What Keeps Directors Up at Night


worried.jpgDuring the S&L crisis of the late 80’s and early 90’s, the Federal Deposit Insurance Corporation sued or settled claims against bank officers and/or directors on nearly a quarter of the institutions that failed during that time. If the past is any indication of the future, then there is a significant risk that directors of failed banks from the recent financial crisis may see some type of action taken against them by the FDIC.

In addition to lawsuits against senior executives of IndyMac Bank, and also senior officers and directors of Heritage Community Bank in Illinois, the FDIC has authorized actions against more than 109* insiders at failed banks to recover over $2.5* billion in losses to the deposit insurance fund resulting from this wave of bank failures.

Based on their work with a number of banks as well as individuals who are the targets of recent FDIC cases in various stages of development, John Geiringer and Scott Porterfield from the Chicago-based law firm of Barack Ferrazzano answer some questions about what could be keeping bank directors up at night.

What are the steps taken by the FDIC after the closure of a bank?

The FDIC begins a preliminary investigation when it believes that a bank may fail and will interview bank employees, officers and directors promptly after the bank’s closure.It is common for the FDIC to send a demand letter to the bank’s officers and directors demanding payment, usually in the tens or hundreds of millions of dollars, shortly before the expiration date of the bank’s D&O insurance policy.The FDIC sends that letter in an apparent attempt to preserve the D&O insurance for any litigation claims that it may later assert.

The FDIC may then subpoena officers and directors for documents and depositions. After conducting depositions, the FDIC will decide whether to initiate litigation against any officer or director. If the agency decides to litigate, it will initiate settlement discussions before actually filing its lawsuit. Because of the many evolving issues in these situations, such as whether insiders may copy documents for defense purposes before their banks fail, potential targets of these actions should ensure that they are being advised by counsel through every step of this process, even before their banks have failed.

What are the legal standards by which the FDIC may sue directors?

The FDIC bases its lawsuits on general legal principles that govern director and officer conduct and also considers the cost effectiveness of any potential lawsuit when making its decision. Federal law allows the FDIC to sue directors and officers for gross negligence and even simple negligence in certain states. What those standards mean as they relate to the conduct of bank insiders during this unprecedented economic cycle is difficult to predict at this time, although we are getting a clearer picture.

In the Heritage case, for example, the FDIC alleges that the defendants did not sufficiently mitigate the risks in the Bank’s commercial real estate portfolio and made inappropriate decisions regarding dividend and incentive compensation payments.

Will the FDIC differentiate between inside and outside directors?

Whether someone is an inside or outside director is one of the factors that the FDIC considers in determining whether to sue a director of a failed bank. According to the FDIC’s Statement Concerning the Responsibilities of Bank Directors and Officers, the most common lawsuits likely to be brought against outside directors will probably involve insider abuse or situations in which directors failed to respond to warnings from regulators and bank advisors relating to significant problems that required corrective actions.

Will D&O insurance cover any liability to the FDIC?

That depends on the amount and terms of the D&O policy. Directors should work with their insurance broker and bank counsel to review their D&O policies and to help them to make this determination. They should determine whether their policy amount is sufficient, whether their policy has certain exclusions (such as regulatory and insured vs. insured exclusions), whether proper notices are being made and under what conditions their policy can be cancelled.

What can directors do to mitigate their risk in the event that their bank fails?

In its Policy Statement, the FDIC states that it will not bring civil suits against directors and officers who fulfill their responsibilities, including the duties of loyalty and care, and who make reasonable and fully informed business judgments after proper deliberation. The FDIC generally requires bank directors to: (i) maintain independence; (ii) keep informed; (iii) hire and supervise qualified management; and (iv) avoid preferential transactions.

Directors should ensure that their bank’s counsel and other advisors are discussing these crucial issues with them. If their bank is in troubled condition, directors should seriously consider the need to hire personal legal counsel and to understand their ability to obtain indemnification.

Figures updated as of 1/4/11 based on latest reportings.

