Confidential Supervisory Information in M&A


merger-6-28-17.pngAll of us have heard the horror stories about banks announcing a merger or acquisition, only to have the deal languish for months awaiting regulatory approval or, even worse, having the deal break apart because of a regulatory issue.

Sometimes the issues only become apparent after regulatory approval applications are filed. Since the financial crisis, some regulators have used the applications review process as a “second look” at the parties involved. This is especially true if the transaction would result in an institution that will cross a supervisory threshold (whether $50 billion, $10 billion, or $1 billion in assets), or if a protest is filed in response to the transaction.

But sometimes the issues would be readily apparent if all relevant information regarding the parties could be freely shared during due diligence. Unfortunately, applicable law imposes restrictions on the ability to share confidential supervisory information (CSI) during the due diligence process. In this article, I’ll describe what CSI is and the limits on sharing it, as well as some alternatives to allow parties to move forward without it.

What Is CSI?
The definition of CSI and the rules regarding its disclosure vary between each federal and state regulatory agency. But generally, CSI includes any information that is prepared by, on behalf of, or for the use of, a federal or state regulator, including information in any way related to any examination, inspection or visitation of a bank, its holding company or its subsidiaries or affiliates. CSI generally includes documents prepared by the regulator or by the examined entity relating to the regulator’s supervision of that entity. Some examples of CSI include exam and inspection reports, supervisory ratings, non public enforcement actions and commitment letters, such as a memorandum of understanding or board resolutions adopted to address supervisory concerns, as well as any related communications with a regulator and progress reports required by an enforcement action.

What Is Not Confidential Supervisory Information?
Certain regulatory actions must be disclosed under applicable law. These include cease and desist orders (or related consent orders), prompt corrective action directives, termination of FDIC insurance, removal or suspension of an institution affiliated party, civil money penalties and any written agreement for which a violation may be enforced by the federal regulator, unless that regulator determines that publication would be contrary to the public interest. Each federal regulatory authority maintains a website at which this information and the relevant documents may be obtained.

Who Can Give Approval to Disclose CSI?
The regulators take the position that all CSI, whether prepared by the regulator or the bank, is the property of the regulator, not the bank. As such, CSI may only be disclosed with the prior written approval of the regulator, and each of the federal regulators have adopted regulations setting forth procedures for how to request disclosure of CSI.

What About Sharing CSI in Mergers or Acquisitions?
While there are some exceptions to the general rule that a bank can’t disclose CSI, including permitting disclosures to directors, officers, employees, auditors and, in some instances, legal counsel, almost all regulators take the position that a bank can’t share CSI with acquirers or targets in merger or acquisition transactions without prior approval. Further, some regulators, including the Federal Reserve, take the position that disclosure requests in these contexts are denied absent unusual circumstances.

This is a very different stance from other highly sensitive information, such as a consumer’s nonpublic personal information, which may be disclosed in connection with a proposed merger or acquisition.

What Are the Risks of Failing to Comply?
Failure to comply with regulator requirements regarding CSI can be a violation of law and could subject a person or entity to supervisory action, including the imposition of civil money penalties. In some instances, disclosure of CSI could also expose a person to criminal penalties.

So How Do the Parties Work Around This?
While CSI itself can’t be shared, other reports likely address criticisms arising in an examination. Under generally accepted accounting principles, the bank’s audit will likely describe any informal administrative action to which the bank is subject, and if the bank is a public company, its securities filings will likely describe administrative proceedings and any progress in complying with them. But if a bank is acquiring a bank in troubled condition, there is likely no substitute for seeing the administrative action to which the bank is subject. In that instance, the parties should build into their timetable the request for obtaining that information from the relevant regulator.

Fintech Action Cools in U.S., Soars Elsewhere


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Looking back over the last year, it is apparent that the fintech industry has become mainstream just as fintech investing cools. What I mean by this is that fintech has matured in the last five years, going from something that was embryonic and disruptive to something that is now mainstream and real. You only have to look at firms like Venmo and Stripe to see the change. Or you only have to consider the fact that regulators are now fully awake to the change and have deployed sandboxes and innovation programs. Or that banks are actively discussing their fintech innovation and investment programs. Or that institutions are being created around fintech like Innovate Finance or the Singapore Fintech Festival. Fintech and innovation is here to stay.

