as non-viable institutions have been
closed and the industry has returned to health, the existing form of
transaction has delivered windfalls to those who subscribed. In the
more than 100 standard conversions in 1992 and 1993, the trading price
at the end of the first day has exceeded the subscription price by, on
average, 26%. In 40 instances, this price increase (the ``pop'') has
exceeded 30%; in 6 instances it exceeded 50%.
As it has become obvious to everyone familiar with the process that
buying stock in a conversion is an easy way to make money, a class of
`'professional depositors'' has emerged--wealthy individuals and
investment partnerships with $50 to $500 accounts at literally hundreds
of mutuals across the country. Investment banking firms active in the
conversion arena advise us that there are perhaps 500 to 1,000 such
professional depositors, and that they can take the account list of
almost any mutual in the nation and recognize hundreds of names at
sight. These professional depositors buy the maximum amount of stock
allowed--and consequently the overwhelming majority of the stock issued
in almost every conversion. Market participants have told us that in a
typical conversion, less than 5% of depositors participate at all--and
that the majority of them are professionals or insiders.
Giving depositors the opportunity to subscribe for stock has not
resulted in broad distribution of stock among them. The vast majority
of depositors in mutual savings institutions keep their savings there
precisely because they are risk-averse. They are likely to read and
ignore or discard the offering circular. The money they keep in a
savings institution has been put aside for retirement, or for
emergencies, or for the down payment on first house, and cannot be
invested in an initial public offering. They do not participate. The
existing conversion process does not benefit them at all.
As it has become obvious to everyone who understands the process
that the stock of converting institutions often trades up sharply on
the first day of issue, those who control mutual institutions have
become more and more interested in converting. Managers and even non-
executive trustees have been awarded free stock and options (at the
subscription price). Employee Stock Ownership Plans (``ESOPs'') have
been created and given priority in buying stock. These and other
devices have resulted in substantial transfers of value.
As it has become clear that most conversions would be
oversubscribed, the ``allocation'' process has clearly been subject to
abuse. For example, we have been told that in transactions where
allocations were likely to be based on size of deposit because of
expected oversubscription, insiders and others in a position to know
the relevant record date have been able to transfer large amounts of
money into their accounts on that single day. Where the right to
subscribe has been limited to long-term depositors, or depositors with
local addresses, we are told that professionals are sometimes able to
persuade other depositors to ``front'' for them (despite rules to the
contrary).
Problems With Appraisals
As market valuation of thrifts has risen (and as conversions have
come to be oversubscribed, with stocks generally trading up), the
integrity of the appraisal process has been compromised. The FDIC's
experience with appraisals is that they typically follow a certain
pattern. A ``peer group'' of stock savings institutions is identified.
(How they were selected out of the much larger universe of potential
``peers'' typically is not well explained.) The peer group market/book
ratio is calculated. It is then stated that the converting institution
should be valued (on a pro forma basis) at a discount from that ratio.
Two reasons for this are typically given. The first is that the
converting mutual is actually inferior to the peer group--which raises
the question, why were they chosen as peers in the first place. The
second, discussed below, is the need for a ``new issue discount.''
(Price/earnings ratios are also calculated, but there is rarely a
cogent analysis of the converting institution's earnings potential once
it appropriately deploys its new capital.)
At March 31, 1994, the thrift industry average market/book ratio
was 99% and the median was 95%. (At year-end 1993, those figures were
five percentage points higher, a year before that 15 percentage points
lower.) The market tends to value recently converted institutions below
the industry average--primarily, in our judgment, because the return on
a newly converted institution's book, or capital, will be low by
industry standards until it is able to leverage the new capital it
raises in the conversion. During 1992 and 1993 as a whole, the average
market/book ratio of a newly converted institution, at the end of the
first day of trading, was 72%. To meet the ``appraisal'' requirement
that an institution's stock trade at what it was sold for in a
situation where a 72% market/book ratio was a reasonable expectation, a
mutual would have to more than triple its capital base. To be precise,
a mutual with a $100 million net worth would need to raise $257 million
(ignoring expenses and the effects of establishing an ESOP or a
management retention plan), since 72% of $357 million (the resulting
book value) equals $257. It is extremely hard for a company in a highly
competitive industry prudently to employ that much new capital.
