Equity Issue Helped Sway 1st Interstate

When First Interstate Bancorp's board met on Jan. 19 to review its ailing merger pact with First Bank System, bad news was waiting.

The Securities and Exchange Commission had dealt the agreement a near fatal blow the preceding evening, and Wells Fargo & Co.'s hostile bid was growing in value.

And there was one more surprise for the board: To make First Bank's $10 billion offer for Interstate work under accounting rules governing pooling- of-interest transactions, First Bank System could have to issue as much as $230 million in new equity.

The disclosure - which came to light in a recent Wells Fargo regulatory filing and was confirmed by an executive at First Bank and advisers and board members at First Interstate - helped push the target bank's board toward the decision it had been resisting. That day, First Interstate decided to negotiate with its upstate rival.

The episode illustrates a problem a number of banks may face in the future. Like First Bank, many banks have been aggressively repurchasing their stock and, at the same time, laying plans to merge through stock swaps.

For several years, the Minneapolis-based First Bank had been buying large numbers of its shares. But in a pooling, no more than 10% of all shares issued can have been repurchased in the preceding two years.

If a pooling is over the 10% level, a company can reissue shares to clear the merger, and this was First Bank's plan.

"There is a fine line that companies run through in their capital acquisition programs, and this illustrates the capital vulnerability in pooling transactions," said Eugene McQuade, a partner at Price Waterhouse.

Executives at First Bank and First Interstate's advisers said they had known of the possible need for additional equity for some time, but chose not to disclose it because they concluded the figure was unlikely to reach as high as $230 million.

Indeed, Susan Lester, now First Bank's chief financial officer, says the actual size of the issue would have been far less - to the point of being immaterial. First Bank maintains the issue would have been about $40 million.

In general, companies are hesitant to issue more equity because it dilutes the holdings of current shareholders.

Even if the company had to issue $230 million in new equity, it would have diluted earnings by only about 2%, analysts said.

Analysts said a 2% dilution would not have been much of a hit to earnings. But they said the need to issue any equity showed that First Bank was stretching its deal's structure to compete with Wells' bid, which the market favored.

"It underlines the sort of consequences of skating close to the edge of the rules on buybacks and pooling," said Felice Gelman, a bank analyst with Keefe Partners. "In order to succeed, they had to structure the deal aggressively."

By the time First Bank withdrew, its bid was roughly $1.5 billion less than Wells' bid.

The news that additional equity would be required to clear the First Bank merger helped convince the First Interstate board to negotiate with hostile suitor Wells, according to a federal document filed earlier this month by the San Francisco company.

At the Jan. 19 meeting, the board learned the SEC had ruled against First Bank's critical share repurchase plan, and then was told of the need for new equity.

"It was a surprise to me," director George M. Keller said of the $230 million figure. "We knew that it could happen, but didn't appreciate it could be of that size or could be necessary at all."

These accounting issues combined with the higher market value of Wells' offer to force the board's hand, said Mr. Keller, the retired chairman of Chevron Corp. Instead of pursuing what he termed a better long-term deal with First Bank, Interstate was compelled to merge with Wells Fargo.

During the two-and-a-half-month bidding war, First Bank said there were no pooling hangups.

David Berry, director of research at Keefe, Bruyette & Woods Inc., said if the bank had disclosed the need to reissue shares, it would have made the proposal less attractive.

On Nov. 6, when First Bank announced its merger agreement, the bank calculated that 1.75 million First Interstate shares would have had to be issued. That would have meant raising $227.5 million, since the Los Angeles bank's stock was trading at about $130 around that time.

But Ms. Lester said the real figure would have been lower by the close of the merger because more than one million of the shares would have been cleansed through already planned employee stock options programs and another pending transaction.

Because the final stock reissuance for the First Interstate merger would have been in the range of $40 million, "it just didn't seem like the market needed to know," she said. Ms. Lester questioned why Wells Fargo's amended registration statement, or S-4, mentioned the reissued shares.

Mr. Keller, the Interstate board member, said Wells likely put the issue in the S-4 to make the point its bid was always better.

In that document, filed with the SEC earlier this month, Wells outlined the critical days leading up to First Interstate's change of heart.

The board met on Jan. 16 to discuss whether investors were likely to approve the First Bank deal given the fact Wells' bid was worth nearly $1.5 billion more.

At the board's next meeting, on Jan. 19, members were informed of the SEC decision and the equity reissuance.

"First Interstate management and the First Interstate financial advisers reviewed the potential impact of the suspension of repurchases and the reissuance of First Interstate common stock on ... a combined First Bank/First Interstate entity," Wells said in its filing.

"After considering these matters, the First Interstate board ... authorize(d) management and First Interstate's legal and financial advisers to participate in discussions and negotiations with Wells Fargo concerning the possibility of a merger of the two companies."

On Jan. 24, Interstate announced it would merge with Wells.

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