For me, the biggest impact has been how busy 2016 has been. Each year is busy, but this year has been amazing. A great example is that I travelled to four continents in six days recently. That’s unprecedented and, a century ago, wouldn’t have been possible. Today, it’s easy. We just jump on and off aircraft and go. What is particularly intriguing for me—and telling—is where I go. After all, as someone at the center of fintech, where I go shows where the action is. In 2016, I’ve been to Singapore, New York and, most recently, London, which are the three fintech hubs for Asia, America and Europe, respectively. But I’ve also been to Nairobi, Hong Kong, Washington and Berlin, all key fintech focal points. Nascent centers in Abu Dhabi, Dubai, Bangkok, Kuala Lumpur also are on the radar. So, too, are are Mexico City, Sao Paolo and Mumbai.

In fact, what intrigues me the most is the fact that fintech has bubbled over in 2016. The latest figures show that U.S. investing in fintech slowed in 2016, while Chinese investments went up. And that is probably the most sobering thought as we head towards the holiday season. Fintech reached its zenith in the U.S. in 2016. Prosper and Lending Club started to have to answer some hefty questions about their operations, and there is no major new digital bank in the U.S. Meanwhile, Chinese fintech investments soared in 2016, and Ant Financial, which operates the Alipay payment platform for the Chinese Alipay Group, has become one of the most talked about IPOs of the year.

In other words, China, India and Africa are where we are beginning to see the most amazing transformations through technology with finance. China has more fintech buzz than anywhere at the moment thanks in large part because of Ant Financials’ innovations. India is doing amazing things with technology, and Africa has seen the rise of mobile financial inclusion that is changing the game for everyone.

The key here is to keep your eyes and ears open to change. Too often, I encounter people—senior banking people—who believe that developments in economies they see as historically poor being irrelevant. They don’t recognize that those historically poor economies are becoming presently wealthy and future rich. They are missing a trick.

In fact, I would go as far as to propose that the economies that were historically poor are the ones that are reinventing banking and finance through technology. They have no legacy and have no constraints, so they are rethinking everything. Eventually, their ideas will become things we all use so ignore them at your peril.

Happy New Year!

Do the Regulators Want Bigger Banks?


big-banks-12-2-16.pngOne of the more intriguing story lines of the banking industry’s consolidation since the financial crisis is the persistent belief that federal regulators privately want a more concentrated industry with fewer banks because it would be easier for them to supervise, and they signal their support for this laissez-faire policy every time they approve an acquisition.

Consider this comment from a respondent to our 2017 Bank M&A Survey: “Regulators are actively trying to reduce the number of charters, to reduce their workload and to give them control, with fewer institutions to supervise. While they do not openly admit it, every agency has admitted to me that they would prefer fewer institutions. This will cause more consolidation.” Implicit in this perception is the assumption of regulatory bias against the thousands of small banks that dot the industry landscape. The aforementioned respondent to our survey was a director at a bank with less than $500 million in assets.

Are the regulators really guiding the industry’s consolidation with a hidden hand? Looking back to the mid-1980s, I think it’s impossible to argue that the last five presidents and 11 secretaries of the Treasury (not to mention numerous federal regulators) were opposed to the idea of consolidation as the industry shrunk from 14,884 insured institutions in 1984 to 6,058 as of June 2016, according to the Federal Deposit Insurance Corp. The most intense period of consolidation was probably a 20-year period, beginning in 1984, where the industry shrank to just 7,842 insured institutions by the end of 2003—nearly a 50 percent reduction!

I found this observation in a 2005 article in FDIC Banking Review, entitled “Consolidation in the U.S. Banking Industry: Is the Long, Strange Trip About to End?” “Over the two decades 1984 to 2003, the structure of the U.S. banking industry indeed underwent an almost unprecedented transformation—one marked by a substantial decline in the number of commercial banks and savings institutions and by a growing concentration of industry assets among a few dozen extremely large financial institutions. This is not news.” And if it wasn’t news in 2005, it certainly shouldn’t be news today.

I think a more interesting question is whether the collective governmental brainpower seriously considered the systemic ramifications of a more concentrated industry—especially the creation of megabanks like JPMorgan Chase & Co., Wells Fargo & Co. and Bank of America Corp. Those three institutions, along with Citigroup, rank as the four largest U.S. banks and collectively held 40 percent of the industry’s total deposits and 42 percent of its total assets as of September 2016, according to S&P Global Market Intelligence.