Pros & Cons of Traditional M&A vs. FDIC-Assisted Transactions


handshake.jpgWith the financial industry cautiously anticipating a recovery from the dramatic economic crisis that resulted in increased regulations and scrutiny for banks of all sizes, many are hoping to see increased activity from traditional M&A transactions. Although the number and size of bank failures is slowing down, FDIC-Assisted deals should not be discounted as a viable growth opportunity in 2011.

As part of our Inside the Boardroom interview series, Rick Childs, a director in Crowe Horwath LLP’s financial advisory services group, outlines below the pros and cons of traditional M&A vs. FDIC-Assisted transactions, and what today’s boards should know before considering these two options.

What are the pros & cons of traditional M&A vs. FDIC-Assisted deals?

TRADITIONAL M&A

PROS:

  • There is more time to perform due diligence and to understand how the organization fits your culture and business plan.
  • Traditional M&A deals are usually negotiated with a single buyer. If a potential acquirer can negotiate and improve its chances of winning the transaction. In an FDIC-assisted transaction, the agency is required by law to select the bid that entails the lowest cost to the FDIC insurance fund. As a result, competition for the bid can decrease the odds of the bidders being successful.
  • In 2010, there were still a number of deals where the target’s earnings were positive. In approximately 42 percent of the traditional M&A deals the target had positive earnings and approximately 26 percent had ROAs in excess of 50 percent. Institutions with positive earnings provide growth opportunities at attractive prices.

CONS:

  • The level of non-performing assets in some of the deals may still make the transaction prohibitive without FDIC loss protection. While bidders for FDIC-assisted deals are able to bid the assets acquired at a discount, the traditional M&A buyers cannot bid less than $0. Or, to put it another way, the sellers of whole institutions are not in a position to pay the buyer to take over the institution while the FDIC-assisted transaction is able to absorb the negative bids.
  • With prices for healthy institutions still depressed, there are fewer healthy sellers. Likely these institutions are waiting for prices to return to historical—which is to say higher-levels, although it’s unclear whether that will every happen.

FDIC-ASSISTED TRANSACTIONS

PROS:

  • The protection afforded from loss sharing has been a catalyst for getting bidders to participate in the bidding process and makes the transaction palatable on a prospective basis as the future losses are covered by loss sharing.
  • For many acquirers, it has offered a unique growth opportunity and there have been a number of serial FDIC-assisted transaction acquirers who have been able to raise capital and build long-term franchise value.
  • Buyers have been able to acquire assets and liabilities but leave behind unfavorable contracts and any potential litigation risks that would be associated with a failed institution.
  • The potential for bargain purchase gains can provide capital for the acquiring institution. However, those institutions should expect the regulatory agencies to exclude capital arising from a bargain purchase until the valuations have been finalized and then validated through examination or external audit.

CONS:

  • The loss sharing contract requirements can be time consuming and expensive to comply with, including reporting, systems and the required loan modification commitments.
  • Limited due diligence and a compressed time frame for the transaction translate into the bidder needing to make a significant number of material estimates to arrive at the bid with limited information. This can lead to unexpected results post transaction.

What is the outlook for both types of deals?

Trends in acquisitions of both types of deals increased in 2010 compared to 2009. On September 30, 2010, the FDIC reported 860 troubled institutions, up from 720 at December 31, 2009. If only 10 percent of those institutions ultimately fail, then 2011 will still see a significant number of transactions.

The total assets of troubled institutions are actually lower than at December 31, 2009, so the transactions likely will be of smaller sized institutions. Traditional M&A transactions also appear to be ready for an increase in activity in 2011, although still tempered compared to more recent history before the current financial crisis.

Are the FDIC-Assisted deals still attractive, or have they lost their allure since the FDIC is providing less loss protection?

