PRO ED COMMUNICATIONS

This is a lightly edited transcript of the Directors’ Seminar presented during the ABA’s National Conference for Community Bankers in February 2003 in Hollywood, Fla. Bank Directors Briefing newsletter sponsored the presentation by Joe Hemker, director of the Financial Institutions Practice at Howard and Howard in Kalamazoo, Mich. Hemker discussed a range of issues of interest to directors, including capital and strategic planning, the advantages of Subchapter S organization, and some early observations of the Sarbanes-Oxley Act. Steve Cocheo, editor of Bank Directors Briefing and executive editor of ABA Banking Journal, served as moderator of the session. Note: This presentation makes the most sense when read in conjunction with the Powerpoint slides that can be downloaded at the same link where you found this file.

COCHEO: Good afternoon. Thanks for joining us today for the Directors Peer Group Session. For those of you who don’t know me, I'm Steve Cocheo, the executive editor of ABA Banking Journal, and the editor of Bank Directors Briefing newsletter, which is at each of your seats.

The role of the director today of course, is changing, but it’s always been a challenging one. Recently I had to explain what being a community bank director was all about to a group of publishing executives who knew nothing whatsoever about community banks. So when I'd been told about this ten minutes before I had to do it I racked my brain trying to think, how do you get this across to people who don’t have any idea what being a community banker is, let alone a director, and all in two minutes?

Suddenly it occurred to me to have these fifteen people stand up at the board table that they were sitting at, and I said, “Would you all raise your right hands?” And they were willing to play along.

And off the top of my head I said, “Okay, I'd like you to take an oath of office,” similar to the oath of office all of you as directors have taken. And making it up as I went along, I said, “I, state your name, promise to oversee the activities of this bank to the best of my ability, promise to keep it on the straight and narrow,” et cetera, et cetera, “in exchange for which I will receive far too little compensation, massive personal liability, and the chance to lose my shirt if FDIC so chooses.”

I think I got their attention.

And I think that kind of puts in a nutshell the challenge of being a community bank director.

Joe Hemker is someone I've heard speak in ABA’s peer group program. He’s the director of the Financial Institutions Practice at Howard and Howard in Kalamazoo, Mich. Joe has extensive experience in privately placed trust preferred securities offerings. He’s been active in setting up Subchapter S banks, and has represented community banks in dealings with regulators for a good number of years.

And now without further commercial interruption I'd like to introduce Joe Hemker.

JOE HEMKER: Thank you, Steve and thank all of you for coming out.

What I'm going to talk about I think comes largely under the heading of Strategic Planning. A lot of what I'm going to talk about is some of the duties that you have as directors, not just of financial institutions but of any organization. And you’ll see the focus is really going to be on making sure that you’re part of the strategic planning process, that you're getting information from management and from others that you need to make the decision.

When you talk about what happened in Enron, what happened in WorldCom and all these other things that led to the Sarbanes-Oxley Act’s passage and other changes in the financial world in the last year or so, a lot of the responsibility for those problems really can be laid at the feet of directors who were not demanding that management provide them with the information they needed; were not asking the question, if we’re going to go this course of action, how does that fit in with our strategic plan, and what is our strategic plan?

There are four topics in the materials that you received in the booklets that were sent out. [Web reader: See your Powerpoint companion to this file.] I'm not going to spend very much time talking about management attraction and retention. I know there was already a session on that, and in the interest of time I'm just going to make a couple of points as it relates to that. I will talk a little bit about corporate governance issues and some of the things that relate to Sarbanes-Oxley, although Sarbanes-Oxley, by its terms, really only applies to companies that are SEC reporting companies, that is, that file 10Ks and 10Qs with the Securities & Exchange Commission, or if you don’t have a bank holding company, with the federal regulators. So some of the things I'm going to talk about are really more contrasting what applies in the banking context outside of the SEC reporting companies and where the regulators might be going with some of that.

Overview of Director Duties

I'm going to start giving you a little bit of overview, just regarding some of the legal basics, as it relates to directors and officers duties generally.

The board of directors and management have a duty to maximize shareholder value. Part of that includes establishing a long-term, strategic plan. And part of the strategic planning process has to be an evaluation as to whether your goal is to be sold at some point in the future or remaining independent. There’s various statutory definitions of what your responsibilities are, but by and large that you are charged with responsibility for managing the business and affairs of your bank. You’re required to discharge your duties in good faith with the care a prudent person in a like position would exercise under similar circumstances and in a manner reasonably believed to be in the best interests of the bank.

There’s obviously a lot of implications with that statement, and I'm going to cover what some of those implications are as we go through this process.

There are three ways that if your actions are ever challenged that courts look at what you do.

(1) By and large, actions of directors are covered by what’s called the business judgment rule.

And it’s important that you try to have your actions covered by the business judgment rule. Because the bottom line is, if a court later looks at your actions and concludes that the business judgment rule applied, you're not going to be held liable. So you want to get your decisions within the protection of the business judgment rule.

