This is the second in a series of articles on best practices for bank boards.  (Part 1 can be found here.) During the past several decades, my partners and I have worked with hundreds of bank boards, for institutions ranging in size from under $100 million in assets to well over $10 billion in assets.  Regardless of the size of the entity, we have noticed a number of common characteristics and practices of the most effective boards of directors.  This series of articles describes ten of those best practices.  In the first article in the series, I focused on two fundamental best practices—selecting good board members and adopting a meaningful agenda for the board meetings.  In this article I will discuss three additional best practices—providing the board with meaningful information, encouraging board member participation and making the committees work.

The presentation includes an overview of the results of the 2012 Bryan Cave Survey of investment bankers and bank consultants to assist in providing strategic advice to clients.  A sampling of results include:

• “In my opinion, the calendar just needs to turn another 3 to 6 more months and more signs of credit stabilization just need to naturally occur. We think folks will be pleasantly surprised to see the natural “mating process” happen on its own in 2012. [This will] start really slow but moderately gain momentum as 2013 unfolds, and by 2014 it will be a great deal different.” – Chris Marinac, FIG Partners
• “Failed bank opportunities need to disappear (still two more years of this in the Southeast); more healthy buyers need to appear; private equity will become much more involved; buyers prices need to improve; Banks with TARP will likely have to sell as capital markets will not open up in time.” – Bill Wagner, Raymond James
• “Dominate its ‘micro’ market as it relates to deposits and their lending competency and try to achieve critical mass (~$750m).” – Jeff Brand, KBW
• “Sometimes the blocking and tackling basics are a competitive advantage – provide the services desired on par with the big banks with care and concern.” – Phil Moore, Porter Keadle Moore

A copy of their PowerPoint presentation is now available online.

One of the central themes of the SIGTARP report is that TARP will continue to exist for years.  In addition to programs designed to support the housing market and certain securities markets that are scheduled to last until as late as 2017, 371 banks remain in the TARP Capital Purchase Program.  While I disagree with some of SIGTARP’s conclusions and framework for the issues, I agree that a clear and workable exit plan for community banks is crucial to financial stability.”  SIGTARP has recommended that Treasury develop a clear TARP exit path for community banks, especially in light of a steep rise in the TARP dividend rate from 5% to 9% starting as soon as late 2013.  “Treasury must develop a workable plan in consultation with the regulators and begin executing that plan to remove uncertainty related to these banks.”

Despite its negative public perception, the overall Capital Purchase Program is universally thought to have earned a positive return for the government.  While estimates for the total TARP program continue to show a significant cost, these costs are primarily tied to the housing support programs (which were never intended to be profitable) and relief provided to AIG and the automotive industry.  Estimates on the CPP program, on the other hand, range from a gain of between $7 billion and $17 billion.  Specifically, the Office of Management and Budget estimated on November 18, 2011 (using data as June 30, 2011) that the CPP would result in a $7 billion gain; the Congressional Budget Office estimated on December 16, 2011 (using data as of November 15, 2011) that the CPP would result in a $17 billion gain; and the Treasury estimated on November 10, 2011 (using data as of September 30, 2011) that the CPP would result in a $13 billion gain.  While Treasury may incur losses on some of the remaining investments, the program as a whole (even without considering how bad the economy may have performed in the event the Treasury had not invested in banks under the CPP), will be profitable.  Investing is a risk/reward analysis, and any investment strategy, especially when considering investments in over 700 financial institutions, should be viewed at the portfolio level.  To that extent, TARP generally, and the CPP specifically, should be viewed as a success.

Under the CPP, Treasury invested a total of $204.9 billion of TARP funds in 707 financial institutions.  Through December 31, 2011, 279 banks – including the 10 largest recipients of funds and 137 that exited TARP by refinancing the investment under the Small Business Lending Fund (SBLF) program – had fully repaid CPP or the Treasury had sold the institution’s stock.  In addition, 28 banks converted their CPP investments into CDCI investments and 13 banks have partially repaid.  On the other hand, 12 CPP investments have been sold for less than their par value and 14 are in various stages of bankruptcy or receivership.

