The Federal Reserve’s new leadership should repeal an ill-conceived dividend waiver rule implemented after the enactment of the Dodd-Frank Act, and reinstate the prior federal rule that worked well by allowing mutual holding companies to waive the receipt of dividends without adverse consequences to public stockholders.
Congress came very close to eliminating the restrictive provisions of the Fed’s dividend waiver rule in Section 598 of the Financial Choice Act, which passed the House in June 2017. Unfortunately, this and many other community bank-friendly provisions of the Choice Act were excluded from the Senate bill that ultimately became law. Hopefully, Congress or the Fed will take a common-sense approach and rectify this prime example of regulatory overreach so that mutual community banks can once again take full advantage of the capital-raising opportunities of the MHC structure.
A few observations about MHCs are necessary to better understand the impact of the Fed’s rule. They are hybrid corporate structures authorized by Congress in 1987 to allow mutual savings institutions to form holding companies and raise capital incrementally. Since 1991, more than 165 mutual savings banks have formed MHCs and have raised more than $28.0 billion of new capital. Notably, until the Dodd-Frank Act, federal MHCs routinely waived dividends and were the preferred method of going public by mutual savings banks.
MHCs are just like other savings bank holding companies, except they must have a majority stockholder that is mutually owned — the MHC. Unlike other savings banks that fully convert to stock form by forming a holding company, selling their entire fair value to depositors and the public and contributing all the new capital raised to their subsidiary savings banks, savings banks that form MHCs sell less than 50% of their value and raise commensurately less capital. The remaining majority interest is retained by each newly formed MHC, which does not contribute any new capital to its savings bank subsidiary.
The Dodd-Frank Act gave the Fed sole federal authority to regulate all holding companies. As part of its new authority to regulate federal MHCs, the Fed adopted a dividend waiver rule that handicaps all MHCs and particularly MHCs formed after Dec. 1, 2009. The rule ignores long established regulatory and judicial precedent by granting each MHC, and indirectly its mutual members, the same equity rights as public stockholders. It essentially requires MHC subsidiaries that pay dividends to their public stockholders to also pay the same dividends to their MHCs, thus effectively prohibiting MHC subsidiaries from paying any dividends to public stockholders. But MHCs should, and need to, waive dividends because they have not invested new capital in their savings bank subsidiaries that would warrant receiving dividends, and they have no need for dividends.
The dividend waiver rule is drafted in a way that ensures no MHCs formed after 2009 will ever waive dividends. First, it requires MHC members to approve dividend waivers annually by an extraordinarily high vote standard, thereby making any approval especially difficult and expensive. Second, it prohibits any new MHC from waiving dividends unless either a majority of its board of directors does not own any subsidiary stock, or no dividends are paid to directors, officers or any employee stock plans of the MHC subsidiary. Lastly, even if an MHC can satisfy these first two conditions, the rule requires adding the amount of waived dividends to the MHC’s interest, thereby diluting public stockholders in the amount of the waived dividends.
Directors of an MHC invariably are also directors of the publicly traded MHC subsidiary, and they should be stockholders of the MHC subsidiary — public stockholders demand this. Therefore, it’s not possible for a majority of an MHC’s entire board of directors who don’t own any stock in the MHC’s subsidiary to approve a dividend waiver. Moreover, no MHC board will waive dividends if it means depriving officers, directors and employee stock plans of their right to receive dividends on common stock that they have paid for. It also makes no sense economically for an MHC board to waive dividends (and may be a breach of fiduciary duty) if public stockholders are diluted by the dollar amount of the waiver.
The Fed’s reason for adopting its dividend waiver rule under its new post-Dodd-Frank authority stems from the specious assumption that because MHCs are common stockholders like public stockholders, they are entitled to receive the same dividends as public stockholders. Therefore, the argument goes, if the MHC is entitled to receive dividends, then waiving dividends creates a windfall for public stockholders to the detriment of the MHC’s members. While this argument is simple in its appeal, it manifests a profound misunderstanding of the MHC structure and is unfair to public stockholders.
An MHC, unlike public stockholders who contribute new capital to an MHC subsidiary, does not pay for its stock, and its ownership interest in such stock is very different from that of public stockholders. An MHC can’t sell or transfer its shares of subsidiary common stock, the shares aren’t traded, and if an MHC subsidiary issues more common stock, the MHC’s stock is canceled and it does not receive payment for those canceled shares. The MHC’s shares, therefore, essentially have no value.
An MHC represents nothing more than the mutual interest of depositors or members of a subsidiary savings bank that has not been converted fully to stock form. And the federal courts, including the Supreme Court, have made clear that depositors are the owners of a mutual institution “in name only,” and that “any theoretical value [to their interest] reduces almost to the vanishing point.” It is also well established that members of a mutual savings bank or MHC have no individualized equity interest and they cannot compel a distribution of capital. Yet the Fed’s rule insists that members of an MHC, whose ownership rights have been described by the federal courts as virtually nil, have rights equivalent to those of public stockholders. This reasoning penalizes a very successful capital raising structure and deprives public stockholders of their property rights.
By making it nearly impossible for MHC subsidiaries to pay dividends to their public stockholders, the Fed is steering mutual savings banks to go fully public when raising capital. Not surprisingly, the dividend waiver rule has had a negative impact on new MHC formations, as only nine mutual savings banks have formed MHCs since the Dodd-Frank Act was enacted eight years ago. Surely the Fed understands that dividends are a key component of investors’ overall returns, and MHC subsidiaries need to pay dividends for MHCs to remain an effective capital raising structure.