Lowering the Hurdles to Open-Bank Assistance

There has been much talk recently, but little accomplished, on the open-bank assistance front. In reality, open-bank assistance transactions are complex, multiparty transactions that are extremely difficult to implement in the time frame available to most troubled institutions.

Open-bank transactions prior to the Financial Institutions Reform, Recovery, and Enforcement Act - the First City transaction, for example - generally took over a year to implement. The environment in which they were completed did not offer a prompt and comprehensive closed-bank alternative to the Federal Deposit Insurance Corp.

Little Time to Waste

In light of congressional and regulatory pressures today, the life span of a troubled banking institution may be insufficient to pursue such time-consuming alternatives.

The moment the institution publicly acknowledges its need for early resolution or open-bank assistance, liquidity pressures can be expected to build, shortening the time available to pursue an open-bank resolution.

Federal Reserve loans to bridge liquidity problems can no longer be viewed as anything but short-term aid - 60 to 90 days. Traditional open-bank transactions usually require shareholder and bondholder consents, which are subject to lengthy procedural requirements of the Securities and Exchange Commission and state law, along with a lengthy negotiation process.

Open-bank assistance transactions require a new approach. Since they will be measured against closed-bank alternatives, this new approach must allow open-bank transactions to compete on an equal basis. This article sets forth such an approach.

Stumbling Blocks to Assistance

Economics is a major hurdle to implementing an open-bank assistance transaction. The applicant and its financial partners must be able to satisfy the 14 criteria set forth in the Federal Deposit Insurance Corp.'s 1990 policy statement on open bank assistance.

They must establish, among other things, that the proposal will cost the FDIC less than other available alternatives, while providing reasonable assurance of the future viability of the institution.

The FDIC will be required to conduct a market test of the transaction, and may feel compelled to solicit bids for closed-bank alternatives.

Consider, for example, First Union Corp.'s recent agreement with the FDIC to purchase assets and liabilities of Southeast Banking Corp. In the closed-bank context, the FDIC is exploring alternatives such as risk-sharing arrangements to obtain many of the economic benefits traditionally associated with open-bank transactions.

On the Plus Side

Many economic advantages can be obtained only in the context of an open-bank transaction:

* The ability, in at least some instances, to avoid marking the bank's assets to market. This will preserve existing reserves and capital, to absorb future losses.

* Maximum preservation of the existing franchise.

* Infusion of new equity into the system, since open-bank assistance transactions would often involve private investors rather than industry participants.

* Avoidance of certain receivership costs.

These must be compared with certain economic benefits of a closed-bank alternative, such as the ability to repudiate some types of lease and other obligations of the bank.

Even if an economically attractive open-bank proposal can be structured, the question still remains: How can such a transaction be facilitated in the available time period?

Role for Conservatorship

The new conservatorship powers of the Office of the Comptroller of the Currency and the FDIC, under FIRREA, provide a simple, basic concept for timely implementation of an open-bank resolution.

First, a capital infusion and an open-bank assistance package would be worked out by a new investor, the holding company, its subsidiary bank, and the FDIC.

Second, the OCC would appoint a conservator for the bank, with consent of its board of directors and the holding company, the bank's sole stockholder. While under control of the conservator, the bank would be recapitalized by the investor, and the FDIC would execute an assistance agreement.

Once the bank is restored to safe and sound condition, by recapitalization and the assistance agreement, the conservatorship would be terminated. The conservatorship would last just the few hours needed to execute the documents and implement the recapitalization.

Points of Law

The bank's utilization of the conservatorship structure, and the exercise of conservator's powers by the regulators, are appropriate and lawful:

* The Bank Conservation Act, as amended by FIRREA, permits the use of conservatorship powers as proposed.

* State corporate laws do not generally require holding company shareholders to vote on conservatorship; and federal law would override any state law limitation.

* Neither the terms of the holding company's debt instruments nor state law relating to creditors' rights should enable creditors to block the conservatorship.

There is no constitutional objection of merit to the conservatorship proposal. Conservatorship is responsive to concerns of potential investors that a traditional open-bank resolution would take months to implement because of the need for holding company shareholder approval and an exchange offer with its bondholders.

Protecting Value

Most important, from a public policy perspective, the conservatorship would assure that the bank does not close. This would protect the value of the bank's franchise and minimize the cost of resolution to be borne by the FDIC.

In a model transaction, the OCC would appoint a conservator for the bank, with consent of its board of directors. To bolster this decision, the OCC could cite its independent findings to support the appointment of a conservator.

Although not essential, the holding company's board of directors could also approve the appointment.

The rationale for conservatorship would be to provide immediate recapitalization as a protection for the bank's depositors and customers, to avoid a risk of closure, and as the only available alternative likely to provide some return to "stakeholders" - as the holding company's securityholders are termed.

Recapitalization

A conservator, once appointed, gains "all the powers of the shareholders, directors, and officers of the bank." These powers allow the conservator to implement a recapitalization of the bank without the delay traditionally involved in obtaining stockholder consents.