As of December 31, 2011, $185.5 billion of the principal (or 90.5%) had been repaid, leaving approximately $19.5 billion outstanding.  Of the repaid amount, $355.6 million was converted into CDCI investments (which is part of TARP), and $2.2 billion was converted into SBLF investments (which is not part of TARP).  In addition, Treasury has received approximately $11.4 billion in interest and dividends and $7.7 billion from the sale of common stock warrants that were obtained in connection with the CPP financings.

The SIGTARP report notes that smaller and medium-sized banks are not existing TARP with the same speed as the larger banks.  Many are not able to pay their dividends and some are operating under an order from their regulator.  Compared with larger banks, the SIGTARP report notes that “community banks may face an uphill battle to exit TARP.”  Community banks do not have the same access to capital as the larger banks and can be more exposed to distressed commercial real estate-related assets and non-performing loans.

SIGTARP reports that “despite the dramatic efforts to expedite the exit of the largest banks from TARP, there appears to be no corresponding concrete plan for community banks’ exit from TARP…” Treasury has acted on a case by base basis to sell its TARP investments (sometimes at a discount) or exchanged for stock with lower priority in connection with a merger, acquisition or sale to a third party that invested new capital, but these actions have remained the exception rather than the rule.  Accordingly, SIGTARP reiterated its prior recommendations:

1. Treasury, in consultation with Federal banking regulators, should develop a clear TARP exit path to ensure that as many community banks as possible repay the TARP investment and prepare to deal with the banks that cannot. Treasury should develop criteria pertaining to restructurings, exchanges, and sales of its TARP investments (including any discount of the TARP investment,
   the treatment of unpaid TARP dividend and interest payments, and warrants).
2. Treasury should assess whether it should renegotiate the terms of its Capital Purchase Program contracts for those community banks that will not be able to exit TARP prior to the dividend rate increase in order to help preserve the value of taxpayers’ investments.

The SIGTARP report acknowledged that Treasury has engaged Houlihan Lokey to provide capital markets disposition services for its remaining CPP investments.  Houlihan is earning a flat fee of $375 thousand a month to provide a variety of services to Treasury, including:

• Analyzing, reviewing and documenting financial, business, regulatory, and market information related to potential transactions of CPP investments;
• Advising and monitoring restructuring strategies prior to the disposition of CPP investments;
• Reporting on the potential performance of certain CPP investments and their disposition given a range of market scenarios and transaction structures;
• Analyzing and proposing disposition alternatives and structures, including the use of additional underwriters, brokers, or other capital markets advisors for the best means and structure to dispose of such assets; and
• Maintaining a compliance program designed to detect and prevent violations of Federal securities laws, and identifying documenting and enforcing controls to mitigate conflicts of interest.

The SIGTARP report notes that Treasury’s next steps in developing clear TARP exit paths for the smaller banks are critical, and encourages Treasury to proactively reach out to participant banks rather than waiting for banks to propose exchanges.  While Treasury does not want to devise standard discounts or terms for small banks to exit CPP, saying “each bank’s situation is unique,” SIGTARP reiterates its recommendations that the issues should be addressed solely on a case-by-case basis.

Given the economics at stake, designing multiple exit strategies that facilitate the conclusion of the CPP may be in everyone’s interest.  In its most simple terms, Treasury invested a total of $204.9 billion in cash, received cash proceeds of $204.6 billion, and still has $19.5 billion in principal amount of securities outstanding. Using the estimated gains of between $7 billion and $17 billion for the program, Treasury expects to receive between 36% and 88% of the remaining outstanding CPP funds (without giving any consideration to remaining warrants or dividends and interest).

During the mid-2000′s, it was commonplace for a bank, particularly a de novo bank, to lease some or all of their bank facilities from an entity controlled by the bank’s directors. At the time, these arrangements truly represented a “win-win” situation. The bank was able to occupy built-to-suit facilities while conserving liquidity so that cash could be deployed through making loans with attractive yields. At the same time, the directors, many of whom were real estate professionals, were able to make a sound real estate investment with the knowledge that a very stable tenant would occupy the property.