What appraisal firms did, in 1992 and 1993, was to ``appraise''
converted institutions on average at 57% of book. They did this despite
the fact that, on average, these institutions traded up the first day
by 26%.
Appraisers' principal rationalization for this discrepancy has been
that, in the context of an initial public offering, a ``new issue
discount'' is required. While it is certainly true that it is difficult
to bring a company public without pricing the shares at a level that
stimulates unfilled demand--resulting in a ``pop''--we question the
magnitude required in an environment where virtually all conversions
are trading up. In some circumstances, the need for a ``new issue
discount'' has been asserted in appraisal updates issued after the end
of the subscription period, and in the face of 100-300%
oversubscriptions. We would also observe that the literal language of
the OTS regulations and guidelines on conversion appraisals does not
allow for a market discount. The question to be answered is: how much
stock has to be sold to eliminate any ``pop''?
We suspect that the practices we describe developed over time as
appraisers, and mutuals and their advisers, attempted to deal in good
faith with the inherent contradictions of, on the one hand, a form of
transaction perfectly suited to institutions on the brink of failure,
or which the market feared, and, on the other, a thrift industry that
has returned to health.
As a footnote to the conversions of the 80's, it is worth observing
that many institutions which emerged with very high capital ratios were
so anxious to earn a good return for their new, demanding stockholders,
that they grew their balance sheets more quickly than they should have
and took risks they did not fully understand. A total of 77 New England
savings banks converted in the years 1984 through 1989; these
transactions increased their weighted average capital ratio to 15.2%
from 6.6%; 16 of them (or 21%) subsequently failed.1 In addition,
the rush by converted institutions to increase assets quickly tended to
reduce credit standards throughout the market, imperiling other
institutions.
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\1\''Understanding the Experience of Converted New England
Savings Banks,'' Eccles and O'Keefe, FDIC (1994).
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Changing the Process
What this history demonstrates is the need for fundamental change:
The ``appraisal'' process puts the government in the
awkward position of substituting its judgement for that of the
market...
. . . and forces most converting institutions to raise
far more capital than they can prudently deploy...
. . . but still fails to eliminate windfalls.
This has put well-intended individuals involved in more
than a few conversions in the ethically uncomfortable position of
pretending the appraisal requirement is met when they know it isn't.
The required form of transaction transfers the existing
value of the mutual to a small group of individuals with the cash,
sophistication and risk appetite to buy the stock.
Because value is being ``given away,'' the process invites
insider abuse. And because the value has to go somewhere, the ingenuity
of market participants eventually frustrates attempts to eliminate the
problem.
We share with others a desire to address problems arising under the
existing rules. We do not in any way want to prevent valid conversions
from taking place--nor encourage conversions that fail to meet a valid
business need. We also desire that our handling of conversions be
generally consistent with that of the OTS.
For these reasons we are publishing elsewhere in this issue of the
Federal Register a proposed rule which: (a) reaffirms our intention to
review conversion applications submitted by state-chartered nonmember
insured savings banks (and applications for insurance from newly
established associations to be owned by mutual holding companies), and
(b) explicitly establishes certain criteria which are comparable to
those of the OTS.
At the same time, we feel it is only fair to put the public on
notice that we believe it may be difficult for a healthy mutual to
develop a sound business plan while raising enough new capital to
receive a valid appraisal.
The noted investment manager, Peter Lynch, describes this problem,
and the existing form of conversion generally, in graphic terms. Buying
stock in a converting mutual, he writes, is like going to an automobile
dealer to buy a car, giving him a check for the purchase price, and
discovering on the way home that the dealer has put your check in the
glove compartment of the car. Unless the car is an extraordinary lemon,
this is bound to be a good deal. And increasing the size of the check--
which is what ``disciplining the appraisal process'' amounts to--won't
make it stop being a good deal.
It is possible that the recent OTS amendments (and the requirements
in the FDIC proposed rule mentioned above) which aim to give long-term,
local depositors more rights--but within the framework of the existing
form of transaction--may produce similarly frustrating results. As
noted earlier, ``real'' depositors are not going to benefit, no matter
what priorities they receive, because ``real'' depositors still may not
subscribe in significant numbers.
