Private Lessons

With only three days remaining before the biggest, most important referendum of his life, Gene Ross still lacked the necessary votes to get his measure passed. Ross was not a politician, but he was behaving like one. As president and chief executive officer at Norfolk, Virginia-based Essex Bancorp Inc., a federally chartered savings bank with some $300 million in assets, Ross had spent the last eight months going through the arduous process of taking the company private. Now, having spent hundreds of thousands of dollars in legal and financial advisory fees and hundreds of hours of his own time on this undertaking, Ross was facing the prospect of failure.

During the proxy solicitation process, Ross contacted as many of Essex’s 1,400 shareholders as he could. With the company’s annual meeting drawing near, Ross went over the shareholder list again to see who hadn’t mailed in his or her proxy, then diligently worked the phones like a candidate in a local school board election. His 11th hour campaigning paid off when the going-private transaction was narrowly approved. “It was close,” he said of the tide that eventually turned in the company’s favor, “but it all came in the last few days.”

By a conservative estimate, more than 600 banks and thrifts insured by the Federal Deposit Insurance Corp. have gone private since 1998, according to data kept by the agency. A more precise number is hard to determine because the agency only keeps track of the number of banks that convert to S-corporation status, which are limited to 75 shareholders or less. There have been 597 S-corporation conversions since 1998, according to the FDIC. (Legally, S-corporations are not precluded from having publicly traded stock, but because of their small shareholder base they are invariably private companies.) The FDIC does not maintain separate statistics on banks that reduce their shareholder base to less than 300, the point at which they are no longer required to file disclosure statements with the Securities and Exchange Commission.

For some banks, the switch to private ownership allows them to avoid the significant costs of filing quarterly and annual reports with the SEC. Others are lured by the opportunity to become an S-corporation, which can provide tremendous financial benefits to small banks. But present in almost every instance is the acknowledgement that an illiquid, thinly traded stock provides all of the disadvantagesu00e2u20ac”and none of the benefitsu00e2u20ac”of being a public company.

But directors, beware. Privatization involves a complicated and lengthy process that requires the approval of the SEC and the institution’s principal regulator. And a going-private transaction that attempts to force shareholders to accept a lowball price for their stock could result in either lawsuits or unwanted takeover offers. “I’d say the process of going private is not for the faint of heart,” says Ross.

The rise in privatizations in recent years may seem counterintuitive given the continued strong performance of many community bank stocks. As a group, banks with assets of less than $500 million have seen their stocks rise 42% since year-end 2000u00e2u20ac”compared to just 0.5% for banks with assets over $10 billion, according to SNL Financial. Still, there are significant numbers of small banks that are classified as public companies but have little if any trading activity in their stocksu00e2u20ac”even in a favorable equities market. While exact numbers are hard to come by, there are probably 300 or more publicly owned banks that are tracked by two listing servicesu00e2u20ac”Pink Sheets and the Over the Counter Bulletin Boardu00e2u20ac”but see little turnover in their stocks. Since most of these stocks lack an independent market maker, the banks themselves end up providing liquidity for investors who want to sell their shares. Usually they are small institutions in out-of-the-way markets that lack the strong growth characteristics that most investors want.

“Some of those banks can be pretty illiquid,” says James Record, SNL’s director of bank and thrift research. “We track about 1,050 public institutions. If you’re in the bottom 300 or so, how do you attract investor interest when investors are only going to put so much money in financial stocks?”

The arguments in favor of going private invariably start with the opportunity to save tens of thousandsu00e2u20ac”if not hundreds of thousandsu00e2u20ac”of dollars in costs associated with being a public company, most of which goes toward the preparation of detailed financial statements that must be filed with the SEC. Another cost associated with being a public company that’s more elusive, but which must be considered, is the amount of time senior managementu00e2u20ac”particularly in small banksu00e2u20ac”must spend preparing these reports every quarter. Asks attorney Walter G. Moeling IV, a partner at Powell, Goldstein, Frazer & Murphy LLP in Atlanta: “Why are you an SEC-registered company paying anywhere from $50,000 to $200,000 a year just to file reports that no one ever reads?”

