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Thriving in the Economic Recovery Thriving in the Economic Recovery
Michael G. KeeleyHunton & Williams LLP1445 Ross Avenue, Suite 3700
Dallas, Texas 75202(214) 468-3345
32615891
Community Bankers Association of Illinois36th Annual Convention
Louisville, KentuckyOctober 2, 2010
Charles E. GreefHunton & Williams LLP1445 Ross Avenue, Suite 3700
Dallas, Texas 75202(214) 468-3331
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TROUBLED BANK ACQUISITIONS TROUBLED BANK ACQUISITIONS
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TROUBLED BANK ACQUISITIONS A MAJOR OPPORTUNITY
One bank in ten in the United States (829) is on the FDIC Problem Bank List
These banks are under regulatory pressure to sell or raise capital can be bought at reasonable prices
Many of these banks have NOLs, built-in losses and other tax benefits which can be used by acquirors to make the pricing even more attractive
Structuring tools are available to minimize acquirors exposure to asset quality and contingent liabilities of the target
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DUE DILIGENCE
Thorough due diligence on target is critical
Talk to targets accountants, attorneys and outside loan review
Review reports of examination, compliance reports under regulatory administrative actions, correspondence with regulators
Review major contracts data processing, facilities leases
Review employee benefit plans- Underfunded plans- Severance policies- Change in control agreements- Impact of troubled bank status
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IMPORTANT TAX CONSIDERATIONS
Net operating loss carryforwards of C corporation targets
Loss carryforward limitations
Section 382 annual limitations
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TOOLS TO ADDRESS 382 LIMITATIONS
Purchase bank from leveraged holding company
Increase in Section 382 annual limitation
BHC can use NOL in year of transaction. NOL is then allocated between BHC and bank
Common shareholder approval is required
Review documentation with target BHC creditors
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TOOLS TO ADDRESS 382 LIMITATIONS (Continued)
Avoid change in control for tax purposes
Change in ownership of more than 50 percent of voting securitiesover a three year period
Acquisition or recapitalization by existing shareholders
Count all less than 5 percent shareholders as a single shareholder
Acquire balance of shares after three years
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TRIGGERING BUILT IN LOSSES
Definition of a built in loss
Trigger by sale of asset to third party after closing
Trigger by sale of asset to selling shareholders or BHC after closing
If built in losses are less than $10 million or 15 percent of assets of target, losses are not subject to Section 382 limitations
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ASSET QUALITY PROTECTION ALTERNATIVES
Goal is to pay seller fair value for loans and assets that are collectable while protecting buyer from losses on those that are not
Escrow portion of purchase price Pay portion of purchase price by promissory note containing principal
reduction feature for post-closing losses In stock acquisition, issue convertible security which converts into
acquiror stock at an exchange ratio that adjusts based on post-closing losses at target
Require selling holding company or shareholders to use portion of purchase price to buy ORE and nonperforming loans out of bank
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ESCROW
Portion of purchase price is escrowed with third party agent for agreed period of time
If excess losses occur in targets loan portfolio, part of escrowed funds are returned to acquiror
Balance remaining in escrow is delivered to seller at end of agreed period of time
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PROMISSORY NOTE WITH PRINCIPAL REDUCTION FEATURE
Portion of purchase price is paid by delivery of promissory note
If excess losses occur in targets loan portfolio, principal balance of note is reduced
Interest ceases to accrue on amount of reduction, but claw back provisions are rare
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USE OF CONVERTIBLE SECURITY
Acquiror issues security to target shareholders which is convertible into acquiror common stock after a set period to time
Conversion ratio is adjusted downward if target experiences excess loan losses prior to conversion date
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REQUIRE TARGET OWNERS TO PURCHASE ASSETS OUT OF TARGET BANK
Definitive agreement can require selling holding company or shareholders to use portion of purchase price to purchase ORE and non performing loans from target immediately after closing
Acquiror sells ORE and collects loans, is reimbursed for collection costs, remits balance of proceeds to selling shareholders or holding company
Seller is paid for assets that are collectable and not for those that are not
Can purchase ORE and loans for cash and a note payable to the bank to increase dollar amount of assets purchased. Note is secured by all assets purchased from bank. Proceeds are applied to cost of collection, then interest on the note and then principal on the note. After the note is paid in full, proceeds are paid to selling shareholders
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REQUIRE TARGET OWNER TO PURCHASE ASSETS OUT OF TARGET BANK (Continued)
Advantages / Disadvantages
- Risk of loss on purchased ORE and loans remains with target bank shareholders
- Balance sheet of target bank is improved immediately as classified assets are purchased out of bank
- If note is used, acquiror should be certain the amount of leverage is not excessive
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REQUIRE TARGET OWNER TO PURCHASE ASSETS OUT OF TARGET BANK (Continued)
Tax benefit - Built-in tax losses on ORE and investment securities are triggered by sale. Note that book loss has already been taken
- If sale is after change in control occurs and built-in losses do not exceed $10.0 million, losses will not be limited by Section 382 and will be fully available for acquiror
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DEFINITIVE AGREEMENT ISSUES
Definition of loss- Who decides when a loss occurs? Examiners, accountants,
outside loan review, inside loan review, and/or management of acquiror
- Can give target shareholders right of first refusal- Is loss only on an indentified group of loans or is it on any loan in
the target banks portfolio?- When does loss protection terminate?