We believe that ``insider abuse,'' which is the focus of much
recent discussion and of several of the OTS amendments and the
requirements of the FDIC proposed rule, is only a piece of the problem.
In one recent conversion, for example, state authorities forced the
institution to rescind stock grants which would have benefited insiders
by approximately $40 million.
This was laudable. But the ``pop'' in the price of the converted
institution's shares benefited those who subscribed by more than $200
million on the first day of trading and by $275 million after one
month's trading. All who had their subscriptions filled were
depositors--but only 5% of all depositors subscribed. We question
whether it can be an adequate response to the trustees' fiduciary duty
to deliver that much value to the tiny fraction of a mutual
institution's depositors with the capacity to line up and collect it.
We continue to believe--as stated in testimony before the
Congressional Banking Committees--that the conversion process is
fundamentally flawed. Thus, in addition to the proposed rule published
elsewhere in this issue of the Federal Register (which is intended to
address concerns within the existing mutual-to-stock conversion
framework) we also are issuing this request for comments seeking views
on an approach which might address the basic flaws in the existing
scheme.
The (Misguided) Question of ``Ownership''
The most vexing question facing everyone who has ever dealt with
mutual-to-stock conversions is: ``Who owns mutuals?'' That may be the
wrong way to ask the question. As indicated earlier, mutuals were
originally closer to charities or community organizations than to
commercial enterprises. As a by-product of doing what they were founded
to do, they have accumulated net worth. The trustees hold that value in
trust. The right question more likely should be: ``If the trustees
decide to convert, to whom should that value be delivered?''
We believe there are two ways to answer the question: leaving it to
the trustees in the reasonable exercise of their fiduciary duty, or
legislation.
Leaving the decision to the trustees is logical, but may be
impractical. The best argument in favor of this approach is that the
history and circumstances of institutions vary, that boards are
designed to balance competing interests and considerations, that
existing law should be adequate to prevent abuse, and that the
government should not interfere unless it has to. As different boards
of trustees wrestle with the issues, a consensus should tend to emerge.
The argument against leaving the decision to the trustees is
twofold. Taking the positive view of such boards, it places an unfair
burden on them and their institutions. They will be lobbied by
potential claimants. Someone will object to whatever decision they
make. Taking the skeptical view--and there is no question that some
boards have interpreted their fiduciary responsibilities rather
loosely--leaving the decision to the trustees is unwise. The FDIC will
in the end have to expend significant resources providing informal
guidance to the conscientious and making sure that trustees'
determinations are reasonable.
Some could well believe that the preferable way to answer the
question of ``to whom the value should be delivered'' would be
legislation. In fact, the main purpose of this notice and request for
comments is to solicit views from the public on a legislative proposal
that the FDIC could prepare and present to the appropriate legislative
body(ies). Legislation could take the form of state law, through which
each state would decide the question for the mutual banks it charters
(or has chartered), or federal legislation, through which the Congress
decides the issue on a nationwide basis. Uniformity argues for federal
legislation, but questions of federal preemption of state law would
have to be considered.
If federal legislation is decided upon, the Congress could either
establish in the statute explicit value-distribution rights or
authorize the appropriate federal agency (presumably, the FDIC for
state savings banks and the OTS for federal and state savings
associations) to determine to whom the value of the mutual institution
should be delivered.
Who Should Get the Value?
We are aware of at least seven groups (in no particular order)
which might lay a claim to a mutual's value:
(1) Depositors.
(2) Other creditors, including holders of subordinated debt.
(3) Borrowers.
(4) Employees--whether through the medium of an ESOP, which
acquires shares in the conversion, or other arrangements designed for
senior management.
(5) Trustees.
(6) The Bank Insurance Fund or the Savings Association Insurance
Fund, the U.S. Treasury or the relevant state government.
(7) Charitable organizations or trusts serving the community and
purposes for which the converting institution was originally founded.
The question of who receives the value is primarily a political
one. Accordingly, we do not believe the FDIC should be the one to
decide among these (or other) claimants. We have a supervisory interest
in seeing the question answered, however, and answered in a way that is
generally seen to be sensible and fair.2 To that end, the
following comments are intended to focus public discussion of the
question.