As we know, much has changed since the mid-2000′s. Vacancies in commercial properties have caused market lease rates to plummet.  Similarly, market values of commercial properties have decreased substantially. Many banks have excess liquidity caused by soft loan demand, making a potential investment in fixed assets more attractive.

Because many of these leases were written with five-year initial terms, a number of banks are now weighing their options with respect to renewal, extension or renegotiation of the leases. To make matters more complex, many director-controlled entities borrowed money to construct the bank facilities. If those notes had five-year terms, they are coming up for renewal, and the lending bank may be eager to move the commercial real estate loans off of its books.

This fact presents a particularly difficult challenge for the affected directors. Banking regulations require that transactions with affiliates be made on terms at least as favorable to the bank as those terms prevailing at the time for transactions with unaffiliated parties. Most bank directors understand their duty to act in the best interests of the bank, but they are also facing personal financial exposure if the lease is not renewed on terms that allow the entity to continue to service its debt obligations. In addition, given public scrutiny of directors and officers who are perceived to have profited at the expense of the bank they serve, creating a proper process to manage these situations has never been more important.

While state law should be consulted regarding the appropriate process for analyzing and approving a transaction with an affiliate, the following best practices are helpful in reaching a fair and appropriate resolution to transactions between a bank and its affiliates. 

• Wear your “bank hat.”  It is imperative that any director with a financial interest in the transaction focus on making the appropriate decision for the bank. Directors should understand that these transactions are likely to be heavily scrutinized by regulators and could potentially be scrutinized by shareholders.

• Allow independent directors to take the lead. To the extent that two or more directors do not have financial interests in the transaction, appoint them to a committee with full authority to analyze and negotiate the renewal of the lease.

• Rely on third party experts. Engage trusted third parties, such as appraisers and other real estate experts, to provide information to the board (or independent committee) regarding the bank’s alternatives. In addition, ask management to prepare a lease/buy analysis based on the bank’s existing and projected liquidity and its ability to leverage that liquidity.

• Document carefully.  Remember, if it is not documented, it did not happen. Be sure that all relevant considerations, discussions and reports are fully documented.

• Consider all relevant factors. While an appraisal or other analysis of market lease rates is helpful, also consider the “soft” costs of failing to renew the lease, which might include: 
               –employee downtime related to moving;
               –additional marketing expense created by advertising the move and updating existing
                 marketing materials;
              –reputation risk created by leaving the existing location vacant; or 
              –loss of branding associated with the existing location. 

  While a situation involving a lease of property from a director-controlled entity can be addressed using these best practices, they also can be used in analyzing a lease between the bank and its holding company. In addition, they can be helpful in renegotiating a lease with a third party or deciding to purchase facilities that the bank currently leases. Regardless of the circumstances surrounding a decision regarding the bank’s facilities, bank directors should familiarize themselves with all available alternatives in order to make the best decision for the bank.

This article was originally published on BankDirector.com.

Specifically, FDIC examiners have begun to scrutinize bank insurance policies to determine whether the policies provide coverage for civil money penalties (“CMPs”) that may be assessed against bank officers or directors. If any bank insurance policies are found on examination to contain an endorsement extending coverage for CMPs to officers or directors, the FDIC is citing such policies as being in violation of Part 359 of the FDIC’s Rules and Regulations.

Part 359, among other things, prohibits banks and affiliated holding companies from making certain “prohibited indemnification payments.” These prohibited payments include any payment or agreement to pay or reimburse bank officers or directors for any CMP or judgment resulting from any administrative or civil action which results in a final order or settlement in which that officer or director is assessed a CMP, removed from office or ordered to cease and desist from certain activities. As a matter of public policy, this provision is designed to prevent banks from bearing the costs of penalties assessed against individuals for actions that could result in harm or potential harm to a bank or to the safety and soundness or integrity of the banking system more generally.

Part 359 explicitly permits reasonable payments by banks to purchase commercial insurance policies, provided that the policy not be used to pay or reimburse an officer or director the cost of any judgment or CMP assessed against him or her. However, Part 359 does permit the insurance paid for by the bank to cover (1) legal or professional expenses incurred in connection with such a proceeding and (2) the amount of any restitution to the bank, its holding company, or its receiver.