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DEFINITIVE AGREEMENT ISSUES (Continued)
Do representations and warranties survive closing?
Acquiror can have offset rights against balance of note
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ACQUISITION OF OVERLEVERAGED TARGETS
Bank stock loans Subordinated debt Trust preferred securities
- Managed pools- Static pools
TARP Note tax consequences of debt forgiveness income
Purchasing bank from target holding company
Is bankruptcy a viable alternative?
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CONCLUSIONS
Troubled banks are numerous and can often be acquired at attractive prices
Utilize tax benefits to enhance economics of transaction for buyer
Utilize available structures to protect buyer from asset qualityissues at target
Negotiate with BHC creditors to discount BHC obligations
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FAILED BANK ACQUISITIONS FAILED BANK ACQUISITIONS
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ACQUISITION OF FAILED BANKS WITHFDIC FINANCIAL ASSISTANCE
Presents acquisition opportunities Terms are favorable
- Financial assistance on loans- Indemnification against liabilities- Options on real estate, contracts and employees
Pricing has been attractive - Average premiums paid for deposits acquired have been very
low by historical standards - Sufficient financial assistance on loans to allow buyers to
record substantial bargain purchase gains at closing Risk of such transactions has been increasing
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NUMEROUS OPPORTUNITIES FOR BUYERS
9 banks failed from 2003 2007
25 failures in 2008
140 failures in 32 states occurred in 2009
21 in Illinois
Approximately 127 banks have failed through September 24, 2010
15 in Illinois
FDIC expects more failures in 2010 than the 140 which occurred last year
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OPPORTUNITIES FOR BUYERS(continued)
Number of banks on FDIC problem bank list has soared from 416 at June 30, 2009 to 552 at September 30 and to 775 banks at March 31, 2010 and 829 at June 30, 2010 more than one bank in every ten despite over 250 bank failures
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IMPORTANT TRANSACTIONS UPDATE
On March 22, 2010, the FDIC changed the bidding structure and loss sharing coverage in assisted transactions. The significantchanges are as follows:
The concept of a Stated Threshold, the point at which loss sharing increases from 80/20 to 95/5, has been eliminated. Lossshare coverage set at a constant 80/20.
The asset premium or discount bid was formerly a fixed dollar bid, then was a percentage of the book value of the assets purchased.
The amount of losses a buyer will absorb before loss sharing begins (the First Loss Tranche) became now a separate element to be bid and will be expressed as a percentage of the book value of assets covered by loss sharing.
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STRUCTURING OF FAILED BANK ACQUISITION -COMPONENTS OF BID
Deposits premium bid Asset premium (discount) bid SF 1-4 family applicable % for SF Tranche 1 SF 1-4 family applicable % for SF Tranche 3 Commercial applicable bid % for Comml Tranche 1 Commercial applicable bid % for Comml Tranche 3 Optional Value Appreciation Instrument
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INTRINSIC VALUE
How established Clawback
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CLAWBACK/WINDFALL PROFIT TAX
On the true-up measurement date (45 days after the end of the 10thanniversary of the bank closing), the assuming bank pays to the FDIC 50% of any windfall.