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\2\Pending a legislative determination of this question, we also
have a supervisory interest in ensuring that the boards of mutual
institutions fulfill their fiduciary duties in preserving the value
of the institution. Accordingly, the FDIC will continue to review
proposed conversion transactions of state mutual savings banks and
take appropriate action where the transaction raises fiduciary
concerns.
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Taking each of the seven parties in turn, we believe that at least
some of the value will have to go to depositors. Although the law of
many states implies that they are not ``owners'' of mutual institutions
in the classic sense of the term, and, at least since the creation of
the FDIC, they have not borne significant risk, they have supplied the
institution with its resources and in many cases have a vote on
conversion. Although we have scant sympathy for those professional
depositors who have opened small accounts in the expectation of large
windfalls and whose hopes would be disappointed by the reforms we
propose, it is perhaps the case that some depositors of all types have
known that conversion was a possibility, and in a sense may have
``bargained for'' at least some share of the value of the institution.
The fact that existing OTS regulations and most states' laws give
savings and loan association depositors preference in subscribing for
stock may not create an entitlement, but it has probably created an
expectation--which will probably have to be satisfied to some degree.
Among depositors, there are questions of allocation: by size, by
tenure, by address. What is theoretically desirable is often beyond the
scope of the converting institution's data processing systems. Attempts
to favor ``local'' depositors can be frustrated in various ways. There
is also the question of record date--and the problem of long-term
depositors who unwittingly close their accounts shortly before the
record date. Our current inclination would be to make the record date
fairly recent (as a convenience) and to award one share of the
aggregate value going to depositors for each year that each account has
been open. We expect that allocating shares to accounts closed prior to
the record date, while theoretically equitable, would prove
impractical.
In contrast to depositors, creditors are uninsured and do take
risk--especially since the adoption of federal depositor preference. On
the other hand, most creditors have that status as an incident of some
other relationship--e.g., as a supplier of goods and services--and
would be surprised (if delighted) to discover that it gave them any
claim on the value of the institution. We would therefore expect a
consensus to emerge favoring their exclusion.
The argument for giving debtholders part of the value is stronger.
They have the position they do because of a conscious financial
transaction. In most cases, such debt is subordinated and does
represent capital. Debtholders, while subordinating themselves to
depositors for a higher rate of return, did not ``bargain for'' any
share of the mutual's net worth--but neither did most depositors. Were
it to be established that subordinated debtholders were entitled to a
share of the value, it might make it slightly easier for small mutuals
to raise debt capital, which has appeal from a safety and soundness
standpoint. As an equitable approach and from our perspective as
insurer, we would favor giving debtholders some of the value of a
converting institution, and we would not expect such a decision to
strike people as unreasonable or unfair.
If such a decision is made, we believe the most feasible method of
allocation is by size of holding, with debtholders as a whole receiving
a share of the value going to debtholders and depositors combined that
is proportionate to debt's share of the institution's combined
liability to depositors and debtholders. The length of time the debt
has been outstanding, or in any particular holder's hands in the case
of tradable debt, should not, in our judgement, have bearing.
Federal Home Loan Bank advances are an important part of the
liability structure of many banks. The question arises: if other
debtholders should receive some of the value of a converting
institution, why not the relevant Federal Home Loan Bank? We believe
there is a good reason for excluding them: the fact that advances are
fully secured, making the Banks effectively senior to depositors.
Although borrowers are technically ``members'' of some mutual
savings institutions, we believe most borrowers think of the
institution as having a claim on them, rather than the reverse. During
that period when they are borrowers, they are in fact already receiving
a benefit. Borrowers are typically required to open deposit accounts as
well. Finally, borrowers' loans can be, and often are, sold to third
parties; distinguishing their rights from those of borrowers whose
loans have not been sold would present formidable legal and logistical
challenges. For all these reasons, we do not believe the consensus
would be to give them a claim, as borrowers, on the value being
transferred.
