Weighing the Value of a Bank Holding Company


governance-6-24-19.pngIn May, Northeast Bank became the fourth banking organization in two years to eliminate its holding company. Northeast joins Zions Bancorporation, N.A., BancorpSouth Bank and Bank OZK in forgoing their holding companies.

All of the restructurings were motivated in part by improved efficiencies that eliminated redundant corporate infrastructure and activities. The moves also removed a second level of supervision by the Federal Reserve Board. Bank specific reasons may also drive the decision to eliminate a holding company.

Zions successfully petitioned to be de-designated as a systemically important financial institution in connection with its holding company elimination. In its announcement, Northeast replaced commitments it made to the Fed with policies and procedures relating to its capital levels and loan composition that should allow for more loan growth in the long run.

Banks are weighing the role their holding companies play in daily operations. Some maintain the structure in order to engage in activities that are not permissible at the bank level. Others may not have considered the issue. Now may be a good time to ask: Is the holding company worth it?

Defined Corporate Governance
Holding companies are typically organized as business corporations under state corporate law, which often provides more clarity than banking law for matters such as indemnification, anti-takeover protections and shareholder rights.

Transaction Flexibility
Holding companies provide flexibility in structuring strategic transactions because they can operate acquired banks as separate subsidiaries. This setup might be desirable for potential partners because it keeps the target’s legal and corporate identity, board and management structure. But even without a holding company, banks can still preserve the identity of a strategic partner by operating it as a division of the surviving bank.

Additional Governance Requirements
A holding company’s status as a separate legal entity subjects it to additional corporate governance and recordkeeping requirements. A holding company must hold separate board of directors and committee meetings with separate minutes, enter into expense-sharing and tax-sharing agreements with its bank subsidiary and observe other corporate formalities to maintain separate corporate identities. In addition, the relationship between the holding company and its subsidiary bank is subject to Section 23A and Section 23B of the Federal Reserve Act, an additional regulatory compliance burden.

Additional Regulatory Oversight
Holding companies are also subject to the Fed’s supervision, examination and reporting requirements, which carry additional compliance costs and consume significant management attention. The Fed also expects bank holding companies to serve as a source of financial strength to their subsidiary banks, an expectation that was formalized in the Dodd-Frank Act.

Diminished Capital Advantages
Historically, holding companies could issue Tier 1 capital instruments that were not feasible or permissible for their bank subsidiaries, such as trust preferred securities and cumulative perpetual preferred stock. They also enjoyed additional flexibility to redeem capital, an advantage that has largely been eliminated by the Basel III rulemaking and Fed supervisory requirements. A holding company with existing grandfathered trust preferred securities or with registered DRIPs may find them useful capital management tools. Holding companies with less than $3 billion in consolidated assets that qualify under the Small Bank Holding Company and Savings and Loan Holding Company Policy Statement are not subject to the Fed’s risk-based capital rules. These companies are permitted to have higher levels of debt than other holding companies and banks.

Broader Activities, Investments
Bank holding companies, especially those that elect to be financial holding companies, can engage in non-banking activities and activities that are financial in nature through non-bank subsidiaries that are bank affiliates. In some cases, these activities may not be bank permissible, such as insurance underwriting and merchant banking. The Fed also has authority to approve additional activities that are financial in nature or incidental or complementary to a financial activity on a case-by-case basis.

Bank holding companies can also make passive, non-controlling minority investments that do not exceed 5 percent of any class of voting securities in any company, regardless of that company’s activities. By comparison, banks are limited to making investments in companies that are engaged solely in bank-permissible activities or must rely on authorities such as community development or public welfare authority to make investments. Banks may also have limited leeway authority to invest in specific securities or types of securities designated under the applicable state banking law or by the applicable state banking regulator.

Banks that are not interested in activities or investment opportunities available to holding companies may be less concerned about eliminating the structure. But an organization that engages in activities at the holding company level that are not permissible for banks or that desires to maintain its grandfathered rights as a unitary savings and loan holding company may not wish to eliminate its holding company.

Operating without a holding company would result in more streamlined regulatory oversight, corporate governance and recordkeeping processes. But a holding company provides the flexibility to engage in activities, to make investments and to create structures that a bank may not. Bank boards should weigh these costs and benefits carefully against their strategic and capital management plans.

Five Critical Mistakes to Avoid in Any Headquarters Project


headquarters-5-15-19.pngCorporate headquarter projects are likely one of the biggest investments a bank will make in itself.