It was the fear that a large bank would fail during the financial crisis, worsening the situation even further, that led to the controversial and much criticized industry bailout and provided the emotional fuel in Congress to pass the Dodd-Frank Act. Even today, approximately seven years after the crisis passed, we are still debating whether another unofficial governmental policy from years past—too big to fail—could be deployed in times of emergency despite the efforts of the framers of Dodd-Frank to kill it once and for all. I would say that Washington ended up getting exactly what it had wanted over the last three decades—a more concentrated industry with fewer banks—but doesn’t seem to be very comfortable with the outcome.

Another interesting question is when will consolidation end? It’s taken as gospel that the four megabanks will not be allowed to do any more acquisitions because they’re already too large, and most of the M&A activity in recent years has been in the community bank sector, where individual banks do not pose a systemic threat to the economy. But is there a number at which point the regulators, Congress or some future presidential administration would say enough? A more concentrated industry poses systemic risks of its own, so does Washington reverse its laissez-faire policy when we reach 5,000 banks, or 3,500, or even 2,000?

If anyone in Washington has an answer to that question, I’d love to hear it. Then again, President-Elect Trump fits the description of a laissez-faire capitalist as well as anyone, so maybe he’ll let the banking industry seek its own final number.

How Technology Could Improve a Bank’s Audit


technology-6-28-16.png“It’s never simply the hammer that creates a finely crafted home. The result of the work hinges on the skills and experience of the carpenter who wields the tool.

So, too, it’s not so much the powerful cognitive intelligence software, the data and analytics tools, and the data visualization techniques that are beginning to open up opportunities for audit quality and insight enhancements from a financial statement audit. The skills and experiences of the auditors and their firms that implement these technological advancements will make the difference in the months and years ahead.”

When we think of the latest in technological innovations, we inevitably focus on the tools and techniques that benefit consumers. And, while that thinking is understandable, it would be a mistake to believe there are fewer technological advancement opportunities available for banks and other businesses. The litany of technological improvements include major commercial advances in the quality of databases, analytical capabilities and artificial intelligence.

In our world, one of the most compelling possibilities is the use of cognitive technology in the audit of financial statements. Cognitive technology enables greater collaboration between humans and information systems by providing the ability to learn over time and through repetition, to communicate in natural language and analyze massive amounts of data to deliver insights more quickly. Think of the improvements possible in the quality of audits when machine learning can be applied to deliver more actionable insights to guide and focus an auditor’s work or provide feedback on our perceptions of risks to an audit committee and management team at a bank.

While still in their infancy, there is vast potential in developing cognitive intelligence capabilities, especially given the exponential increase in the volume and variety of structured and unstructured data—this is particularly welcome given the ever increasing expectations on auditors, audit committees and management teams.

A prime example of an audit-based application of cognitive technology is the ability to test a bank’s grading or rating control over its loan portfolio. KPMG has developed a bold use case and is building a prototype that will machine “read” a bank’s credit loan files and provide a reasoned judgment on our view of the appropriate loan grade. The KPMG loan grade is compared to the bank grade, with our auditors focused on evaluating the loans with the greatest probability of a difference between the KPMG and bank loan grades.

While still in the development stage, we are encouraged by how cognitive intelligence could be applied to help us improve the quality of our bank audits. Currently, auditors carefully select a sample of loans to test from a bank’s loan portfolio. The sample is selected to provide both coverage of the loan types and grades, as well as where the auditor believes there is the greatest chance of loans being graded incorrectly. Aside from only reviewing a sample of the overall portfolio, today’s audit process is intensely manual. With the prototype being developed, the auditor would be able to select all the loans in a particular portfolio (say, oil and gas) or eventually the complete population of graded loans. The potential benefits to audit quality are very exciting—there is a distinct possibility that every loan in a banks’ portfolio could be reviewed and graded, while bringing outliers to an auditor’s attention. The bulk of the audit effort would then be focused on evaluating these potential outliers.

Further, using the combination of cognitive technologies, data visualization, predictive analytics, and overall digital automation would permit a much more granular evaluation of a bank’s enormous pool of internal and external information. Consider the potential insights that could be extracted when these powerful tools are linked to sources of market indicators. Looking into the future, the possibility exists for building a loan-grading tool to focus on grading commercial mortgage real estate loans tied to a market index of credit-quality values on commercial mortgage bonds, for example.

A tool that reviews changes in the market index against changes in a bank’s portfolio of commercial mortgage real estate loans could both improve audit quality and provide valuable insights into whether the two are consistent. If they are not consistent, those working with this technology—who are freed up from the manual duties–could spend valuable time determining whether or not there is any valid explanation for the inconsistency, better assess the remaining audit risk, and pass along the findings to a bank’s management and audit committee.