We would point out, however, that at least some knowledgeable
observers view the rights of depositors to a share of the converting
institution's value as not really that much stronger than those of
borrowers. The vast majority of both groups do business with mutuals on
an arms-length basis, at market terms, at no significant risk, and with
no expectation of a windfall. In the view of some observers, it is only
the absence of any other ``owners,'' the fact that depositors turn up
on the side of the balance sheet where stockholders would be if there
were any, and the practice of treating depositors as stand-ins for
owners that give depositors the presumption of a right to receive
value.
Rewarding Employees and Managers
It is sometimes said that managers--and to a lesser degree
employees--of mutual institutions enjoy more job security and a less
demanding work environment that their counterparts at organizations
subject to stockholder discipline, but are in turn less well
compensated. Conversion changes their situation. Some argue that these
considerations--and years of loyal service--entitle managers to a share
of the value. The opposing view is that managers of mutuals chose to
work there and ``bargained for'' whatever pay they got.
We understand both sets of arguments. The no-entitlement view, if
we can call it that, has logical purity. The view that managers deserve
part of the value has emotional appeal, especially when they have spent
decades at the converting institution. The issue of appropriate
treatment of long-serving employees is a good example of the
essentially political nature of the value-distribution question.
Were we required to decide this issue without legislative guidance,
we would prefer to see all benefits to employees of insured
institutions be delivered as compensation. We would certainly endorse
the creation of an ESOP immediately after conversion. If the conversion
process has entailed extra effort on the part of some (or all)
employees, they may be entitled to bonuses. And if conversion entails a
radical reduction in job security, it may be appropriate to adopt a
severance policy consistent with standard industry practice for stock
institutions.
Focussing on the top few executives and non-executive trustees, it
is certainly the case that their jobs become harder and less secure
following conversion. They may be entitled to significant raises. It
may be appropriate for a few senior executives to receive employment
contracts. Again, all such steps should be evaluated within the context
of ``compensation.'' We believe that for individuals who control the
conversion transaction to lay any claim, in their capacity as managers
and trustees, to a portion of the value being transferred creates a
conflict of interest.
It is currently common practice for converting institutions to
create stock option plans. We believe it is appropriate for stock
institutions to have incentive compensation plans of this type. As
indicated in the FDIC proposed rule mentioned above, we agree with the
OTS that such plans should, at the earliest, be adopted at the first
stockholders' meeting following conversion and that the exercise price
for any such options should be set at that time, rather than being
based on the conversion price. The latter practice, which had been
common, gave those who controlled the transaction an incentive to
underprice the shares, and masked transfers of value to those
executives receiving options, which, if properly measured, and viewed
as compensation, would have been deemed excessive.
A ``Government'' Share?
Several individuals and organizations have suggested that a share
of the existing value of converting mutuals should go to one of the
deposit insurance funds, or to the U.S. Treasury, or to the government
of the state which chartered the institution. We are uncomfortable with
the first suggestion. Converting institutions have been paying
premiums, just as stock institutions have. No one would lay claim to a
portion of the latter's net worth. The FDIC should not do so with
regard to mutuals.
Some have advanced the argument--based on the cost of the savings
and loan crisis--that taxpayers generally, through the medium of the
Treasury, should get a portion of the value that conversion releases.
As a fairness matter, we believe this argument is flawed: Institutions
now converting have not failed, and have not cost taxpayers anything.
Most state savings banks, whose conversions fall under our
jurisdiction, are insured by the Bank Insurance Fund, which taxpayers
have not had to support.
Another argument for conveying the value of converting mutuals to
the government--whether state or federal--is that ``no one owns them,''
and that the fairest course is therefore to avoid giving the value to
anyone in particular. We will have more to say on this topic later in
this Notice, but would observe that if the form of transaction
suggested below is adopted, many of those who receive the value of the
institution will get cash, and will pay taxes on it as income, giving
government its ``share.''
Fulfilling Mutuals' Original Purpose?
As indicated earlier, mutuals were created for reasons that have
now largely disappeared. Ordinary citizens have plenty of places to put
their savings. A host of private- and public-sector entities facilitate
home-ownership. The trustees of a mutual savings institution having
regard for their fiduciary duties might liken their situation to that
of the board of the March of Dimes, which had to redefine its mission
after polio ceased to be a major threat. From that perspective, it may
be appropriate for a portion of the value of a converting mutual to be
transferred to one of more community organizations or charities.