With a lot of time and money on the line, it is no surprise that these massive projects quickly become an area of major stress for executives. Most management teams have limited experience in executing projects of this kind. The stakes are high. Bad workplace design costs U.S. businesses at least $330 billion annually in lost efficiency, productivity and overall employee engagement, according to Facility Executive.

A lot can go wrong when planning a corporate headquarters. Executives should use a data-based approach and address these issues in order to avoid five critical oversights:

1. Overpromising and Under-delivering to the Board
You should feel confident that every decision for your planned headquarters is the right one. The last thing you want to do after you get the board’s approval on the size, budget and completion date for the project is go back for more money and time because of educated guesses or bad estimates.

Avoiding this comes down to how you approach the project. Select a design-build firm that considers your needs and asks about historical and projected growth, trends and amenities, among other issues. This will help mitigate risk and create a plan, budget and timeline based on research and deliberation

2. Miscommunication Between Design and Construction
Partnering with a design-build firm helps alleviate the potential for miscommunication and costly changes between architects and construction crews. Look for firms with a full understanding of costs, locally available resources and current rates, so they can design with a budget in mind. Some firms offer a guaranteed maximum price on a project that can eliminate surprises. 

3. Missing the Mark on Efficiencies and Adjacencies
The way employees work individually and collaborate with others is changing. Growing demand for work areas like increased “focus spaces,” more intimate conference rooms and other amenities should not to be ignored. Forgetting to consider which departments should be next to each other to foster efficiency is also an oversight that could dampen your bank’s overall return. Look for a firm that has an understanding of banking and how adjacencies can play a role in efficiency that can guide you toward which trends are right for your bank.

4. Outgrowing the New Space too Soon
I have witnessed a project that was not properly planned, and the board was asked to fund another project for a new, larger building only five years after the first one. As you can probably imagine, the next project is being watched and scrutinized at every turn.

Most architectural designers will ask you what you want and may look at whatever historical data you provide. Beyond that, how will you know if the building will last? A good design-build firm should incorporate trends from the financial industry into your design; a great one will provide you with data, projected growth patterns and research, so you can demonstrate to the board that the bank is making the right investment and that the new space will last.

5. Forgetting the People Piece
Not communicating with your employees or leadership on the reasons behind the change or how to use the new space often means leaving money and happiness on the table. The design and the features of the building frame the company culture, but the people complete the picture.

Make sure to show your workforce the purpose of the new space. Help get everyone excited and on the same page with the use, process and procedures. Do not drop the ball after the hard work of building the headquarters.

When it comes to any project—especially one of this size and magnitude—always measure twice and cut once.

How to Design a Winning Capital Management Plan


capital-4-22-19.pngThe significant downturn in bank stock prices witnessed during the fourth quarter of 2018 prompted a number of boards and managements to authorize share repurchase plans, to increase the amounts authorized under existing plans and to revive activity under existing plans. And in several instances, repurchases have been accomplished through accelerated plans.

Beyond the generally bullish sentiment behind these actions, the activity shines a light on the value of a proactive capital management strategy to a board and management.

The importance of a strong capital management plan can’t be overstated and shouldn’t be confused with a capital management policy. A capital management policy is required by regulators, while a capital management plan is strategic. Effective capital management is, in large part, an exercise in identifying and understanding future risks today. Capital and strategy are tightly linked — a bank’s strategic plan is highly dependent on its capital levels and its ability to generate and manage it.

There are a couple of guidelines that executives should bear in mind as they develop their capital management plans. First, the plan needs to be realistic and achievable. The windows for accessing capital are highly cyclical. There’s limited value in building a plan around an outcome that is unrealistic. Second, if there is credible information from trusted sources indicating that capital is available – go get it! Certain banks, by virtue of their outstanding and sustained performance, may be able to manage the just-in-time model of capital, but that’s a perilous strategy for most.

Managements have a number of levers available to manage capital. The key as to when and which lever to pull are a function of the strategic plan. A strong plan is predicated on staying disciplined but it also needs to retain enough nimbleness to address the unforeseen curveballs that are inevitable.

Share Repurchases
Share repurchases are an effective way to return excess capital to shareholders. They are a more tax-efficient way to return capital when compared to cash dividends. Moreover, a repurchase will generally lift the value of a stock through the reduction in shares outstanding, which should increase earnings per share and the stock price itself. Share repurchases are generally the favored mechanism of institutional owners and can make tremendous sense for broadly held and liquid stocks.