The deals are still attractive and what the bidders appear to be doing is considering the level of expected losses including the revised coverage into their bids. In the 4th quarter of 2010 the asset discount on the deals with loss sharing increased over the prior quarters. Further, about 15 percent of transactions in 2010 didn’t include a loss sharing agreement, and in those transactions the asset discount was approximately twice as much as the loss sharing transactions. Our experience with bidders has been that they adjust to the changes in the FDIC structures.

Is this change in loss protection making traditional deals more competitive?

The changes in the loss sharing agreements do not appear to be changing the landscape. Bidders adjust their bids to encompass the expectations of losses. At the same time, buyers in traditional deals are including contingent payments, escrows and other holdbacks tied to credit performance as ways of providing some protection against future losses.

What are the impediments to getting traditional M&A deals done?

Capital is clearly an issue for many acquirers in traditional deals, and because the discounts on traditional deals are limited by the level of capital, some deals actually produce goodwill once the purchase accounting adjustments are all recorded. Regulators are expecting higher levels of capital and as a result the available buyer pool may be limited. Additionally, many potential sellers may be waiting until prices rebound and the returns to shareholders are maximized.

Potential acquirers are also weighing the ongoing costs of acquiring an institution with significant credit problems. The time and expense related to working out a significant number of problem credits can be prohibitive for some institutions. Finally, activity in certain states has been nominal in the last several years, so for buyers in those states, a potential transaction may be well outside their market area and that can be an impediment.

The Return of Darwinian Banking


Listening to Ben Plotkin, EVP and vice chairman at the investment banking firm Stifel Nicolaus Weisel, as he provided a broad industry overview at our Bank Executive & Board Compensation event last week in Chicago, the image that came to mind was a heavy-weight boxer who has been staggered by repeated blows to the head but somehow is still standing.

Looking at the fundamentals, there’s no question that the U.S. banking industry has been bloodied by the worst economic downturn since the Great Depression of the 1930. According to Plotkin, the industry’s profitability plummeted from a high-water mark of $128.2 billion in 2006, to $97.6 billion in 2007 – to just $15.3 billion in 2008. Plotkin illustrated this on a bar chart, and that dramatic 2009 earnings decline resembled a Sears Tower elevator dropping from the top floor to darn near the basement.

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“Unreal” Earnings

Of course, we all know that industry’s record profitability from 2002 through 2006 was fueled by the bubble economy and a hyperactive mortgage market. Or as Plotkin put it, “A lot of people say those earnings weren’t real.” And indeed they weren’t considering how much of that money was given back in the form of loan and bond losses, but I think it’s also amazing that the banking industry didn’t sustain even more damage than it did.

The number of banks on the Federal Deposit Insurance Corp.’s troubled institution list rose to 829 in the second quarter of this year, but banks are dropping at a much lower rate than in the early 1990s, when the collapse of the commercial real estate market resulted in many more bank failures than we’re likely to see this time around.

Improving Trends

But there is light at the end of the tunnel for most banks, and it’s not necessarily a freight train hurtling towards them. Based on Plotkin’s numbers, it would seem that the industry’s asset quality problems have finally peaked. After rising sharply from 2006 through 2009, non-performing loans have finally leveled out and even declined slightly to about 3.2% in November. Healthy banks with strong balance sheets (including better than average asset quality) have also been able to raise capital from institutional investors.

The industry’s net interest margin (which is essentially the difference between the interest rate on a loan and all the costs associated with getting that loan) has also shown recent improvement. Through the first two quarters of 2010 the margin was approximately 3.85% — compared to 3.39% in 2006 and 3.35% in 2007, when the industry was (ironically enough) rolling in dough. Those numbers say two things to me.

One, loan pricing is gradually improving as bankers are able to charge higher rates on their loans. And two, the industry compensated for its cut-rate pricing in 2006-2007 with volume – which turned out to be a recipe for disaster.