(2) There are certain types of decisions that are subject to enhanced scrutiny. Typically those are instances where directors implement defensive measures in response to a takeover offer or a perceived threat to change in control. What we advise our clients with respect to this issue is if you have not gone through a strategic planning process, if your role is to remain independent, there are various protective measures that you can put in.

This may include a staggered board where one-third of our board gets elected every year instead of the entire board each year, or whether you have some excess common or preferred to deal with issues should they arise in the future.

It’s important that take such steps when a threat is not present. Because if you do, it’s going to be protected by the business judgment rule.

If you wait until there’s some threat to the bank’s independence before you do it, then the courts are going to look at it on an “enhanced scrutiny standard.” And basically these are outcome determinative tests.

If the court concludes that the business judgment rule applies, almost certainly your decision-making is going to be upheld. But, if the court determines you're doing it in response to a threat and that’s the first time you're taking this action, they’re going to apply the “enhanced scrutiny standard.” And more often than not, courts overturn judgments of directors once they determine that the “enhanced scrutiny standard” of review applies.

(3) The other standards that sometime applies is the “entire fairness” standard.

If there is an actual conflict of interest in your decision-making that involves a majority of directors, the courts will use an entire fairness. They basically then just look at the decision on their own and determine whether it was fair.

Generally courts will not substitute their judgment for that of a bank’s directors and the directors will not be liable for mistakes in judgment if they’ve acted reasonably and in good faith.

Reasonableness requires that the board’s decision be thoroughly considered and based on adequate information, including, when necessary, the advice of experts such as legal counsel, financial advisers, and independent accountants. Good faith requires that your decisions not involve personal or other conflicts of interest. So the question comes up, how do you know how much information you need to ask for?

Obviously, if you're involved in a lending decision, for example, and it’s the type of loan that your board has seen many times before, you don’t have to necessarily bring your attorneys in, bring your accountants in, to evaluate that loan. You obviously do have to ask management for sufficient information on which to base your decision, but under those circumstances independent advisers other than the information that management provides is probably not necessary.

On the other hand, if you're going into a line of business that the bank’s never been in before, or say you're putting in some stock option plans that might have change-in-control features, such that vesting accelerates upon change in control of the organization then it’s important that you have your lawyers come in and talk to you about what the implications of that are.

How does that work if there were a change in control? Have your accountants or some other financial expert come in and say, “Here’s the impact that an acquirer would look at if they looked at the change in control features of those option plans, if they’re going to do an acquisition they’re going to factor in the cost of that to them in coming up with a price.”

So it really is determinative based on the circumstances at hand and how much information you need.

But if you do go through the process of asking for the appropriate information, you consider that information and come up with a rational decision. It doesn’t have to be right, because again, because if in 20/20 hindsight these things are almost never challenged unless somebody thinks your were wrong. But even if it’s wrong, if you’ve gone through that process you are protected by the business judgment rule.

Why Should You Adopt A Long-Term Strategic Plan?

Why should you adopt a long-term strategic plan? One is simply the threat to community bank independence. Obviously you work in a consolidating industry. The pace of consolidation has slowed in the last year or so because of the economy, and also probably because of the change from the pooling accounting to purchase accounting method of accounting for bank transactions. But I think it’s pretty evident that consolidation is going to continue in this industry for some period to come.

I've been involved in a little over two hundred bank purchases or sales over the last twenty years. In the community bank context, the biggest reasons for sale of a bank are aging directors and shareholders or lack of management succession. You’ve got a shareholder that has 25% of your bank and they’re getting up in years, they need liquidity. There’s going to be pressure to sell your institution unless you’ve got some planning in place in advance to deal with that issue. Obviously lack of liquidity in the market for your stock is part of that, increasing demands for improved financial performance, and vulnerability to unsolicited offers and other aggressive acquisition techniques.

Here are some of the keys to community bank independence: providing liquidity for your stock, retaining and incenting employees, attracting and protecting directors. If you do not have, in your articles of incorporation for your bank holding company or your bank, provisions that limit the liability of directors except generally in the context of gross negligence, you should be talking to your attorneys about getting those kinds of protections in. Almost every state has authorization in their corporate laws and most banking codes, including the National Bank Act, that authorize you to put in your articles of incorporation features that protect you from shareholder claims or other claims, except maybe in the context of gross negligence.

Capital Issues

Let’s discuss some of the specific strategies for providing liquidity.

One is formation and use of a bank holding company. I'm often asked, if I have a bank holding company, do I need a financial holding company because of all the activities that a financial holding company can now engage in, you know, with some of the banking changes that were made in the last couple of years.

Quite frankly, for community banks I really don’t see this as a powers issue. I don’t think, with a few exceptions, most community banks do not need holding companies because they can engage in some new activity. What they really need it for is capital planning. It allows you to have a lot more flexibility in dealing with stock buy-back issues, and other issues that come to bear that are just much more inflexible when you have a bank that does not have a bank holding company.