For individuals serving as officers or directors of banks, CMP assessments represent a potential risk to personal assets. In addition, CMPs are generally assessed not through the civil litigation process, but rather through an administrative proceeding or enforcement action, where burdens of proof and standards of review generally favor the assessing agency, and intent to violate the rule giving rise to a CMP assessment is not necessarily required in order for the penalty to be assessed. As a result, there has been a long-standing demand for some form of coverage for bank officers and directors to address this risk. A solution used by the insurance industry for decades has been to offer CMP coverage by way of a separate endorsement to the D&O insurance policy purchased by the bank. This endorsement is then invoiced separately, and the individuals covered under the endorsement pay the premium associated with the endorsement out of their own pockets.

However, in recent months, this approach has been criticized by the FDIC, which has cited any policy written in the name of the bank or its holding company that, by endorsement, provides CMP coverage for individual officers or directors, regardless of who actually paid the premium associated with such coverage.

In response, as policies with CMP endorsements begin to expire, insurance carriers are likely to begin pulling the CMP endorsements from these policies on renewal. While Part 359 would not prohibit individual officers and directors from independently purchasing their own policies for CMP coverage, outside of the framework of the bank’s base policy document, insurance professionals have indicated that such stand-alone policies are not generally available at the present time. Given the generally low premiums historically associated with CMP coverage in the community bank space, carriers will not necessarily have strong economic motivation to rush to develop stand-alone CMP products for community bankers. In addition, a stand-alone CMP product, if and when created, may likely carry with it a somewhat elevated premium, as carriers would need to recover the incremental costs of that product’s development.

Even with strong economic motivation, it would likely take time for such products to be developed, resulting in an intermittent period where coverage remains unavailable and this risk to officers and directors remains unmitigated. As a point of comparison, products designed over the past several years to address the shortfalls in the regulatory coverage being offered by primary carriers only began to appear in the community bank space some months after shortfalls in regulatory coverage began to become a widespread phenomenon, notwithstanding that the premiums associated with regulatory coverage products were proportionally much larger than CMP coverage premiums.

A stopgap solution could be for carriers to restrict the definition of losses covered under the CMP endorsement to account for “defense costs” and reimbursement to the institution only — those items specifically carved out by the language of Part 359 – but such an approach, from the perspective of the individual, would not mitigate the risks to personal assets posed by the CMPs themselves.

Exactly how things will develop on this front remains to be seen. However, the likely net result of this trend – at least in the near term – will be increased costs to individuals serving as officers and directors of financial institutions, whether actual or contingent. The general trend of increasing exposure for bank officers and directors continues notwithstanding that salaries and fees for services rendered by officers and directors remain subject to increased scrutiny and, in many cases, are being frozen or cut proactively in the interests of cost savings. In addition, officers and directors continue to face elevated demands on their time as they seek to navigate the challenging economic waters and ensure the safe and sound operation of their institutions. At some point, finding or retaining qualified individuals who are willing to bear the costs associated with service – particularly service as a director – may become a challenge for some financial institutions.

The specific terms and scope of coverage provided by insurance policies vary widely, and bankers with questions about their specific insurance policies should contact their insurance professional or coverage counsel.

]]> http://bankbryancave.com/2011/12/fdic-criticizes-civil-money-penalty-insurance/feed/ 0 http://bankbryancave.com/2011/12/best-practices-for-bank-boards-part-1/ http://bankbryancave.com/2011/12/best-practices-for-bank-boards-part-1/#comments Mon, 05 Dec 2011 17:08:01 +0000 Rob Klingler http://bankbryancave.com/?p=7897 Today’s banking industry is constantly being buffeted by waves of financial, regulatory and operational challenges. The increased regulatory burden and related costs impact every financial institution in both the approach to doing business and the expense of doing business. The industry is in transition, with no clear path forward. As a result, there has never been a greater need for well functioning, informed and courageous boards of directors of banks and bank holding companies. There has also never been a more important time for board members to keep in mind that their responsibilities can be boiled down into one simple goal: the creation of sustainable long-term value for shareholders.