A significant decline in mergers and acquisitions activity has become a factor in the decision of some banks to go private. “We’re in a changing merger market,” says Stephen M. Klein, co-chairman of the banking team at Seattle law firm Graham & Dunn PC. When the merger market was still booming in the late 1990s, selling out was a viable exit strategy for large shareholdersu00e2u20ac”including CEOs and outside board members who owned large blocks of stock. In the face of slackening demand for community bank acquisitions, a number of banks have turned to going-private transactions instead. Now, he says, “Prices are coming down. Demand for small banks is coming down, especially in outlying areas.”

The growing popularity of S-corporation status is a big driver in the trend toward privatization. Because S-corps do not pay corporate income taxes, they are able to downstream a significantly larger percentage of their profits to shareholders in the form of dividends. S-corps also avoid the double taxation of corporate profits, where earnings are taxed once at the company level and again when they are distributed to shareholders in the form of dividends, which greatly increases their profitability on a comparative basis. This in turn allows large shareholders to enjoy a more substantial return on their investment in a market where an outright sale is problematic. However, it can be expensive to go the S-corporation route since a large number of common shareholders will have to be bought out, though the legal and financial advisory fees associated with this option aren’t appreciably greater than going private. S-corporations have gained in popularity since the late 1990s when the shareholder ceiling was raised to 75. Of the 8,149 depository institutions insured by the FDIC at the end of last year, 1,645 of them, or 20%, operated as S-corporations.

The simple fact is that many small banks with thinly traded stocks probably never should have become public companies in the first place. For some, it was the dream of using their stock to expand the company. “A lot of this is driven by the belief that they’ll have a better multiple and they’ll be able to do acquisitions,” says Wade Schuessler, a managing director at Samco Capital Markets in Dallas. But unless they are in a strong growth market and succeed in attracting the attention of one or more brokerage firms that will assign an investment analyst to cover their bank, their stock will languish. “What happens is, they become a public company, but their stock trades like a private company so there’s no benefit [to being public],” he adds.

While the advantages of going private may seem compelling to banks that are stuck in this worst-of-all-worlds dilemma, the decision to buy out minority shareholders must be considered very carefully against a backdrop of considerable risk. Going-private transactions can quickly lead to trouble if they aren’t handled properly, since it’s not unusual for the bank to get sued by shareholders who believe they are being forced to sell at an unfair price.

The board of any bank that is considering privatization will want to retain a financial adviseru00e2u20ac”typically an investment banku00e2u20ac”to provide a fairness opinion. Simply put, a fairness opinion is a statement by an outside party that the price being offered to stockholders for their shares is fair and reasonable. The adviser will perform a thorough financial examination of the banku00e2u20ac”including its future earnings capacityu00e2u20ac”and compare its stock to similar banks. And it is the best defense against shareholder suits, although certainly it will not prevent them.

Typically, the value determined in the fairness opinion will determine the buyout price that will be offered to shareholders in a prospectus should the board decide to go forward with the transaction. But Moeling advises that directors should consider an additional 10% to 20% premium as an added defense against litigation. He says that banks rarely lose value in a going-private transaction since their earnings-per-share invariably goes up as the shareholder base is reduced. “I’ve never seen people pay anything even close to earnings-per-share dilution,” he says. Thus, generosity may be the best possible hedge against shareholder suits. “It’s a good defense measure,” says Moeling. “You’re protecting yourself from litigation. And if you do an ‘S-corp’ as part of that, you’ll make so much money you won’t be able to see straight.”