There are three components to your capital structure.

(1) Obviously the most common is common stock.

Holders of common stock are the ultimate owners and represent the most basic type of security ownership interest in the bank holding company.

Almost all bank holding companies have common shareholders.

The advantages of common stock is that if you need to raise capital for the issuance of additional common stock, obviously it counts as Tier One capital. It has the most positive impact cash flow because there are no mandatory dividends. And it provides for the highest capital ratios.

The disadvantage is that it’s most dilutive to your existing shareholder base. It has some negative impacts on performance ratios that I'm going to show you in a few minutes. And it’s the most expensive form of capital in the long-term.

Preferred stock. The holders of preferred stock generally are entitled to a preference with respect to dividends. Usually preferred stock carries with it a fixed dividend rate. If you don’t pay it in a particular quarter —it’s usually a quarterly dividend payment, it’s usually cumulative, so it carries over from quarter to quarter. There’s also a preference with respect to preferred stock on dissolution of the organization.

The advantages of preferred stock. It counts as Tier One capital. Depending on the structure, it can be designed as perpetual preferred stock which will count as Tier One capital if you have all the right components. It’s less dilutive to your common shareholders than the issuance of common stock.

One of the disadvantages currently is that it’s difficult to sell on reasonable terms. Now, it’s possible that this is going to change. I'm sure most of you are aware that President Bush has proposed tax legislation that would exclude dividends a hundred percent from taxation. [As of May 12, the House and Senate versions of the legislation differed, and the President’s proposal had had a seesaw history.] If that happens, preferred stock may well become a very attractive tool for investors because it’s essentially going to be on a par with tax-free municipal bonds. Most likely it’ll cost slightly more than tax-free munis just because of the risks associated with it, but a lot of people think that preferred stock will become very attractive again.

One of the other disadvantages of preferred stock is it’s typically not redeemable without Federal Reserve Board approval. It also impairs the ability for you to elect Subchapter S treatment should that be a part of your plan. That’s because with an S corporation you can only have one class of stock, and since you already have common, when you issue preferred you’ve disqualified your company from being an S corporation.

Trust preferred securities. I'm sure most of you have heard trust preferred securities. Your banks are probably being called on by the investment bankers with respect to some of the pools.

I'm going to talk a little bit about the pools in a second, but I'll give you a little historical overview.

Trust preferred securities basically have two major advantages. One is they do count as Tier One capital. Currently up to 25% of your Tier One capital can be in trust preferred. Secondly, it’s tax-deductible. There’s no other form of capital that the dividends that you pay on are tax-deductible.

The way this came about was in 1996 the Federal Reserve Board, approved a structure for the trust preferred securities that continues to exist today. The problem for most community banks was that it was prohibitively expensive. Because what you have to do to set these things up is get together with an investment banker, set up what’s called a special purpose vehicle that actually issues the securities, and historically, that’s been a Massachusetts business trust. A Massachusetts business trust has to have an indentured trustee. The indentured trustee is usually a large bank that engages in the indentured trustee business. It’s very expensive to pay the fees of an indentured trustee, both upfront and on an ongoing basis.

Typically then the Massachusetts business trust would issue securities to the public or to institutional investors, but it would do so on a registered basis. That means registering those securities with the Securities & Exchange Commission. That also is a very expensive process. The securities then are issued in exchange for the proceeds. The proceeds go into the Massachusetts business trust. It then loans the money to the holding company in exchange for a long-term subordinated debenture that creates this deductibility feature.

Because of the costs associated with this, through the late 1990s, it was only the large banking holding companies that were doing it. The first one we did was in 1996. It was a five hundred million dollar issuance. And until pools came along, it had almost to be above at least fifty million in the size of the offering, which obviously is not of interest to most community banks.

The features of trust preferred securities are that they are non-voting. They do count as Tier One capital. The interest you pay on the debenture is tax-deductible. They’re not convertible into any other class of stock. And they’re not a second class of stock for Subchapter S purposes. So you can have an Subchapter S corporation that has trust preferred and not disqualify your S corporation election.

They are thirty-year debt instruments. This is one of the conditions that the Fed imposed. They can be fixed rate or floating. Typically, the ones we’ve seen issued in the last eighteen months or so have almost all been floating. There are no financial covenants. The issuing bank holding company has a right after five years to prepay it. There is no right on the part of the holder to put it back to the company; it’s just a right of the issuer to prepay.

You—the issuer--have the right to defer interest payments for up to five years should you get yourself in financial trouble. There are costs to doing that. During the deferral period you can’t make any dividend payments to your common holders, and there are some other costs associated with that. But if you get yourself into that situation you have the right to defer interest payments and it’s not a violation of the terms of the trust preferred.

The advantages of trust preferred is that it is debt, for tax purposes. Up to 25% of your Tier One capital can include trust preferred. It’s not dilutive to your common ownership and the trust preferred shareholders do not share in future appreciation.