This approach raises the question, ``Which organizations?''--which
could be extremely hard to answer. As with the matter of dividing up
the value in the first place, leaving the decision to the trustees
places a burden on them. Nevertheless, under this approach, the
trustees are the ones to decide. If no appropriate vehicles existed, a
trust might be established to receive the transferred value and make
grants over time. The responsibility for allocating funds is borne by
thousands of trustees of colleges and hospitals and foundations and
charities all over the country; there are plenty of examples to
follow--and laws to prevent abuse.
An alternative to endowing a new or existing charitable
organization is for the converted institution to accept special
obligations to serve the convenience and needs of the community for
banking services. This is a very broad subject, which we are not
prepared to explore exhaustively here. We would make three basic
points, however. First, while all banks clearly have public
obligations, it seems likely that imposing different burdens on
institutions which are otherwise direct competitors will ultimately
create safety and soundness concerns. For that reason alone we would
oppose this approach.
Second, the value transfer inherent in an institution's voluntary
acceptance of a special obligation to the community--e.g., a promise to
make affordable housing loans, or to open branches in distressed
neighborhoods--is difficult to measure against immediately cashable
value delivered to depositors or others. We think it would be difficult
for trustees to know what they'd actually done.
Third, the history of mutual savings banks does suggest that
organizations to which any portion of the value of a converting
institution might be transferred should be locally focussed, and should
have the encouragement of self-help as a major objective. To give only
two of many possible examples, helping to capitalize a community
development bank, or establishing a day care facility which permitted
single mothers to work, would have satisfying historic resonance.
No Entitlement; No Forced Conversion
The idea that some of the value of a converting institution should
be delivered to the ``community'' it was chartered to serve is as
strongly opposed by some as it is supported by others. This is another
excellent example of the political (rather than regulatory) character
of the issue.
At least two arguments against a ``community'' share have been
advanced. The first is that the ``wrong'' charities and community
organizations would be chosen--wrong from the speaker's point of view,
that is--because of their skill and persistence in lobbying the board.
The second is that such organizations, seeing latent wealth available,
would put pressure on boards to convert.
This second argument is also advanced, as it was in the early '70s,
against giving depositors transferrable rights: if value is
``available,'' they will put pressure on institutions to convert.
Being exempt from constituent ``pressure'' is unhealthy for any
organization. Legislators have to face the voters. Independent agencies
are subject to oversight. Stock organizations can be taken over. We do
not believe that the trustees of mutuals should be allowed to ignore
completely the views of those the institution exists to serve.
Nevertheless, we would emphasize that however one decides the
value-distribution issue, that does not answer the (misguided)
question, ``Who owns a mutual?'' It does not, in our view, give anyone
standing to demand that an institution convert--any more than a group
of private citizens could demand that the Red Cross ``convert''!
Conversion is a decision for the trustees, and until they make such a
decision, the FDIC will not get involved--except where inadequate
capital makes it desirable from a safety and soundness standpoint.
Mutuality has a distinguished history in America. In the aggregate,
mutuals have cost the FDIC proportionately less than have stock
institutions. We would not endorse a system that compelled mutual
institutions to change their character.
New Form of Transaction
Having adopted an answer to the question, ``Who gets the existing
value?'', the problem of delivering that value is easier to address. We
would suggest the following approach:
The trustees decide how much capital they need to raise as
a business matter. (There is no ``appraisal'' process.)
The trustees hire underwriters to conduct an initial
public offering--and an escrow agent for the purposes described below.
Rights to subscribe for the stock of the converted
institution are distributed to ``rightholders'' in accordance with the
principles outlined above.
Each of these rights will have value. For example, if a
mutual with $100 million of net worth elected to raise $20 million, and
distributed 4 million rights to buy 4 million shares (at $5 each), and
the market valued the converted institution at 80% of resulting book
(or $96 million), the shares would trade at $24 each, and the right to
buy a share for $5 would be worth $19.
The rights would be ``transferrable'' only in the sense
that, at the end of the subscription period, the escrow agent would
exercise on behalf of any rightholder who had not done so, turn the
stock over to the underwriter for sale, give $5/share of the proceeds
to the company and send the difference to the rightholder.