And, since such a tool would not be used in a vacuum, each bank’s results and weighted average loan grade could be compared across our portfolio of clients or a select segment of similarly sized institutions.

Even though cognitive intelligence is a powerful tool, it is important to remember that it is just a tool. The real value in cognitive and artificial intelligence is in its ability to allow human beings—in this case bank auditors—the time to think about, and respond to, the results of the testing, then work with audit committees to develop innovative solutions to real-world challenges confronting the industry.

Trends Emerging in Compensation Policies for Bank Executives


Governance policies related to executive compensation are on the rise as a result of increased influence of bank regulators, shareholders and the Securities and Exchange Commission (SEC). These policies are intended to reduce compensation-related risk, encourage a long-term perspective and align executives with shareholder interests.

Meridian’s 2015 proxy research of banks with $10 billion to $400 billion in assets illustrates the prevalence of “standard” and “emerging” practices. Standard practices tend to be common regardless of asset size. Emerging practices are more prevalent at larger banks, but are likely to cascade to community banks over time.

Policies on Risk Adjusting Payoutsrisk-adjustment.PNG
Standard: Clawback Policies
Clawback policies allow the recovery of incentive compensation that has already been paid or vested when there has been a financial restatement and/or significant misconduct. Most banks currently have clawback policies; however, these may need to be revisited once the SEC issues final clawback rules. While many existing policies allow compensation committee discretion to seek recovery, the proposed rules (July 2015) would require a mandatory clawback of “excess” incentive pay in the event of an accounting restatement.

Emerging: Forfeiture Provisions
While clawback policies seek to recover awards already paid, forfeiture provisions provide for the reduction of incentive payouts and/or unvested awards based on negative risk outcomes such as  a lack of compliance with risk policies. While these provisions are standard at large banks that have faced significant regulatory scrutiny, they are only beginning to be used at smaller banks.

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Standard: Anti-Hedging Policies
Anti-hedging policies prevent executives and directors from participating in transactions that protect against or offset any decrease in the market value of company stock. Such transactions could create misalignment between shareholders and executives since executives would not suffer the same losses as shareholders if the share price drops.

The SEC’s proposed rule (issued February 2015) requires companies to disclose the types of hedging transactions (if any) allowed and the types prohibited for both employees and directors. As seen in our study, most banks already disclose formal anti-hedging policies.

Emerging: Pledging Policies
Pledging policies prevent or limit executives’ and directors’ ability to pledge company shares as collateral for loans. Pledged company stock creates a risk that executives may be forced to sell shares at a depressed stock price in order to raise cash to cover the loan margin, which could further the decline in stock price.

However, some companies allow limited pledging with pre-approval. Pledging enables executives to monetize share holdings without selling company stock. Since 2006, public companies have been required to disclose the amount of company stock pledged by executives and directors. Proxy advisory firms and shareholders typically criticize only significant levels of pledging.

Policies on Retention of Stock AwardsStock-retention.PNG
Standard: Stock Ownership Guidelines
Over 80 percent of banks in our study have stock ownership guidelines that require executives to maintain a minimum level of ownership. Ownership guidelines are typically defined as a multiple of base salary. For CEOs, the most common ownership requirement is five times base salary, while other executives range between one times and three times base salary.

Emerging: Post-Vesting Stock Holding Requirements
Many investors and shareholder advisory firms have started pushing for additional stock holding requirements. Holding requirements restrict executives from selling stock earned from equity awards or option exercises for a period of time after vesting or exercise. Some holding requirements require executives to hold a percentage of shares until ownership guidelines are met. More rigorous policies require executives to hold a percentage of shares for a set period of time (e.g., one year after vesting) or until (or even after) retirement.

Banks have been ahead of many industries in adopting these governance practices as a result of the regulatory scrutiny on compensation programs, and we expect the emerging practices will continue to gain in prevalence across banks of all sizes.

Fighting Off the Activists


3-2-15-CommerceSt.pngShareholder activism is on the rise and has become an increasingly relevant topic in boardrooms throughout the country. The regional and community banking sectors have also seen an increase in activist investors submitting shareholder proposals. The adage is true: The best defense is a good offense. With activist investors, the best defense is maintaining an extremely efficient, profitable bank with performance metrics and key operating ratios in the top quartile of a realistic peer group.  If this does not describe your situation, then your bank may prove an ideal target for an activist. An honest, objective assessment of a bank’s susceptibility to an activist, as well as strategic preparation about the bank board’s initial response will largely dictate the outcome of an activist’s approach. 