Some of the disadvantages is it is locked in for the initial five years. There are very limited circumstances in which redemption can occur during the first five years. The after-tax costs can be higher than debt. And as I mentioned, the expense upfront and annual administration have historically been a disadvantage.

Recently, as I said earlier, I'm sure many of you have been called upon by investment bankers to talk to you about pooled trust preferred offerings. Pool offerings, as the name implies, involve an issuance in which a number of institutions participate. There might be twenty or thirty institutions that will participate in a single pool. It might issue anywhere from three million to ten million. Those are clearly numbers that make sense to a community bank. They all get together and basically do the pooled offering. It still uses a Massachusetts business trust so it still has the cost of the indentured trustee. These still typically are registered so there’s still the registration costs, but it’s spread over those twenty or thirty institutions and therefore is made affordable.

In terms of some of the current rates and terms, the pools—we’ve seen some of them recently as low as three twenty over LIBOR. One some of the private deals that we’ve been doing, I'm going to talk a little bit more about for community banks, we’ve also come up with a structure that we use for community banks that want to do private placements. Those have typically been based on prime and going anywhere from one to one-and-a-half over prime.

The advantages of pooled offerings. If you’ve been in existence for more than four years and you have over a hundred and fifty million in assets, these may offer significant advantages. There are disadvantages—typically there’s a limited life to the rate cap on pool transactions. Most of the transactions that are done on a variable basis will have a rate cap, have a maximum rate that can go up if interest rates go up, but they’re usually only in place for five years—the theory being that since you have the right to redeem after five years, you don’t need the rate protection after five years. Well, a lot of institutions don’t want to be put in that position and so on some cases they’ve been able to negotiate with the pool issuer or investment banker a right to have the full thirty years to have that rate cap apply, but they typically have to pay a slightly higher rate.

There’s also typically annual maintenance fees. May not be available for banks with less than a hundred and fifty million in assets. But as I said, some of those have been going recently for as low—with institutions, as low as a hundred million in assets. By and large, institutions have to be in existence for at last five years. And pro forma, their Tier One risk base capital has to be ten percent or greater. Terms of these securities can be less attractive in stand-alone terms, although as I said, three twenty over LIBOR is a pretty attractive rate.

While you can’t control totally the timing of a pooled issue, they are coming out pretty rapidly, usually about every two months, so if you want to participate in a pool most of the time you can do so within a couple of months planning. Typically, pools do require audited financial statements.

My firm came up with a structure that we’ve been using in the midwest. We’ve done five transactions now in the last year that have been done with community banks that have done issuances anywhere from three to five million in total, and they’ve done it as private placements. And the reason they’ve been able to do it is the way that these things have been structured has really reduced the cost significantly. Because, instead of using a Massachusetts business trust as a special purpose vehicle, we use a limited partnership. The issuing holding company serves as the general partner of the limited partnership. So it basically serves instead of the indentured trustee. And therefore the cost associated with that is gone.

The structure basically of all these transactions is something like this: the bank holding company’s on top. It sets up the special purpose subsidiary. In the case I'm talking about it’s going to be a limited partnership that issues the trust preferred securities to the investors. The proceeds come back in. The proceeds are loaned up to the bank holding company in exchange for these debentures. The advantages of this type of structure is that the cost is significantly reduced because you do not have an indentured trustee. There won’t be any annual fees. The bank holding company as the general partner controls the operations. Its timing is controlled by the issuing bank holding company. It sets the rates, caps, call features, et cetera Audited financial statements are not required.

In addition, investors can be peer banks. Most of the transactions we’ve done recently in the midwest, all of the buyers have been other banks, and there’s some major advantages to that. From a legal standpoint, if you’re on the buyer’s side and ask the question can I do this, the OCC, the FDIC and a number of states have ruled that these are appropriate investments for banks.

Obviously any of you that are involved in the investment side of your institutions know that, first of all, the investments you’re permitted to make on behalf of the bank are fairly limited, and certainly you can’t invest in instruments that are not rated or readily marketable. What the regulators have concluded, however, is that when you really look through the substance of this transaction, what’s really underlying it, it really ultimately is a loan by the investor to the bank holding company. And since banks are in the business of loaning money, the regulators have ruled as long as you follow your underwriting standards in making this investment they’re going to require you to just essentially treat it as a loan.

The advantage to you as the issuer of issuing to other bank holding companies or other banks, is that the transaction costs are significantly lower. So if you do a private placement of this nature and all of the buyers are banks, the costs are significantly reduced because not only do you not have the indentured trustee, but you don’t have the registration costs. So these issuances of three, four, five million dollars are cost-effective to other institutions.

What are the advantages to you as a buyer? Why would you want to buy into one of these other bank’s issuances? First of all, the rates, if you think of it as a loan, are fairly favorable. It’s typically, as I said, based on prime rate and they’ve gone at prime plus one to one-and-a-half.