Achieving long-term value for shareholders may seem an elusive goal in the current environment. On more than one occasion, bank board members have commented to me that they feel they are now working for the benefit of the regulators. However, as with any time of turmoil and change, the challenges we now face will pass. As bank boards look for ways to strengthen their institutions, they should not overlook the opportunity to strengthen themselves as a group. One way of doing that is to adopt the practices of the most effective boards of directors.

Over the past several decades my partners and I have attended hundreds of bank board meetings, for institutions ranging in size from under $100 million in assets to well over $10 billion. Regardless of the size of the entity, we have noticed a number of common characteristics and practices of the most effective boards of directors. This is the first in a series of articles which will describe the 10 best practices we have observed among highly effective boards of directors. In this article I focus on two fundamental best practices — selecting good board members and adopting a meaningful agenda for the board meetings. 

Best Practice No. 1―Selecting Good Board Members

Some of the most challenging and distracting issues a board can face are those related to its own members. These issues typically arise in connection with conflicts of interest between board members and the banks they serve, or when board members experience financial stress. They can also arise when there are personality clashes in the boardroom, or when one or more board members seek to dominate the conversation. The best time to avoid such issues is during the selection process for new directors. Compromise and wishful thinking in the selection of directors will almost always dilute the effectiveness of the board as a whole. Key characteristics of good directors include:

• Independence―being free of conflicts.
• Time to devote to the job — including time to gain a knowledge of the industry, to prepare for board meetings, and to participate in committees
• Attention — being fully engaged and proactive as a board member.
• Courage―having a willingness to deal with tough issues.
• Curiosity — possessing an intellectual curiosity about the bank, the financial services industry and the trends impacting both.

A group of good, solid and dependable board members is, in my experience, preferable to a big-hitter, all-star line-up of directors. A board is most effective when it acts as a group, with a culture in which all members can voice their opinions, and in which probing, and sometimes difficult questions can be asked. Dominant personalities and board cultures in which constructive debate never occurs have contributed to the demise of many banks in the current downturn. Careful selection of new board members, keeping in mind the strengths and weaknesses of the other members of the board, is well worth the time and effort involved.

 Best Practice No. 2―Adopt a Meaningful Agenda

Take the time to review, revise and update your board agenda. I’m aware of several banks that are using the same approach to board meetings and the same agenda as 30 years ago. The absence of any objection from board members may only mean that they are drifting off to sleep during the half-hour-long financial presentation. Board members greatly appreciate a shift to a more efficient and effective agenda, with a focus on committee reports and presentation of only meaningful information about the condition and operations of the bank. This can free up substantial time for the board to focus on the overall direction and progress of the bank.

Most directors only visit the bank once or twice a month, which makes a full understanding of the bank’s plans and status very difficult. There needs to be an educational element in board meetings. Most directors have an ongoing need, and desire, for growth and development in their understanding of the banking industry. With such education, directors can become more effective in their recognition and understanding of the risks to be monitored, as well as the factors that most influence a bank’s strength and performance.

Board packages should be delivered well in advance of each meeting in order to provide the directors with adequate time to prepare. Committee chairs should be prepared to give concise but informative reports at the meeting. Financial and operational presentations by management should focus on telling the board members what time it is, not how the watch was built. This approach can result in more interesting and informative board meetings and will likely result in greater interaction and contribution by the board members.

This is the first in a series of articles by Jim McAlpin on Best Practices for Bank Boards.  It was originally published on BankDirector.com.   Look for more “best practices” in upcoming posts.

As the parent of a human two year-old, I’m quite happy to at least have this site exit its “terrible twos.”  The site encountered some growing pains last year, but we’ve changed hosts, changed look, and driving forward.

Since its launch, BankBryanCave.com has hosted over 127 thousand visitors, and has delivered 277 thousand page views.  Included in those visitors are a significant number of bank regulators and policy makers, including over 900 visits from the FDIC, 360 visits from the Treasury Department, 350 visits from the OCC, 290 visits from the US Senate, 260 visits from the U.S. House of Representatives, 160 visits from the Federal Reserve Board and 140 visits from the U.S. General Accounting Office.