Regulatory structures, such as passivity agreements and certain requirements of the Bank Holding Company Act of 1956 (i.e. acting in concert), offer management advantages that are not available to non-banks. However, regulatory impediments generally do not provide much of a deterrent to activists who support their cases with empirical evidence designed to gather the support of other shareholders. More importantly, the playbook for an activist defense too often results in some form of capitulation to an activist. It is not uncommon for an activist to be awarded a board seat or for the target to be forced into announcing a review of its strategic alternatives. While arguably a compromise, too often those concessions are akin to letting the fox in the henhouse and simply put, things are never the same.

Accordingly, even with regulatory protections or other structural impediments that a company may have to slow down an activist, if a board has concerns about its vulnerability to an activist, it would be wise to seek the advice of experienced investment bankers.  Even if the board does not have concerns, it is wise to consult with an investment bank that has not been involved in the business activities of the bank or its holding companies, and is experienced in activism. The investment bankers can provide an independent assessment of the bank along with the available strategies and appropriate tactics to respond to the activist. The investment banker should be prepared to provide underperforming banks with strategic advice on the steps to be taken to increase the profitability of the bank and simultaneously prepare a strategic plan to fend off the unwanted advances of an activist. The plans need to be anticipatory in nature. If the board begins to plan only after an attack, its actions are reactive and the activist is in control of the situation.

When an activist calls, it is often the temptation for management to recommend that the board reject or stonewall the initial foray against the target or as described above, quickly compromise. The circle-the- wagons approach provides the activist just the type of unreasonable response that may garner support for the activist cause.  Failure by management to communicate with the activist shareholder is usually the response that motivates other shareholders to immediately align with the activist. 

Activists do not initiate contact without specific reasoning to put forward valid shareholder proposals. The typical activist is looking for ways to maximize the value of its investment rather than run the bank or remove mangers.The failure to recognize this point causes most targets to act unreasonably and cause the activist to pursue that very strategy of removal. Rather than an out-of-hand rejection, the board should give the activists’ recommendations serious consideration. In some situations, compromise or embracing the viable ideas of an activist may actually have some merit and show that the board is reasonable and confident that it has a plan to address shareholders’ concerns. Whatever the initial reaction by the target, it should not be based on a hasty decision-making process. 

Although it may be wise to give studied consideration to shareholder proposals, this is a far cry from acceptance. In the initial phases of a discussion, the board should consider the ultimate objective of the activist. Is this activist a long-term investor interested in a strategic acquisition? Is he a short-term investor interested in receiving a higher price in the near term? Or, regardless of the investment holding period, is he interested in putting the bank in play in order to precipitate a takeover and obtain a higher price for all shareholders? The ultimate objective of an activist, which can evolve as circumstances change, will often dictate the appropriate corporate response. The board needs to demonstrate it is acting in the best interests of all shareholders and exercising is its fiduciary duties in good faith.

This Is Not Your Granddad’s M&A


1-26-15-Naomi.pngDoing a bank M&A deal is nothing like it was just a few short years ago. The regulatory environment has changed substantially. The process takes longer and due diligence is much more involved than ever before, said speakers at Bank Director’s Acquire or Be Acquired Conference on Monday, an annual three-day conference in Scottsdale, Arizona, that attracted more than 800 attendees this year. 

While deal pricing has improved, as well as the sheer number of buyers and sellers in the market looking to do a deal, actually getting from transaction to completion is somewhat of a challenge, speakers said. For one, regulators are scrutinizing both buyers and sellers for any regulatory compliance issues. A few years ago, it wasn’t a big deal if a seller had some compliance problems.  It was assumed that the buyer would take care of them. That’s not always the case anymore, and sellers should try to clean up their problems, both from a regulatory standpoint and also to make themselves more valuable to potential buyers.

John Dugan, a partner at the law firm Covington & Burling LLP, and former comptroller of the currency from 2005 to 2010, said banks need to anticipate regulatory questions and potential delays as well as address with regulators how the bank will handle the increased compliance demands of becoming a larger institution, he said. Banks that reach the thresholds of $10 billion or $50 billion in assets following an acquisition will have adhere to  new sets of regulations. For example, at $10 billion in assets, banks must undergo stress testing and their debit fee income will be cut substantially due to a provision in the Dodd-Frank Act.