Cash Dividends
Returning capital to shareholders in the form of cash dividends is generally viewed very positively in the banking industry. Banks historically have been known as cash-dividend paying entities, and the ability and willingness to pay them is often perceived as a mark of a healthy and stable company. A company’s decision regarding whether to increase a cash dividend or to repurchase shares can be driven by the composition of the shareholder base. Cash dividends are generally valued more by individual shareholders than institutional shareholders.

Business Line Investment
Community banking at its core is a spread dependent business. The ability to diversify the revenue stream through the development or acquisition of a fee generating business can be an effective and worthwhile use of capital. Common areas of investment include mortgage banking, wealth management, investment products and services and insurance. Funding the lift out of lending teams can also be a legitimate use of capital. A recent development for some is investment in technology as an offensive play rather than a defensive measure.

Capital Markets Access
Effective capital management plans also consider the ability to access the capital markets. In the community banking space, accessing capital is not always a foregone conclusion. Over the past couple of years, the most common forms of capital available have been common equity and subordinated debt. For banks of a certain size and market cap, it’s a prudent capital management strategy to file a shelf registration, also known as form S-3, which provides companies with flexibility as to how and when they access the capital markets. The optionality provided by having a shelf registration far outweighs the concern that the shelf itself suggests a shareholder dilutive activity is on the horizon.

It’s important to note that these capital management activities can be utilized individually or in combination. An acquisition may necessitate the need to access the capital markets. Or given the relative inexpensiveness of sub debt, raising some for the purpose of a share repurchase could make sense. A strong capital management plan can allow a management team to be ready both offensively and defensively to drive their businesses forward in optimal fashion.

Information contained herein is from sources we consider reliable, but is not guaranteed, and we are not soliciting any action based upon it. Any opinions expressed are those of the author, based on interpretation of data available at the time of original publication of this article. These opinions are subject to change at any time without notice.

The Case for Rating Community Banks Investment Grade


investment-9-18-18.pngFor years, legacy rating agency thinking held that community banks could not be rated investment grade. They were too small, the thinking went, and therefore could not compete with scale-advantaged larger banks. Moreover, this structural deficiency likely made community banks riskier, as they were naturally subject to adverse selection in terms of loan originations.

All of this is intuitive. But it doesn’t stand up to further scrutiny.

If we consider the history of bank failures, we see that very small banks and very large banks are disproportionately represented. Meanwhile, well-run community banks, with long-standing ties to local markets, core deposit funding and well diversified risks have a long history of successfully riding out credit cycles. That piqued our interest. But we still needed to get over the hump of competitiveness. How could a community bank’s cost structure—the basis for pricing assets and liabilities—match the efficiency of the largest banks? We took a closer look.

Started with funding costs. Turns out that government guaranteed deposit funding—available to all FDIC-insured institutions, large and small, is a great equalizer. In fact, most community banks derive substantial amounts of their funding via core deposits, giving them an advantage over the largest banks that require substantial sums of more expensive market-sourced funding.

What about operating costs? Surely, the largest banks enjoy substantial economies of scale relative to community banks. That may be true, especially in terms of being able to absorb things like the significant increases in regulatory reporting and compliance costs. What we found interesting, however, is that the efficiency ratios of community banks in many cases compare favorably to those of the larger banks. Our research came up with two explanatory considerations. First, according to the FDIC, the benefits of economies of scale are realized with as little as $100 million in assets, and second, among larger banks, the benefits of scale are typically offset by the added costs brought on by complexity and administrative friction. This serves as a reminder that, in terms of competitiveness, banking, especially small to mid-sized commercial banking, is a local scale business, not a national (or international) one.

Now, you might point out, broader and more sophisticated product offerings must tip the scale in favor of larger banks. And there must be some benefit to the substantial technology and marketing spend of the larger banks. We wouldn’t disagree. But we also believe community banks can punch back with value of their own created out of local market knowledge and relationships as well as superior responsiveness. And most small businesses really don’t demand a sophisticated product set, and marketing spend generally creates value in consumer financial services, much of which left community banking some time ago.

So, what about the risk side of the equation? Larger banks by definition will have greater spread-of-risk than community banks, where risks are more concentrated, certainly in terms of geography, and quite possibly loan type (most notably CRE). What our research found was that through cycles, community banks’ loss rates per loan type were typically better than those of larger banks. In other words, no evidence of adverse selection, and a realization that most markets in the U.S. are relatively well diversified economically.

This is not to say that all community banks are investment grade. Well-run community banks can be rated investment grade. Therein lies an essential element of our rating determination—an in-depth due diligence session with senior management. Here, we look to understand the framework and priorities for managing risk, key aspects of growth strategies, and the rationale underpinning capital and liquidity structure. This is a story sector, and the management evaluation is critical to our rating outcome.