Why would the big pension and mutual funds be willing to invest capital in a troubled industry? Perhaps because they anticipate a predatory environment in which the strong and the swift will devour the weak and the weary. “Many of the catalysts for renewal of the traditional M&A market are beginning to take shape,” Plotkin told the audience. Asset quality is slowly beginning to improve, signaling potential acquirers that the worst is over. Strong banks have access to capital, so they can afford to acquire. And banks with diminished earnings power and little or no access to institutional sources of capital may find that selling out to a more highly valued competitor is their only viable strategy to reward their long suffering owners.

It’s a Darwinian principal that has helped drive bank consolidation for the past 25 years, and no doubt for a few years more.

 

Happy Employees = Happy Communities


This past week, Bank Director and The NASDAQ OMX Group hosted our sixth annual Bank Executive & Board Compensation Event in an unseasonably warm Chicago. After an early registration and light breakfast, over 270 bankers and advisors from across the country gathered in the large ornate grand ballroom of the Intercontinental Hotel to kick off our two-day event with an opening session on the Future of Performance Compensation Plans.

Moderated by Todd Leone of Amalfi Consulting, a panel consisting of a compensation committee chair, senior human resources executive and a board chairman shared their insights on how to design compensation programs that deliver a competitive edge, while still rewarding the CEO and balancing the needs of the company and shareholders.

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To jump start the session, Todd presented the attendees with an overview on the four regulatory factors that have changed the responsibilities of compensation committees, and therefore making their position the most challenging of the board. These regulations consistencies include:

  • Compensation committees are now being held accountable for performance-driven compensation plans across the entire organization, including the lowest paid employees.
  • Clawbacks are predicated upon reinstatement of earnings, and performance bonuses will need to be re-paid if a loan goes bad.
  • Committee members will be instrumental in reviewing the risk of compensation plans and should have an audit process in place.
  • Members will need to look beyond the fiscal year to ensure that the team is focused on long-term goals as well as short-term ones.

Many observations and recommendations were presented by the three panel members but the following topics were considered the highlights of the discussion.

Managing Regulations & Risk Review

  • Greg Ostergren, the compensation committee chairmen for Guaranty Federal Bancshares, a $732-million institution out of Missouri, described the effectiveness of hiring a chief risk officer to help manage regulations, review compensation plans and to help the bank stay ahead of curve.
  • For smaller community banks where resources may be limited, panelists recommended that the compensation committee take on the duties of risk oversight. In some cases, the human resources or internal auditing team can take on this role of giving a more objective viewpoint.
  • While TARP banks are ahead of the curve with regard to risk review, panelists were in agreement that non-TARP banks should follow suit just to be prepared for the regulators.

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Incentive Based Pay Structures

  • When it comes to executive compensation plans, one approach is to develop a mixed ratio plan that accounts for performance metrics, company culture, and business development. Paul Barber, SVP & HR manager for Graystone Tower Bank, a $1.6 Billion non-TARP bank, shared that 50% of their executives’ incentive compensation is based on credit quality.
  • A panel member also suggested that 30-35% of the Relationship Manager’s reviews be based on a clean portfolio.
  • Bonus incentives for the commercial lenders can be changed from cash to stock options, so that employees are compensated on the performance of the bank over long periods of time rather than the ability for someone to make a quick buck.

Recruiting & Retention Challenges

  • With all the regulations coming down the pike, attracting top talent to a troubled bank can be a challenge. One creative solution is to bring new recruits on as consultants before submitting them to the FDIC for approval as management.
  • Sam Borek, chairman and acting CEO of OptimumBank in Florida, reminded the group that while the FDIC doesn’t approve of signing bonuses, it does approve of staying bonuses which can aid in the recruiting of top management talent.
  • In terms of future compensation planning, clawbacks can actually work as a retention tool by requiring that the executive team receives a bonus after meeting their three-year goals during their employment term.

While several points were discussed among the panel, the overall recommendation was to consider what works best for your bank based on your region, business goals and staff needs. And as Sam Borek so thoughtful shared, his company’s number one stakeholder group is the employees, as happy employees create happy customers who make for happy shareholders who ultimately make for happy communities. Everything else falls in line behind that key mission.