Yes, it’s true that these are thirty year unsecured instruments. On the other hand, a lot of banks, when they’ve analyzed these have said you know, the risk of a lot of the secured loans that I have in my portfolio is a lot higher than making an unsecured loan to another bank. But I understand their business, I understand how they’re regulated. They’ve got a whole series of issues that make that, the risk of default even lower than a lot of my secured loans.

What’s the effect of issuance of capital using these various types of capital? I'm going to give you an example here where you’ve got a bank with ten million dollars in capital wants to increase its capital by fifteen percent or $1.5 million to $11.5 million. I'll show you the impact with common, preferred, and trust preferred.

In the common stock setting—in all the settings, you’re going to have your ten million in capital to start with—they’ve got a hundred thousand in common outstanding currently, they issue fifteen thousand new shares at a hundred dollars a share to raise that million-and-a-half, which of course, raises their pro forma shareholders equity to eleven-and-a-half million and also their Tier One capital. For the example, we’re going to assume there’s a million five in earnings. The shares outstanding went from a hundred thousand to a hundred and fifteen thousand so their earnings per share are now $13.04. Return on equity is 13.04%.

Contrast this with preferred stock, again, using the same million dollar capital bank, a hundred thousand shares. They issue fifteen thousand shares of preferred stock at a hundred dollars a share. This also goes to the equity line, and it also goes to the Tier One capital line. The same million five in earnings. Here, however, we’ve got a mandatory dividend payment of five-and-a-half percent which equates to $82,500. The common shares outstanding remain a hundred thousand, so the earnings per share, there’s actually a slight pickup in earnings per share, but the return on equity goes down slightly because of the fact that there’s this dividend being paid and you’ve had the same increase in shareholders’ equity that you saw in the common situation.

Now you look at the trust preferred. Same scenario, but here we issue a million five in trust preferred at five-and-a-half percent. Same five-and-a-half percent rate that you're using for the preferred stock in that example. This does not go to the shareholders’ equity line. Total Tier One capital goes up to $11.5 million. Same million five in earnings. Your interest payments on your trust preferred, because it’s tax-deductible, that five-and-a-half percent after taxes is actually 3.3%. So your cost is $49,500. Your shares outstanding remain at a hundred thousand shares so your earnings per share go up $14.51 and your return on equity, since trust preferred doesn’t go to the shareholders equity line, also goes up.

So, do the side by side comparison. If you look towards the bottom you see the EPS for all three cases. The most expensive form of stock in terms of the impact on earnings per share is common, followed by preferred stock, and trust preferred being the least costly. From a return on equity standpoint, the most costly is preferred stock with, at least at that rate of five-and-a-half percent, with common stock being the second most costly, and trust preferred again, being the least costly.

What would you use trust preferred to do? Obviously if you need Tier One capital you can use it to pay down debt while simultaneously increasing Tier One capital. You can support internal growth, acquire another bank or branch, repurchase common stock. If you had that situation where you’ve got a significant shareholder—let’s say you had a 25% shareholder who’s getting up in years and needs to have liquidity and needs to get cashed out—you can effectively, by the use of trust preferred stock, replace 25% of your common stock with trust preferred, buy out that interest, and not have any negative impact on your Tier One capital.

You can also use it to cash out ineligible or smaller shareholders in a Subchapter S transaction, which I'm going to talk about next.

Subchapter S

Subchapter S is not for everybody. In terms of who should consider it, it would probably be best to start with who should not consider it. The principal barrier to being a Subchapter S corporation is the limit on the number of shareholders that you can have. Currently you can’t have more than 75 shareholders and be an S corporation. There’s been talk for the last couple of years about raising that to 150. [Legislation is again pending to liberalize Subchapter S rules, as of 5/12/03.] If you could, using the technique I'm going to describe in a minute, get down below 75 shareholders or 150, whatever the case might be, if your plans in the next three to five years are to grow by issuing additional common stock, either, in a stock offering or if you’re going to do an acquisition of other institutions that might involve stock issuances, then an S corp is probably not for you.

Similarly, S is likely not for you if you're thinking about selling in the next three to five years. The reason is because if you’re a C corporation and you go to an S corporation and then within a three to five year window, you go back to C corporation status, there are recapture issues that make it disadvantageous for you to make the S election in the first place.

If you are otherwise in a situation where it makes sense for you to think about S election status, there are major advantages. Basically the biggest advantage and the most well-known advantage of an Subchapter S corporation is that it eliminates the tax at the corporation level. The taxation on earnings that the corporation derives, or the bank derives, flow through directly to your shareholders. And so you’ve effectively resulted in thirty-four cents in taxes saved for every dollar your bank holding company earns.

There’s a second component of savings as well. For every dollar you retain in an Subchapter S corporation that you don’t pay out in dividends, that increases the basis in the Subchapter S corporation shareholders’ stock. So that results in twenty cents in capital gains tax saved when that shareholder saves their tax because their basis has gone up dollar for dollar on those retained earnings.