In a model transaction, the conservator would immediately exercise its powers to reclassify shares of the bank's capital stock into, for example, Class A common stock and Class B preferred stock. Class A common stock would be issued to the investor in exchange for a cash payment to the bank. This investment would be made simultaneously with, and subject to, the execution of an assistance agreement between the bank and the FDIC.

Stock Conversion

The bank's common stock held by the holding company would be converted into Class B preferred stock. The Class B preferred could even be a contingent equity security with value tied to performance of the bank's troubled assets.

If the bank held any intercompany debt obligations to the holding company, they would be exchanged for common equity of the bank prior to the reclassification. Thus, in the reclassification transaction, they would be exchanged into the Class B preferred stock.

Alternative recapitalization structures involving a merger, sale, or purchase-and-assumption transaction between the bank and the investor could be structured to achieve essentially the same result.

Burdensome Obligations

The conservator would not necessarily need to take any actions that could not have been implemented in a traditional open-bank transaction, with the consent of shareholders and bondholders and no special regulatory powers.

If the FDIC is appointed as conservator, however, it would have additional powers under the Federal Deposit Insurance Act and FIRREA. Among other things, the FDIC would have authority to disaffirm or repudiate any of the bank's burdensome contracts or leases.

Immediately following recapitalization of the bank and the execution of an assistance agreement, the conservatorship would be terminated. The Holding Company could then begin to solicit consents for a prepackaged Chapter 11 plan of reorganization.

The consent solicitation could be in connection with a rights offering made available to consenting stakeholders, providing them with an opportunity to invest in the bank's Class A common stock.

Since the holding company's debt would likely be in default, an involuntary filing would be possible. Distribution to the various stakeholder interests would be heavily influenced by the priority of their respective claims in bankruptcy.

Once consents have been solicited for a prepackaged plan, the holding company would file a Chapter 11 proceeding. The company's remaining assets would be distributed to stakeholders in accordance with terms of the prepackaged plan.

These could be structured to approximate the terms that would have been offered in a consensual exchange offer. Although reorganization of the holding company could entail a somewhat lengthy process, continuing operation of the recapitalized bank (no longer under control of the holding company) would not be affected.

Courses of Action

The board of directors of the holding company could properly take into account several possible considerations at the time it adopted the conservatorship structure:

* Continuing operating losses and deteriorating capital may make the bank unable to sustain its operations without substantial additional equity capital in the near term.

* Faced with substantial liquidity pressures, the bank may be unable to continue meeting its obligations as they mature - unless it borrows from the Federal Reserve's discount window; and access to the discount window may not be available for an extended period of time.

* If the bank does not improve its capital and/or liquidity positions, there is substantial risk that the OCC will appoint a receiver.

* Under receivership, in a traditional closed-bank transaction, the FDIC would likely contend that the holding company is due nothing for its interest in the bank. Expensive and protracted litigation with the regulators might be necessary to recover any value - and the outcome of such litigation would be highly uncertain.

* The holding company may have been unsuccessful in its extensive efforts to raise additional capital, in the absence of FDIC assistance.

* In the context of open-bank assistance, conservatorship may be the most favorable transaction for the holding company and its constituencies, to result from extensive efforts to raise additional capital.

* The FDIC may have been unwilling to assist any other transaction providing greater value to the holding company stakeholders.

* Investors may have been unwilling to proceed under any structure other than the pro-shareholder vote and bondholder exchange offer to be completed in less than four to six months - perhaps substantially longer - due to state corporate and federal securities requirements applicable to proxy solicitations and exchange offers. And there may be insufficient time to recapitalize the holding company.

* There may be no realistic alternatives to conservatorship other than a closed-bank transaction. Conservatorship is, therefore, the best and only available attempt to preserve value for holding company stakeholders.

* The relative benefits of an open-bank resolution may be substantial for the bank's customers, depositors, other creditors, and other constituencies.

From a legal standpoint, the conservatorship/recapitalization structure should not be deemed a "disposal" of substantially all the holding company's assets. A "disposal" of this type could require a shareholder vote under applicable state law and require bondholder consent under the holding company's debt indentures.

The appointment of a conservator is separate and distinct from the sale of the bank. Moreover, no action of the holding company board is required if the bank board consents.

Not Subject to Review

If state law holds that the decision of a bank or its holding company to consent to a conservatorship is subject to stockholder approval, the state requirement would have to yield to paramount federal law.

In plain language, the federal law states that appointment of a conservator "shall not be subject to review." Unambiguously, Congress has precluded any court from interfering with the appointment. Another section of the law gives the OCC "exclusive power and jurisdiction to appoint a conservator."

Congress and the regulatory agencies strongly support early resolution of troubled financial institutions, to reduce the costs to the FDIC of an impending failure.

Early resolution may provide the only means of preserving some value for a troubled institution's stakeholders, once alternative means of recapitalizing the institution have been fully explored and exhausted.

The structure outlined above should provide the necessary bridge between these positive benefits and the procedural hurdles that have impeded the effective implementation of an early resolution transaction.

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