Dugan said his firm has seen an increase in Community Reinvestment Act protests following the announcement of a deal. Buyers and sellers should have at least a satisfactory rating on CRA exams.

 “It used to be larger institutions that were targeted, and now [advocacy] groups are going [after] smaller institutions,’’ Dugan said. Such challenges can delay the closing of an acquisition. Some compliance problems are especially serious.  “If there is a BSA (Bank Secrecy Act) issue at hand, it is almost certainly a deal killer,” Dugan said. 

Speakers at the conference emphasized the importance of talking to the bank’s regulators regularly to inform them of the bank’s plans to make acquisitions, and to inform them well in advance of a deal announcement to get a sense of whether the deal will be approved. Regulators will rarely say anything definitive, but could provide a good indication of potential problems.

“The days are gone of calling your regulator the night before a deal,’’ said Eric Luse, a partner at the law firm Luse Gorman PC, in Washington, D.C.

Regulators are less likely to share information with a buyer about a potential acquisition target than in years past, Dugan said. There was a time when  it was common for a buyer to send someone to attend board meetings of the seller after a deal had been signed, but regulators are increasingly asserting that practice is taking control over the organization before the deal is final, said John Freechack, a partner at Barack Ferrazzano Kirschbaum & Nagelberg LLP in Chicago. Regulators also are pushing back against deal language that protects a buyer by allowing a buyer to refuse the seller’s approval  of certain sized loans in advance of the closing of the deal.

The M&A process in general takes longer to complete. Al Laufenberg, a managing director at investment bank Keefe, Bruyette & Woods, said deals that took five to six months from announcement to closing a few years ago are now taking eight or nine months. Part of that is the longer timeframe to get regulatory approval. But buyers and sellers are spending more time on due diligence as well. Buyers are spending extra time scrutinizing other issues alongside credit quality, including cyber security policies and regulatory compliance, he said. Buyers may spend only two days on loan quality and 25 days reviewing cyber security and compliance with regulations, he said. 

Building in extra time to do a deal and ensure good regulatory relations could make a huge difference in successful deal-making. 

Four Ways Board Members Can Avoid Personal Liability


9-24-14-Dinsmore.pngOn top of everything else bank board members must think about these days, they must also consider and avoid their own exposure to personal liability for actions taken (or not taken) in connection with their board duties. What can you do to avoid personal liability?

  1. Good corporate governance is the first line of defense for a board of directors. With today’s demanding regulatory climate, bank boards are being held more accountable than ever. Directors need to go back to the basics. Understanding the duties of care and loyalty are the foundation of corporate governance and properly documenting actions taken at the board meetings provides evidence that directors exercised their fiduciary duties.

    Beyond this, regulators are asking, “Was the board informed?” and “Did the board approve this?” The key to avoiding personal liability is to stay informed of important decisions by management. There are legal protections in most states for boards that make judgments in the course of business. The board can show it exercised business judgment by documenting the decision-making process with full disclosure, including any discussions fully disclosed in the minutes. Each individual director is obligated to speak up and challenge management.

  2. Engaged independent, outside directors can strengthen a board’s exercise of its fiduciary duties. Though most Federal Deposit Insurance Corp. lawsuits against bank directors have come out of bank failures, with the creation of the Consumer Financial Protection Bureau and the increasing role of shareholder activists, we may see heightened scrutiny on boards with an eye towards damages should the bank sell, falter, or fail. Engaged, independent directors have an important role to play in protecting the board. They should hold regular executive sessions without management, and these sessions also should be documented. In keeping with this concept, it is effective for the board to name a lead independent director who will guide executive sessions and secure the minutes. The lead outside director should also communicate with management.
  3. A knowledgeable director is a good director. Having an appropriately educated board is good for the bank, good for the individual director, and looked on favorably by the regulators. Directors would be wise to undertake risk management education, with content appropriate for the size and scope of the bank. The test applied by the regulators is whether the board is knowledgeable enough to understand the risks attendant to the bank’s operations and product lines (existing and planned), and to challenge management’s analysis of such risks and the proposed action plans to mitigate or take advantage of them. This is not to suggest that directors need to be experts in, for example, designing a capital or liquidity stress test model, but directors are expected to understand management’s analysis of the output in order to effectively guide the bank’s decision-making process.

