Mutual-to-Stock Conversions of State Nonmember Savings Banks

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