It is likely, under this form of transaction, that very few
rightholders would chose to exercise, and that the underwriters would
essentially be selling the whole institution. This gives rise to
several questions. For example, wouldn't the transaction costs be
awfully high, relative to the amount of new capital being raised? The
answer has to be yes--but the cost should be measured relative to the
major strategic accomplishment of conversion itself; presumably there
was a reason to convert, or the trustees wouldn't have undertaken it.
It is also worth observing that the need (opportunity) to sell nearly
100% of the stock will lead many more underwriting firms to compete for
the business.
Another question is why not just distribute stock certificates
instead of rights? The basic answer is that the selling effort of a
public offering is what gets the market to focus on the fair value of
the shares, and gets a group of underwriters committed to make a market
in them afterwards. A direct distribution of shares could saddle the
bank with an uneconomically large number of shareholders. It would
leave unsophisticated holders of small numbers of shares in danger of
being persuaded to sell at prices below intrinsic value. Finally, to
the extent that rights were distributed to a community-oriented
charity, a stock sale should probably be required to avoid leaving a
controlling block of stock in the hands of a foundation or organization
which might be governed by the directors of the converted mutual.
One argument advanced against this form of transaction is that the
existing process has raised enormous amounts of money to recapitalize
ailing thrifts, and that while the industry is healthy now, we may need
to be able to do that again some day. True--but the approach here
proposed would be able to do that as well. If a thrift with a low
equity ratio wanted to convert, it could distribute rights and hire an
escrow agent and an underwriter, just the same. The shares could be
priced wherever they had to, to be sold. The rights just wouldn't have
much value--but that would appropriately reflect the institution's
perilous condition.
Another argument advanced is that the recent market is a highly
unusual one, that the embarrassing increases in share price on the day
of conversion have already begun to shrink and could soon disappear.
They may or may not--and ``pops'' per se, though on a more modest
scale, are effectively a requirement of the initial public offering
market--but the transactions the existing conversion process requires
would still be inefficient to the point of being improper. Under
current rules, a well capitalized thrift is only able to avoid a
``pop'' by increasing its equity ratio to the point where its market/
book ratio falls below industry norms--which says that a lot of the new
capital will either be underutilized for several years, or used
imprudently. What all parties at interest should want is the highest
market/book ratio that can be obtained, because that suggests the right
business judgements have been made regarding capital structure and
growth prospects. The elimination of ``pops'' would suggest a
destruction of the value the trustees hold in trust, and a violation of
their fiduciary duty of care--regardless of who that duty is owed to.
Merger Conversions
The OTS interim final rule would prohibit merger conversions--
whereby a stock institution acquires the assets and assumes the
liabilities of a mutual with no significant payment to anyone--except
where the survival of the converting institution is in question. The
form of transaction we here propose would permit merger conversions,
but would make them essentially a purchase of subscription rights by
the acquiror, with the value paid for the rights--either in cash or
other consideration--going to rightholders. This would have efficiency
benefits for those smaller institutions whose decision to convert
flowed from a decision to affiliate with a larger organization.
Trustees who decided to convert and be acquired would of course have
the same obligation to get the best possible price for rightholders.
Mutual Holding Companies
The Competitive Equality Banking Act of 1987 and the Financial
Institutions Reform, Recovery, and Enforcement Act of 1989 authorized
conversion of mutual savings institutions into federal mutual holding
companies, which in turn transfer virtually all their assets and
liabilities to new, stock savings institutions, part of whose stock is
acquired by subscribers in the conversion, with the majority retained
by the mutual parent. This structure has the benefit of permitting
converting institutions to raise only the amount of new capital they
actually need. It has, however, in our view, potential for even a
higher level of insider abuse than in standard conversions. We note
that many newly formed mutual holding companies propose to refuse
dividends declared by their operating subsidiary--with no corresponding
change in their percentage ownership of the subsidiary as dividends
flowed to its minority stockholders. It seems to us that this could
constitute a breach of fiduciary duty on the part of the trustees--
which would be particularly acute were the trustees significant
stockholders of the subsidiary. (It is worthy of note that ``pops'' in
conversions involving mutual holding have been in the 40% range,
compared to 26% for standard conversions.) As our suggested form of
standard conversion would eliminate the need to raise excessive amounts
of capital, we believe use of the mutual holding company structure
should be discouraged in future conversions.