As we noted in the beginning…

There is no fee of any sort connected with this site or its usage – it is another example of the many ways we try to give back to the industry that has been so good to us in so many ways. We hope you expect this kind of effort and contribution from us, since we have always considered our clients to be our partners in our industry. We hope you will continue to look to us in good times and bad.

A central premise of our financial institutions group is that sharing information collected from all of our attorneys creates significant intellectual power and value for our clients and each other.  We look forward to continuing to share.

While we always recommend that bankers point out any factual inaccuracies in a Report of Examination via a written response, we believe that bankers may be able to help themselves by presenting additional information before the Report of Examination is issued.  This approach may be particularly helpful if a bank believes its regulatory ratings are being downgraded as a result of inaccurate or incomplete findings by their examiners.  As stated in a recent article by SNL Financial (subscription required):

[Danny Payne, former commissioner of the Texas Department of Savings and Mortgage Lending and now an industry consultant,] said there may be instances where examiners have been overzealous or harsh in their recommendations or findings. “But before the reports are issued, the pre-report communication processes and negotiations between the bank and examiners usually result in a fair ruling,” he said. “By the time issues reach the enforcement order stage, all subjective debates and negotiations typically have been completed and decided.”

We have found that many disagreements with examiners can be resolved through the presentation of additional information.  At the very least, these discussions help bankers gain further understanding of the analysis by examiners.

As we move further into this economic cycle, we are seeing more “borderline” cases where presenting details to examiners can make a difference in the conclusions reached by examiners.  As a result, we encourage bankers to communicate openly with examiners about the condition of their banks.  If you would like to discuss these concepts, please contact any member of our Bryan Cave financial institutions group.

There was recent news from the FDIC though that I think qualifies pretty strongly as green shoots material.  On September 14 the FDIC announced that it will be closing down its Midwest Temporary Satellite Office located in Schaumburg, IL toward the end of September 2012. The FDIC had previously indicated that the office would remain open until the end of the second quarter of 2013. The FDIC had announced earlier this year that its West Coast Satellite Office will close January 30, 2012.

The Southeast Temporary Satellite Office located in Jacksonville is theoretically scheduled to stay open until the end of 2013 due to the larger number of bank receiverships located across Georgia and Florida. I believe, however, there is a fair chance that the late 2013 date will, in fact, be moved up closer to early 2013 or even late 2012 based upon a review of the latest CALL Reports. While there are still a fair number of troubled banks moving through the FDIC pipeline toward receivership the numbers of troubled banks are definitely in the decline.

There is a corresponding decline in the number of new problem credits banks are seeing. Whereas a year ago bank special assets departments were bringing in two new credits for each one they resolved, now the ratio is one to one or even less. There is also much more internal pressure at institutions to rehabilitate credits if possible so that they can be moved out of special assets and back to the line.

Banks clearly face tremendous challenges due to the sluggishness of the national economy and lack of new loan demand.  There are other challenges as well as banks move out of real estate and into C&I lending and we all deal with the deleveraging that the American consumer is experiencing. Even acknowledging all of those issues, however,  over the next twelve months we should see much less focus on Texas ratios and much more attention on how do banks grow business after having survived the great financial panic of 2008.

Boards and senior management need to be focused on the issue of organic growth and how to best accomplish it.  In some cases it may be more appropriate to consider strategic acquisitions. In any event, the role of careful strategic planning on the part of boards and senior management has never been so important. Whether you do it with a banking consultant that you have dealt with for years or one of our experienced lawyers, the key is to plan now in order to control your future.

While the information in the presentations may seem obvious to bankers, the data reviewed by the examiners may not reveal important and helpful trends in the bank’s condition. For most of our clients, these trends are not obvious when reviewing financial statements and the other information typically provided to the bank’s regulators.

We are happy to share our experiences with approaches that have had a positive influence on the exam process and to refer bankers to resources that may help with preparation for regulatory exams. For more information, please feel free to contact any member of our Bryan Cave financial institutions group.