What are the requirements for an Subchapter S corporation election? As I said before, you have to have seventy-five or fewer shareholders. All shareholders must be eligible. And that means the statutory definition of eligibility excludes from those shareholders who are C corporations. You can’t have partnerships, you can’t have IRAs, and there are certain types of trusts that can’t be shareholders in an S corporation. You have to have a single class of stock, as I mentioned earlier. And 100% of your shareholders have to consent in writing to the Subchapter S corporation election.

Well, the question then comes up, if I've got shareholders who don’t want to sell their stock or you’ve got one shareholder that won’t sign this Subchapter S election, how do I accomplish that? There’s a technique. It’s basically a “squeeze-out merger.”

You set up a shell corporation. The shell corporation merges into your bank holding company. And in that process you squeeze out shareholders that wouldn’t qualify or otherwise present you with problems. This does not require regulatory approval. It does require shareholder approval. Under the terms of your merger agreement, shareholders who are eligible to be Subchapter S shareholders who consent in writing to the S election, who sign a shareholders agreement by which they agree in the future not to dispose of their shares to shareholders who would not be eligible or would otherwise, affect your eligibility as an S corporation, and then who also own more than a set number of shares, remain as shareholders. Basically, what you do on that last point is you just look to see where the cutoff is. You look at your shareholder base, if you’ve got everybody over a hundred shares, if you took out everybody under a hundred shares you would be below seventy-five shareholders, then that’s where you might set your target. Conversely, what happens to the remaining shareholders? Those who not eligible for Subchapter S treatment, won’t consent in writing to the S election, or who will not sign the shareholders’ agreement, or in my example, who own less than the hundred shares, receive cash.

You have to go through a valuation process, which means you hire an outside expert. It might be your accounting firm or some other valuation expert to come up with a fair value to cash out those shareholders, but that’s what happens to those shareholders.

One of the big questions that often comes up in the community bank context is this:

Many of these people that are going to get squeezed out in this context aren’t going to be very happy about it, and they’re bank customers, they’re children of directors, etc. With proper planning you can minimize the impact. If you know you’re going to do this, as I said, you have to have a shareholder meeting to approve it. Oftentimes what we advise our clients is say you’re going to have a special shareholder meeting this November to get the transaction approved by your shareholders, but you know now you’re going to be doing it and you’ve got your annual meeting coming up in April. Start talking about it.

Tell those shareholders that, if you’ve got a parent who has distributed shares to their children and, you know, they’ve got five shares here, five shares there, but they want to keep those shares in the family, that they may want to reconsolidate stock ownership so that they can have one shareholder that owns all those shares instead of five or ten. And thereby they can still remain in the organization.

Another strategy is to maintain a list of former shareholders for use if stock becomes available. This can help both with liquidity, but also from a relationship standpoint. If you tell your shareholders when you're cashing them out that you will put them on a list if they so desire, that if shares become available by one of your retained shareholders in the future, then obviously that promotes good will—and it also promotes some liquidity in your stock, and marketability in your stock.

It also can be done in conjunction with a privately placed trust preferred securities. We saw a transaction recently in Illinois where a corporation had over 450 shareholders and squeezed out enough shareholders that they went down to 65 shareholders. And basically what they looked at when they looked at their shareholder base, it just had so many spread out among so many small shareholders that they were able to do it. They issued trust preferred securities. It took their Tier One capital was fully funded at that 25% level. In conjunction with that, they knew they were going to have some upset shareholders, so in their case they decided to go ahead and register the offering so that they could offer it to their community shareholders.

So those people that were being cashed out were offered the opportunity, even though they weren’t real happy about having to pay the capital gains tax on the shares that were redeemed, they were offered the opportunity to take that cash and invest in trust preferred securities.

And many people participated. Most weren’t that excited about being common shareholders. What they liked was being connected with the bank and they liked the dividend. And now they’re still connected with the bank and they have a higher dividend.

There are three sources of funds for paying the cash out portion of an S corporation election.

One is obviously, if a bank has earnings available, to pay a dividend.

You can borrow funds from third parties.

Or you could use the trust preferred securities to do it.

The after-tax return for shareholders of a community bank holding company increases by 35 to 45 percent by going to an S corporation. I'm going to illustrate graphically how shareholders’ cash flow and liquidity also increases dramatically. And with these kind of enhancements the bank holding company should be worth more should you decide to sell it.

I'm going to give you an example of a hundred million total asset bank holding company that has ten million in capital. The bank holding company earns $1.5 million after taxes. This should say $2.25 million pretax. Has a hundred thousand shares outstanding. In order to get Subchapter S eligible, the holding company squeezes out 20% of its shares or twenty thousand shares at one-and-a-half times book value for a total of three million dollars. It funds the purchase with trust preferred securities that have a fixed rate in this context of 7%. The bank holding company’s annual interest expense would be $210,000 pretax, $139,000 after tax.