    A best practice is to develop and adopt a director education policy/program that includes, at a minimum, the following:

    • general description of subject matter expected to be covered and updated annually;
    • number of hours/days of education expected for the year;
      acceptable forms of education—external, internal, self-study, trade association seminars, etc.
    • who pays the cost (including travel);
    • whether attendance/completion will be included in annual director evaluations; and
    • assignment of responsibility for documenting, monitoring and reporting on compliance with the policy.
  4. Paying attention to and engaging with your regulators will reduce your risk of serving on a bank board. A bank director’s primary responsibilities vis-a-vis the bank’s regulators are:

    • to review and understand regulatory reports and other correspondence from the regulator;
    • to formulate corrective action to address issues/deficiencies identified in regulatory reports;
    • to assign responsibility to appropriate bank management or staff for implementation of corrective action;
    • to monitor and manage the progress of corrective action to its timely and effective completion; and
    • to maintain an open line of communication with the bank’s examiner in charge and others within the regulatory agency, as appropriate.

These responsibilities apply whether your bank is well managed, highly profitable, and well capitalized or subject to a formal enforcement action. If your bank finds itself in the latter category, the risk of personal liability is significantly higher. The federal regulatory agencies have little patience for boards that do not take seriously their responsibility to “fix the problems” and are quick to threaten and impose civil money penalties where timely, effective and complete corrective action is not taken. Timely and open communication with the regulators is also important, especially where corrective action deadlines will not be met. Regulators are human too, and like most of us, they hate bad news surprises.

Bank board members need to keep personal liability top of mind. These four practices may not be complete safe harbors, but they will go a long way to helping protect personal assets.

What to Do When Caught Between Investors and Regulators


hands-tied.jpgIt’s tough to please both regulators and shareholders these days, especially when they want contradictory things. Take the case of executive compensation.

Shareholder groups have been pushing for a greater tie between performance and executive pay. One of the most powerful of these, Institutional Shareholder Services, screens executive pay packages to see how they stack up against peers relative to performance and how the change in CEO pay mirrors change in total shareholder value over five years. ISS recommendations to shareholders on such matters can strongly influence a company’s say-on-pay shareholder advisory vote. Umpqua Holdings Corp. and other banks found this out, as described in a recent story in Bank Director magazine.

But looking at the stock price and shareholder value is exactly what regulators don’t like.

Jim Nelson, a senior vice president of supervision and regulator for the Federal Reserve Bank of Chicago overseeing large banks and savings institutions, is concerned with the use of stock price or return on equity as a measure of performance in making pay determinations. Return on equity doesn’t factor in the risk that executives might be taking to achieve such returns, he said at Bank Director’s Bank Executive & Board Compensation conference recently in Chicago.  There are many factors that can influence the stock price which are outside the realm of management’s control, he said.

“We think most of the people in the firm don’t have a direct impact on the value of the stock price,’’ he said. “We’re looking for a measurement tied to something that that person does control.”

Regulators also explained how they feel about shareholders in their 2010 Guidance on Sound Incentive Compensation Policies, which applies to all banks and thrifts.

The joint regulatory guidance says “shareholders of a banking organization in some cases may be willing to tolerate a degree of risk that is inconsistent with the organization’s safety and soundness.”

So there’s the rub. Do you please shareholders or do you please regulators? But there are ways to combine the concerns of both.

“It’s not the amount [of bonus or incentive pay],’’ Nelson said. “What we’re looking at is the arrangements. You should reward individuals who are producing an attractive risk-adjusted return for you. If they are making more money with low risk, they should be paid more than someone who is making money with high risk. I think that is aligned with what shareholders want and the board wants. There is a lot more free enterprise in this approach than people think.”

He said some big banks are adjusting their profits based on risk metrics before handing out bonuses.

Meanwhile, big banks also are taking into account the needs of shareholders and the recommendations of shareholder advisory groups. Tying short and long-term bonuses, at least in part, to shareholder return is one way to do that.

For example, Buffalo, New York-based First Niagara Financial Corp., one of the nation’s 25 largest bank holding companies with $35 billion in assets, paid out long term incentives to top executives in three ways: stock options, time-vested restricted stock and performance-based restricted stock that vests in three years based on total shareholder return relative to the SNL Mid-Cap Bank Index.

Barbara Jeremiah, a First Niagara director who chairs it compensation committee, said when the bank ran into troubles trying to raise capital for its acquisition last May of HSBC branches in New York and had to cut its dividend in half, the board recognized the hit shareholders took and wasn’t locked into paying short-term bonuses based on earnings per share. The board had made sure it had some level of discretion in determining the bonus, she said.