Lowball offers, on the other hand, can not only result in litigation, they may spark an unwanted takeover bid from another bank. This is precisely what happened to Lagrange, Georgia-based Flag Financial Corp. In a complicated situation, which also involved the arrival of a new senior management team that wanted to make a significant investment in the company, $567 million Flag decided in 2001 to go private. Its strategy involved a reverse stock split that would have forced out minority shareholders and reduced its investor base to less than 300. A senior executive at Flag, who asked not to be identified, said the bank wanted to save the $125,000 a year it spent on filing the necessary disclosure statements with the SEC, especially since the bank’s stock had relatively little liquidity. “A lot of energy is being expended on a process that, when you look at it, it’s hard to justify,” the executive says.

In the meantime, the bank received an unsolicited indication of interest from a potential acquirer. Flag rejected the solicitation when it arrivedu00e2u20ac”but also cancelled its proposed reverse stock split. “We didn’t feel good about forcing anyone to sell at a time when someone out there was kicking around a number that they were comfortable buying the company for,” says the Flag executive.

For directors, it’s also crucial to consider how taking a small bank private will affect the community it serves. Invariably, community banks have significant numbers of local shareholders since the bank’s founders went to them to raise capital when the institution was chartered. Should a significant number of minority shareholders also be among the bank’s largest depositors, trying to buy them out too cheaply might cost the bank some business.

Moeling says that directors often have a difficult time asking these same people to sell back their shares, even at a premium. “The board looks at this and says, ‘These are the same people I tried to get to buy this stock seven years ago. How do I tell them to go home?’” Moeling says that’s where making a generous offer is a sensible thing to do.

When senior managers and directors pursue a going-private transaction, they must find the money to acquire the minority interests. Schuessler points out that a bank must still be adequately capitalized after the transaction, which will limit how much of its excess capital it can use. Randy Dennis, president of DD&F Consulting in Little Rock, Arkansas, provides the simple example of a $100 million bank with 8% capital that wants to repurchase enough shares to go private. The maximum amount of excess capital it could use to fund the repurchase and still meet the minimum 5% capital requirement would be $3 million. Because of regulatory concerns about excessive leverage, “The holding company is going to be limited in the amount of debt it can borrow to buy back stock,” he explains. This might leave the company short of the necessary buybacks to get under a shareholder threshold, particularly to become an S-corporation. One option that an increasing number of banks are beginning to use is the issuance of trust preferred securities, which are considered to be debtu00e2u20ac”and thus are tax deductibleu00e2u20ac”but can be counted as capital up to 25% of total capital.

For Essex, the decision to go private first surfaced during a strategic planning session in the late 1990s. Today, the company’s primary subsidiaryu00e2u20ac”Essex Savings Bank F.S.B.u00e2u20ac”offers a full range of retail banking services through five branches in Virginia and North Carolina. Back in the early 1990s, however, Essex had gotten itself into trouble serious lending trouble and would have been taken over by the Resolution Trust Corp. in 1995 if a private group of investors hadn’t injected new capital into the bank. Ross, a certified public accountant by training, was recruited to turn the bank around in 1997 and soon returned it to profitability.

Stock performance, however, was another matter. Over time, the presence of the private investor group had negative implications for the attractiveness of Essex’s stock to institutional investors. The group had received warrants that, if fully exercised, would have given the members control of 80% of the company’s common stock. They also received preferred shares with a redemption value of $15 million and were entitled to a 9.5% dividend on these shares.

Combined, the preferred shares and accrued dividends exceeded the total amount of common equity, resulting in negative book value per common share.

Essex’s complicated capital structure clearly needed to be resolved if the company was going to continue to grow. There was very little liquidity in its stock despite being listed on the American Stock Exchange. “Some days it wouldn’t trade at all,” Ross says. Essex’s directors also had doubts about whether they would be able to sell the company. Even though the bank’s book value per common share was negativeu00e2u20ac”and was likely to remain that way for the foreseeable futureu00e2u20ac”he board expected that its common shareholders would still want a higher-than-market premium for their shares in any sale. “Clearly a merger would have been more difficult, because how do you separate that public and private ownership?” says Ross.