The impact of that. First, the bank holding company’s aggregate earnings decline by that $139,000 after taxes paying on the trust preferred. So it goes from $1.5 to $1.36 million. But at the same time, the number of shares are decreasing from a hundred thousand to eighty thousand. So the effect of that is the bank holding company’s per share earnings increase from $15 a share to $17 a share, over 13%. That’s just because of the repurchase and has nothing to do with the S election. The bank holding company then makes the S election. And let’s show you what the comparisons are.

Again, in our example, $2.25 million in earnings. In the S corporation context there’s $210,000. This is shown kind of as an income statement—it’s actually a cash flow statement to shareholders, but there’s $210,000 in cash that goes out to pay the interest on the trust preferred. The C corporation has to pay the corporate income tax. The corporate income tax is $765,000. The S corporation has no corporate income tax because it flows through to the shareholders.

Now, in this S corporation, because the shareholders are paying the tax, remember I talked earlier about there would be a shareholder agreement you would enter into with your shareholders to make sure that they don’t sell the shares to a non-qualifying shareholder. There’s another component to that shareholder agreement, and that is that the corporation promises to pay a dividend to the shareholders that will allow them to pay the tax.

Sometimes I'm asked, “what happens if we can’t pay the tax?”

Well, the answer is pretty graphically illustrated here. If you have the corporate income tax you’re paying $765,000. You’re only paying a slightly higher amount if you’ve got the S corporation. So I guess the other way of looking at it is if I'm unable in this S corporation to pay the $787,000 if I still had the C corporation I'd probably be unable to pay my taxes. That’s probably a far worse problem for you than being unable to pay your shareholders a dividend. The dividend is paid out at the highest marginal tax rate, currently 38.6%, because you have to pay a high enough dividend so all your shareholders can pay their taxes, and you have to pay the same dividend to all your shareholders.

And this example shows that your income after taxes, or cash flow after taxes, is $1,485,000 for the C corporation; $1,253,000 for the S corporation. For purposes of this example we’re going to assume that we’re going to have $500,000 retained by the corporation. So the available dividend to the C corporation shareholders is $985,00o. To the S corporation shareholders it’s $753,000.

To this point you don’t see the impact.

But the next line shows you where the impact is.

We’ve already paid the tax in the S corporation. The C corporation shareholders still have to pay a tax on this dividend. That’s $380,000 using this example. So the after-tax dividend for the C corporation shareholders is $605,000, whereas it was $753,000 for the S corporation. The impact is actually greater than that because, remember, in the S corporation we’ve taken out 20% of our shareholders. So those shareholders that are getting that $753,000 are 80% of your former shareholder base. So if you apply that same dividend that the 80% of those shareholders that would not have been squeezed out, but who remain in the C corporation, they’re effectively only getting $484,000 of that $605,000. So the real comparison, when you compare shareholder to shareholder of C corporation to S corporation is, in the C corporation, those shareholders are getting $484,000, whereas in the S corporation they’re getting $753,000 in additional cash, which is a pickup of 55.58%.

On top of that, as you remember, I said the earnings that are retained by the corporation goes to the basis of the S corporation shareholders. So those shareholders in the S corporation are getting a 20% pickup on that. That’s because when they go to sell their stock, they’re not going to have that 20% capital gains tax. So it’s really pretty dramatic.

Before I go on to the next topic there’s a question that’s often asked: What happens if the Administration’s proposal is passed as it relates to the dividend exclusion?

First of all, I guess nobody knows what’s really going to happen there. Some have suggested that although the proposal is for a 100% dividend exclusion, that what the Administration would settle for, and really is trying to get, is a 50% exclusion. While the numbers would change, from what I just showed you, there still is a dramatic increase even if it were at 50%. In addition, I've received several mailings recently from accounting firms who have indicated that even if it’s 100% dividend exclusion there’re still major advantages to having an S corporation.

ESOPS

As I said, I'm not going to spend a lot of time on stock based compensation. I am going to talk about one issue and that’s an employee stock ownership plan strategy that can work in certain limited circumstances.

Basically there are ways, through the use of an ESOP, that you could cash out a major shareholder on a tax-free basis. There are a whole series of technical requirements, but basically through the use of an ESOP, if you fund it by purchasing stock that’s held by one or more of your shareholders and you purchase all of the stock that they have—that is, they can’t retain one share of stock and have this work—if you do that, and when all is said and done on a pro forma basis, post acquisition, your ESOP owns 30% or more of your common stock outstanding, then the selling shareholder within a certain period of time, can reinvest those cash proceeds in a qualifying investment, which typically is a New York Stock Exchange listed company or the like, and they have a tax-free transaction.

They do not pay taxes on the receipt of the cash. They don’t pay taxes until they sell the stock they bought. And they get a carryover basis from their basis in the bank holding company stock, but they’ve effectively converted illiquid stock into a liquid stock on a tax-free basis and relieved you of the pressures of having to deal with a significant shareholder that may need to be cashed out.