Our research suggests that well-run community banks can compete successfully with larger banks, and generate solid fundamental performance through the cycle. We rated our first community bank in 2012, and today that figure stands at 115 and counting, testament that our approach has resonated with investors and depositors alike.

What You Should Know About Recent Trends in 401(k) Fee Litigation


litigation-6-25-18.pngParticipation in 401(k) plans has grown astronomically since they came into existence almost 30 years ago. Today, tens of millions of employees participate in 401(k) plans, and total assets under management exceed $7 trillion. It is little wonder that 401(k) plans have increasingly become targets for litigation over the last decade. In 2017 alone, dozens of new cases were filed against 401(k) plans, with settlements collectively exceeding $145 million. Litigation has also extended to substantively similar 403(b) plans. It is therefore important for plan sponsors and administrators to be aware of recent litigation trends and take appropriate steps to minimize litigation risks.

Basis of 401(k) Fee Litigation
401(k) plans are “employee welfare benefit plans” governed by the Employer Retirement Income Security Act (“ERISA”) and, as such, must be managed exclusively for the benefit of plan participants. Plan sponsors and administrators (collectively “plan fiduciaries”) are accordingly subject to a fiduciary duty—which courts refer to as “the highest duty known to law”—requiring them to act prudently (i.e. with the “care, skill, and prudence” of a prudent person) and loyally (i.e. only for the benefit of plan participants) towards plan participants. Practically, this means that plan fiduciaries must carefully consider the expenses of the plan; and the type and cost of investment options.

Common Allegations in 401(k) Fee Suits
Flowing from the fiduciary duties owed, fee suits commonly allege that plan fiduciaries:

  • Should have offered substantively identical but less expensive investment options;
  • Did not obtain the best possible price from plan service providers; and
  • Failed to adequately monitor the cost of investments and administrative expenses over time.
  • Poor investment performance (though many courts have found that poor performance alone does not indicate that the fiduciary’s decision-making process was flawed); and
  • Prohibited transactions claims, as ERISA prohibits fiduciaries from making payments to “parties in interest” from plan assets (though often, courts have found that exemptions clearly applied to permit payments).

Recent Trends in 401(k) Fee Litigation
Recent trends indicate the plaintiffs’ bar has broadened their sights: increasingly targeting other defendants apart from larger 401(k) plans, and alleging new bases of breach.

Plaintiffs’ Bar Increasing Targets of Litigation
Historically, plaintiffs have targeted larger 401(k) plans. Recent settlement successes against 401(k) plans have buoyed the plaintiffs’ bar, and smaller plans are increasingly targeted. Large universities, which offer 403(b) plans, are also increasingly targeted. In August 2016, a dozen suits were filed against universities. In 2017 and 2018, new suits have continued to be filed with regularity against universities.

Recent Bases of Fiduciary Breach
There has been an uptick of claims targeting investment options. Plaintiffs are challenging proprietary funds (wherein fiduciaries include their own proprietary funds in the 401(k) plan), alleging that those investments benefit the fiduciary at the expense of plan participants. Plaintiffs are also targeting money market funds, claiming that the plans should have offered stable value funds instead; as the latter serves the same purpose but yields highest interest rates.

What Can I Do to Minimize Litigation Risk?
Unfortunately, there is no magic bullet. Plaintiffs’ firms are savvy, and whether plan fiduciaries have discharged their fiduciary duties is often a fact-sensitive inquiry; meaning that early resolution of litigation (i.e. at the motion to dismiss stage), is not always possible.

However, ERISA does not impose a duty on fiduciaries to achieve perfect outcomes. As long as fiduciaries consistently strive to make decisions in the best interests of plan participants, they have a good chance of demonstrating that they have discharged their fiduciary duties when challenged in court. In other words: process, process, process. Brotherston v. Putnam Investments, LLC, 2017 WL 1196648 (D. Mass. Mar. 30, 2017) illustrates this. There, plaintiffs claimed that Putnam’s proprietary products were too expensive and that Putnam lacked a fiduciary process. The court had the opportunity to review Putnam’s processes post-discovery, and found that there was no evidence to show that Putnam had breached its fiduciary duties by placing its interests ahead of participants, or that a reasonable fiduciary “in the shoes of” Putnam would have chosen a different investment lineup.

Thus, while obtaining early judgment may be difficult, establishing a robust process to consistently monitor the plan’s investment selection and plan expenses is key to demonstrating discharge of fiduciary duties and increasing the odds of success on a dispositive motion later in the litigation.