The board adjusted incentive compensation for CEO John Koelmel to reflect the decline in stock price and reduction of the dividend. Jeremiah encouraged compensation committee members and human resources directors at the Bank Director conference to read and stay abreast of how others viewed executive pay, making note of an article by Gretchen Morgenson of The New York Times entitled  “C.E.O.’s and the Pay-‘Em-or-Lose-‘Em Myth.”

 “We need to keep that outside view,’’ Jeremiah said. “How do our customers and others view us?”

How to Win the Regulators’ Approval


As banks are expected to follow more strenuous regulations and requirements, one thing that can help ease the load on the board is having a good relationship with the regulators. There are simple ways directors can improve in this area, and as with most relationships, it comes down to two main principles: communication and engagement. 

What steps should bank boards be taking to ensure that they maintain a good working relationship with the regulators?

Ralph-Sharpe.jpgTransparency, honesty and timeliness are essential; never hide or sugarcoat bad news. Provide realistic projections—better to understate and over-perform. Be engaged; welcome opportunities to meet with examiners—with or without management, and in and out of board meetings. Ask questions, and listen to the answers. If you disagree, do so respectfully.

Stay informed and keep up with regulatory developments. Read the Office of the Comptroller of the Currency’s Director’s Book (available online) and attend regulator outreach sessions when offered. Assign a regulatory liaison to ensure timely and complete responses are provided to examiners for things such as Matters Requiring Attention (MRAs), but don’t bury examiners in paperwork.

Finally, learn the business of your bank. Know the difference between being a director instead of an investor.

—Ralph Sharpe, Venable

geiringer.jpgAs a former regulator, I find that I sometimes need to remind directors that examiners are people too, and that how they are treated during examinations can directly impact your bank’s ratings. Directors need to set the “tone at the top” that everyone at the bank should treat examiners with courtesy and respect, take seriously any reasonable suggestions that they make, and handle any disagreements with as much civility as possible under the circumstances.

Directors themselves can build better relations with regulators by sending representatives to key meetings with examiners and occasionally requesting executive sessions with them to discuss issues outside the presence of management. Of course the best way for a bank board to maintain a good working relationship with regulators is to oversee a safe and sound bank.

—John Geiringer, Barack Ferrazzano

Cliff-Stanford.jpgMeetings with regulators, such as exit meetings, are crucial opportunities to listen and to seek clarification of points raised by the regulators. This does not mean that directors should be passive or should not register concerns or objections to factual inaccuracies. However, arguing and cementing a position on a “judgment call” issue during a meeting with examiners can often lead the examiners to cement their own in return, hurting the chances that directors can influence the perception of the bank’s performance.

Remember the placard from the British Government during World War II– “keep calm and carry on.” Examiners will have findings, sometimes in the form of Matters Requiring Attention by the Board, but often there are simple (not necessarily easy) steps to be taken. Directors will show much good faith and earn credibility with examiners by concerted engagement to drive management to address key regulatory concerns promptly.

Finally, remember that regulators have bosses and careers, and operate in a fast-moving regulatory environment just as banks do. Directors that show an appreciation for the challenges faced by regulators will create a store of goodwill that can only help their bank.

—Cliff Stanford, Alston & Bird

Angelee-Harris.jpgBuild your own communication lines with regulators. Rather than relying solely on management to maintain primary contact with regulators, authorize your chairman, audit committee head and perhaps your compensation committee chairman to meet face-to-face with primary regulatory contacts. After that, be sure to maintain consistent communication on behalf of the board.

Be honest with regulators and seek their guidance. When regulatory issues occur, alert regulators early and disclose all known facts—no matter how negative. There is oftentimes a tendency to downplay negative details or dribble out full details over time. These actions erode a regulator’s trust. Instead, talk early and often to regulators. Admit when you need to get back to them with more facts. Do not assert facts you cannot support. Regulators are a key resource, so be open to ask them for advice and guidance.

Try to see issues from a regulatory viewpoint. Like banks, regulators work in an environment of heightened scrutiny and could be called to task for failure to conduct full diligence or take proper action. Anticipating and offering to provide the proper access and information a regulator needs to fulfill her duties will go a long way to maintaining good regulatory working relationships.

—Angelee Harris, Manatt Phelps & Phillips