from shareholders because they provide a tax-advantaged mechanism for repaying the debt. After the debt has been repaid, however, many community banks view the holding company as an administrative inconvenience. But holding companies actually have advantages that community banks often overlook. These advantages more than offset the nominal costs of maintaining a holding company and should encourage community banks to consider establishing them. Some of the advantages: Borrowing capacity. Unlike banks, bank holding companies, or BHCs, can borrow money, which means they can fund an acquisition, buy back stock, or raise capital for a subsidiary bank without diluting shareholders' interests. BHCs can service holding company debt with nontaxable bank dividends and with the tax savings resulting from the ability to file a consolidated federal income tax return. This makes holding company debt more tax-efficient than individual debt, which must be serviced with after-tax dollars. Repurchase of stock. A BHC has much greater legal authority to purchase or redeem its own stock, using life insurance proceeds, borrowed funds, or dividends from its subsidiary bank, subject to certain limitations. Accordingly, the ownership of BHC stock may be more attractive to shareholders than bank stock. Compensation. A BHC also provides greater flexibility for compensating individuals who provide strategic direction for the bank, but who may not be receiving compensation. Because there are fewer regulatory requirements for deferred compensation plans (such as salary continuation plans and director deferral plans) at the BHC level, the administrative costs of those plans may be lower. Flexibility. The BHC would own 100% of the bank stock. Accordingly, the BHC's board can amend the bank's articles - without shareholder approval - to effect many changes, including changing the bank's name, domicile, or head office; expanding indemnification; and limiting director liability. Future acquisitions. Banks can use a BHC as a vehicle for making acquisitions. BHCs often can give banks the flexibility they need to obtain the desired corporate or personal tax treatment for a transaction. A BHC also gives banks the option of acquiring another institution and operating it as a separate entity. Expanded powers. BHCs generally have greater authority, under the Bank Holding Company Act, to conduct permitted nonbanking activities, which can generate fee income. Filing fees. State regulators and the Comptroller of the Currency impose fees on a wide range of corporate activities, but the Fed does not impose such fees on BHCs. The two most likely structures for forming a BHC are an exchange agreement and a merger. Through an exchange agreement, the holders of bank common stock would exchange their shares for BHC common stock. With a merger, an interim bank or company is formed for the sole purpose of merging into the existing bank. The main advantage of choosing the exchange option is that it is cheaper and simpler. The disadvantage is that, unless the bank stock is held by a small group, all generally in the bank's community, it is unlikely that the BHC will acquire 100% of the bank. As a result, dividends from the bank to the BHC would be siphoned off to minority shareholders who may not even have responded to the offer of BHC stock for bank stock. In other words, an exchange is a voluntary transaction. Shareholders must take action. If they do nothing, they remain bank shareholders. A second disadvantage to an exchange is that typically the exemptions from registration under the securities laws are more limited in scope than those applicable to a merger. As a result, depending upon the number of shareholders and their characteristics, an exchange might actually wind up costing more than a merger. If the merger option is chosen, shareholders of the bank receive BHC stock. If the holders of the outstanding shares vote in favor, then the merger will occur. Shareholders who do not like the offer usually can perfect their dissenters' rights. The BHC becomes the sole shareholder of the bank. Even if shareholders do not take any action, they are no longer shareholders of the bank. Their sole right is to receive the consideration offered in the merger. There are two primary advantages to a merger. First, there are typically exemptions from registration under the state securities laws. Second, in a merger, the BHC would acquire 100% of the bank stock, thereby receiving all dividends paid by the bank. The disadvantages are, first, that shareholders can dissent and receive the appraised fair value of their shares in cash. Second, a merger tends to be more costly. The BHC must obtain regulatory approval to form the interim bank or company and merge it into the existing bank. In addition, depending upon the circumstances, the disclosure document for a merger may be more expensive to draft than for an exchange among a very small number of shareholders. There are three exemptions to federal registration that are typically used in connection with a BHC formation. First, if, as a result of the BHC formation, shareholders of the bank will receive the same percentage of the stock of the BHC (other than as a result of shareholders' perfecting their dissenters' rights), then there is an exemption from registration. The other two exemptions typically used on a federal basis are for offerings entirely directed to residents of a particular state and offerings to a limited number of individuals plus an unlimited number of "accredited investors." "Accredited investors" include individuals who, because of their high net worth or high earnings are deemed to be sophisticated enough not to need much additional protection. The test of accredited investor status includes individuals who have earned more than $200,000 in each of the last two years, or individuals who have net worth of more than $1 million. On a state basis, there is typically an exemption for merger transactions. Some states even have exemptions for bank holding company formations. Other than those two exemptions, the typical state exemptions are for offerings to a limited number of individuals. Typically, these offerings require that such individuals be both "sophisticated" (engage in investments generally, or have a representative that engages in investments generally and have certain indicators of economic sophistication) and are "well informed" (such as by receipt of a disclosure document). The formation of the BHC would require the preparation and filing of an application to the Federal Reserve for prior approval of the BHC formation. The formation of the BHC also may require applications to the bank's regulators. In the case of a merger transaction, an application at the bank level is always required. In the case of an exchange, a BHC application is generally required in the case of a BHC being formed to acquire a state bank, but is not for a national bank. Although a BHC is not the be-all and end-all for community banks, the powers and flexibility of a BHC can significantly enhance the options available to bank owners. Peter G. Weinstock is a partner in the financial institutions section of Jenkens & Gilchrist, a Dallas-based law firm.