The directors voted to take the company private in January 2000, and one of Ross’ first moves was to establish an independent special committee to advise the board of directors on a fair price to acquire Essex’s common shares.

Privatization transactions have inherent conflicts of interest because the largest shareholders are usually members of the board. While the board has a fiduciary responsibility to look after all its shareholders’ interests, the largest shareholdersu00e2u20ac”who will own the company once the transaction has been completedu00e2u20ac”have an interest in buying out the minority investors as cheaply as possible. “Anytime a company decides to go private, there are concerns about board independence,” says Ross.

The Essex committee retained its own legal and financial counselors for advice during the process, and it provided a fairness opinion to the board. Just two members sat on the committee: Ross and a second director. Neither of them held any preferred shares or warrants and their common stock holdings were small. Two board members who were preferred shareholders were excluded from the committee.

Taking a company private is a detail-intensive undertaking. Over the next eight months Ross met with the company’s auditors to discuss the accounting treatment they would use, and he sought tax advice from other advisors to make sure the transaction could be structured as tax-free. Ross took the added step of alerting Essex’s directors and officers liability insurers that the company was embarking on a going-private transaction, and he negotiated changes in the policy to provide more complete protection. (For more on D&O considerations, see sidebar.) The SEC had to review the company’s proxy statement, a process that Ross says always seems to take longer than people expect. Build in extra time for this step, he suggests, because “it’s really hard to get them to meet your time constraints.”

Essex’s directors’ goal of going private was to buy out the common shareholders, leaving the preferred shareholders with sole ownership of the company. The board members chose a complicated deal structure in which they asked shareholders to approve the creation of a new subsidiaryu00e2u20ac”Essex Acquisition Corp.u00e2u20ac”that would acquire all the outstanding common shares of the old holding company, Essex Bancorp Inc. This structure was chosen, says Ross, because it only required a 50.1% affirmative vote for the merger to be approved, while a straight tender offer might have failed to retire all of the common shares. A $2 million bank-funded line of credit secured by Essex Acquisition Corp. was used to buy out the common stockholders at $1.45 a shareu00e2u20ac”the price recommended by the special committee. Ross had to borrow money because with a negative book value, the company did not have any excess capital that could be used to repurchase the common shares, and its preferred shareholders declined to contribute any additional capital.

The regulators also play a major role in the process. In Essex’s case, Ross had to meet with the Office of Thrift Supervision to review the institution’s plans for going private. Regulators were concerned about how the transaction was going to be funded and wanted to know why it was in the depository subsidiary’s best interests, especially since Ross would have to take on debt, which could only be serviced by upstreamed dividends from the depository subsidiary, Essex Savings Bank F.S.B. Ultimately, the OTS saw value in cleaning up Essex’s capital structure and eliminating the preferred dividends so the company would have a better opportunity to raise additional capital, even as a private concern.

The transaction was finally approved by 53% of Essex’s voting shares, with 21% of the common shares opposing, 7% abstaining, and 19% not voting at all. The overall cost of going private was $1.85 million, with a little over $1.5 million going towards the share repurchases and approximately $300,000 covering the costs of the transaction.

In Ross’ estimation, Essex now faces a brighter future as a private company with a simpler capital structure. It has chosen not to become an S-corporation even though it has just 60 or so shareholders, because it still has a sizeable amount of tax loss carryforwards from previous years that it can use to offset its income. Ross says the company’s fundamentals are quite strong, in part because the local economyu00e2u20ac”which includes an enormous U.S. Navy base at Norfolku00e2u20ac”is more protected from economic downturns than many other locales in the country. “Recessions seem to be softer here than in a lot of other places,” he says. In fact, the bank is fully leveraged, and Ross is considering a variety of strategic options, such as capital raising or a merger, that will enable it to continue to growu00e2u20ac”most of which it couldn’t have considered before going private.