Summary
As we have studied the mutual-to-stock conversion process, it has
become clear that there are two intertwined problems to be solved. One
is technical: how to do it? The other is political: who should get the
value? The first problem is interesting and challenging, but the second
one is fundamental.
Deciding who should get the value makes a lot of people
uncomfortable. Almost every answer makes someone angry. As we read the
history, the FHLBB settled on the existing form of transaction
precisely because it allowed them to avoid answering the value-
distribution question. We have come to believe that the primary appeal
of some value-distribution schemes--e.g., giving it to depositors or to
``the government''--is that they appear to disperse value enough to
make the issue moot. As we have discussed the subject over the past two
months, we have observed how tempting it is to continue to avoid it.
Lawyers and investment bankers and professional depositors with a
vested interest have urged us to drop the subject--which is not
surprising. But even disinterested individuals wind up asking, ``Do we
care?''--and they reach that point with remarkable consistency.
We should care. The integrity of a banking system is a national
treasure. Careless distribution of the value of converting institutions
undermines that integrity. A form of transaction in part designed to
avoid the value-distribution question--though it worked well for a
while--today forces well-meaning bankers and lawyers and trustees and
regulators to wink at polite fictions. Many have suggested that this is
hardly a crime, since there is no victim. We disagree. Honor is the
victim.
Life is full of compromises. There is no ``right'' answer to the
value-distribution question. But there is a right process for
addressing it. We invite broad participation in fashioning a
compromise, as only democracy can, with which no one is entirely
satisfied, but in which all can take pride.
Questions on Which Comment Is Sought
The FDIC is hereby requesting comment during a 60-day comment
period on all aspects of this notice, including the following specific
issues:
(1) Should a mutual institution be required, as a threshold issue,
to demonstrate a need to convert--or is it sufficient that it provide
an adequate business plan for the future?
(2) In the absence of legislation, could and should the FDIC adopt
guidelines or set standards for the distribution of the existing value
of a converting institution, or could or should the matter be left
entirely to the trustees?
(3) Whether it is legislation or the FDIC or the board of trustees
that sets standards, what should they be? Who should get some of the
value, how much, and how specific should the rules be?
(4) If depositors (or creditors or borrowers or employees) are to
receive some of the value, how should it be allocated among them?
Should amount of deposit or tenure of association be accorded more
weight? Must depositors and debtholders be treated identically? What
practical constraints exist, based on mutuals' information systems and
resources? What should the record date be?
(5) If charitable organizations or foundations are to receive a
portion of the value, how should the suitability of the recipients be
determined? Should there be a presumption that the trustees' selection
of recipients is reasonable? Do there need to be rules to prevent abuse
of such entities--e.g., through ``consulting contracts'' with trustees?
Should such entities be required to sell at the time of conversion, or
should they be permitted to diversify over time, in accordance with
existing federal tax and banking laws?
(6) Does ``pressure to convert'' from parties who would receive
value if an institution did so represent a legitimate public policy
concern? How great might that pressure be? How can trustees of
institutions which have not elected to convert be protected from
unreasonable litigation?
(7) What potential problems (including tax issues and insider
abuses) are there with the proposed new form of transaction, and how
can they be avoided or alleviated? On the assumption that the market
will gradually improve on any form of transaction, how specific does
legislation or regulation need to be in that area?
(8) Should converting institutions (including those doing merger
conversions) be required or encouraged to obtain ``fairness opinions''
from independent financial advisors? Should the FDIC attempt to
``police'' the market judgements involved in the process in any way?
(9) Should new mutual holding company creations be permitted? If
not, how should existing ones be regulated?
By the order of the Board of Directors.
Dated at Washington, D.C., this 31 day of May, 1994.
Federal Deposit Insurance Corporation.
Robert E. Feldman,
Acting Executive Secretary.
[FR Doc. 94-14006 Filed 6-10-94; 8:45am]
BILLING CODE 6714-01-P