The measurement of the clawback is equal to 50% of the excess, if any, of the Intrinsic Loss Estimate less (ii) the sum of (A) 25% of the asset premium (discount) plus (B) 25% of the cumulative shared loss payments plus the permissible servicing expenses related to all shared loss assets
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ACQUISITION OF FAILED BANKS - KEYS TO SUCCESS
Understand the transaction structure Assemble team
- Due diligence - Financial and accounting - Legal and regulatory - Do trial run
Line up financing Advise regulators in interest in process and in specific institutions FDIC supplemental bid list for larger bank targets
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Surviving Your Next Exam Surviving Your Next Exam
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Current Regulatory Environment
Stricter examiner scrutiny Shift from supervisoryapproach to enforcement approach
Federal regulation is Washington centric limited local discretion and impact
SBR Supervision by Ratio Nonowner occupied CRE ratio 300% ADC loans 100%
CRE trends
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Congressional Oversight Panel Report CRE Losses and the Risk to Financial Stability, February 10, 2010:
Over the next few years, a wave of commercial real estate loan failures could threaten Americas already-weakened financial system. The Congressional Oversight Panel is deeply concerned that commercial loan losses could jeopardize the stability of many banks, particularly the nations mid-size and smaller banks, and that as the damage spreads beyond individual banks that it will contribute to prolonged weakness throughout the economy.
Late 80s/early 90s playbook
Current Regulatory Environment
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Preparing for your Next Exam
Think CAMELS and Risk Management asset quality is the key
CRE guidelines are now bright lines Status quo is not a good strategy ALL directional
consistency Growth and earnings are yesterdays objectives
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Asset Quality/Credit Risk
Commercial Real Estate (CRE) Monitor and document concentrations and
subconcentrations Prepare workout plan on every material nonowner
occupied CRE relationship (as if classified), especially ADC loans
Document active management and aggressive risk reduction strategy
Stratify risks stress tests Test appraisals
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Asset Quality/Credit Risk continued
ADC Loans Address interest reserves Amortize credits Guarantees
Appraisal Process and Review Review and modify appraisal process/policy Test appraisals Document exceptions
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Asset Quality/Credit Risk continued
Credit Review Process Review/update loan portfolio management process Test independence/hire outside firm Prepare workout/action plan for classified/problem
assets Workout Officer/Department/Staffing
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Asset Quality/Credit Risk continued
Loan Policies and Procedures Revise/tighten policies Add concentration limits Reduce loan approval limits Implement other controls Use of interest reserves
Participations Purchased Staffing and Expertise (align with risk and economic
environment)
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Equal Credit Opportunity Act
Unlawful for any creditor to discriminate against any application, with respect to a credit transaction on the basis of Race, color, religion, national origin, sex, marital
status or age; Because an applicants income is derived from a
public assistance program; or Because an applicant has, in good faith, exercised
any right under the Consumer Credit Protection Act Banks are creditors for purposes of ECOA
All bank regulators have administrative enforcement authority and are exercising it
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ECOA Penalties and Violations
Less than satisfactory CRA Actual or punitive damages in individual or class action
lawsuits Punitive damages limited to:
$10,000 in individual actions Lesser of $5000,000 or 1% of creditors net worth in
class actions
Attorneys fees to aggrieved applicant ECOA violation may constitute violation of other federal
laws
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Procedure
1. Pre-Exam Process2. Compliance Examination3. Notice of Preliminary Findings4. Opportunity to Respond5. Follow-up by Agency6. Possible referral to DOJ
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Long Term Recommendation
Banks should develop internal mechanisms to ensure loan pricing uniformity, including: Creating a loan pricing matrix Ensuring that deviations from the matrix are
explained through legitimate factors Developing internal evaluation procedures
(including periodic internal regression analysis) Ensure bank policies are transparent and uniform Address potential problems prior to examination
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$30 billion small business lending fund to invest capital into community banks
Treasury to invest senior preferred stock for C Corps or debt securities for Sub S
Amount of Investment::- < $1 billion in assets = 5% of RWA- > $1 billion < $10 billion = 3% of RWA
Small Business Lending Fund
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Provide regulators with small business lending plan- Small businesses have:
- Equity of less than $10 million- Revenue of $50 million or less
Provide linguistically and culturally appropriate outreach to certain groups
- Minority communities- Women- Veterans
TYPE OF LOANS COVERED:- C&I- Owner occupied non-farm, non-residential real estate- Finance agricultural productive and other loans to farmers- Loans secured by farm land
Requirements
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Treasury consultation with banking regulators CAMELS 1 or 2 CAMELS 4 or 5 CAMELS 3 ?
Eligibility
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Starting point- 5% for C corps- Tax adjusted for S Corps
Buy down of Rate- As low as 1%
For every 2.5% increase in small business lending rate will be decreased by 1%
Base line is average amount of small business lending reported by issuing bank for the four full quarters prior to enactment of Act.
Rate
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Refinance CPP Better story Avoid taint of TARP
Added Bonus
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Develop small business lending plan
Develop systems to track new organizations
Act early
What to do Now