Very limited in terms of when these things can apply. There’s a whole series of Department of Labor regulations and IRS regulations that, you know, apply to these kind of things because it is an ERISA plan.

You ought to talk to your accountants about where they see financial accounting standards as it relates to stock option plans going. For the most part, qualified and nonqualified stock option plans have historically, if they’re done right, not been subject to financial reporting expense requirements.

There is a trend away from that. It’s conceivable in the next two or three years that they might require that stock options be expensed, either as they’re exercised or otherwise. And if you talk to your accountants and if you’ve got some potential big exposure in conjunction with those, if those financial accounting standards do change, then you ought to be planning for that as part of your strategic planning process.

Corporate Governance

With that I'm going to flip forward to some of the issues on corporate governance. Again, as I said at the outset, Sarbanes-Oxley is really generally applicable only to institutions that are reporting companies, that is, report on 10K or 10Q.

Can I have a show of hands how many companies present file 10Ks or Qs? Okay. About three or four. Okay.

How many of you have asset sizes over five hundred million? Okay. It looks like most of you.

Many of the things that were imposed by Sarbanes-Oxley, whether it be the certification requirements of financial reports, the independent directors on your audit committee, the requirement that you go through analysis of your internal controls and all those sorts of things --those have been in place for some time for those of you who are over $500 million in assets.

One new requirement is the one that your audit committee includes someone with financial experience. If you're under $3 billion in assets, that’s a new requirement for you.

But for the most part, the new requirements, whether it be the certification issues or some of these other things I just mentioned, are things that have been in place and you’ve had to deal with for quite some time. So I think I'm going to skip over the certification issues in the interests of time and go to a couple of other issues that Sarbanes-Oxley put in place.

(1) One is bans on loans to executive officers and directors. As many of you probably read, one of the abuses that took place in a number of the companies was that there were low-interest loans given to executive officers that might be forgiven over time. And Congress in response essentially issued a ban on that.

For banks and bank holding companies, it’s really not much of an impact, because one of the exceptions that exists is loans made by FDIC-insured banks. Since you’ve all been subject to Reg O already, these new requirements really don’t have much impact.

There are a couple of areas of concern, however, if you’ve got any of these things in place that are just unanswered questions.

One is split-dollar life insurance policies. A lot of organizations use split-dollar life insurance as a vehicle to incent management. And basically these are policies where, ultimately, the executive receives the proceeds. It might be, you know, payable on death or at a certain age that the proceeds are payable, but the company pays the premium. The only part of the proceeds that the executor of his or her estate would not get is the company gets a return of the dollars that it actually paid in premium. There’s a question as to whether that’s a loan. It’s really an unanswered question at this point. And if it’s a loan, does it fly in the face of this ban? There are certain structures of some of those that could be considered loans, that also could be problems. Also there’s an issue with respect to relocation loans.

I'll just mention there was a major abuse at Enron that took place with respect to their pension plan. The pension plan was in a blackout period where the participants in the pension plan couldn’t get rid of their Enron stock while everything was going in the tank. But at the same time executives of Enron were selling millions of shares. In response, Congress has implemented a ban that’s sort of simultaneous with a ban that might exist on a pension plan, then those blackout periods, executives can’t sell stock either if you’re a public reporting company.

Then there’s also some listing standards you can take a look at in the materials. There also are criminal penalties in place for attempting to improperly influence audits. That was obviously one of the Enron allegations.

The audit committee financial expert I mentioned--this thing has gone around a lot of different permutations. The biggest problem, one of the biggest problems, that people had with this concept was that not only were you going to have to have a financial expert on your audit committee, that almost by definition had to be a retired CPA or a retired CFO. The analogy that was made in the argument was that Alan Greenspan could not qualify under that test.

The test that ultimately came out actually added a phrase at the end that basically listed all these criteria and then said, “or other relevant experience.” Now, what that means nobody quite knows yet, but presumably, if you want to ask Alan Greenspan to be on your audit committee, he will now qualify.

Code of ethics for senior officers is now mandated. Whistleblower protections, obviously there’s a lot of issues relating to that in Sarbanes-Oxley.

Professional conduct rules for attorneys—there’s really one aspect of that that’s still unresolved that is a major issue for the legal profession. Basically what these rules now require is that with respect to reporting companies, outside attorneys, if they see violations of securities laws or the like, are required to report that to the internal legal counsel or the CEO. If they don’t get an appropriate response, they’re then required to go to the audit committee or the board of directors. That has some practical implications because one of the arguments that’s out there is that that’s going to cause CEOs or chief legal counsel to be less candid with their attorneys when they have problems that they need to deal with.

But that really isn’t the ethical issue that’s out there. There is a component of this rule that has not yet been enacted by the SEC that’s still under consideration, and that would _ there’s a lot of different variations of it, but when all is said and done, it requires the attorney, if the board or the audit committee doesn’t give an appropriate response, to then report the violation to the Securities & Exchange Commission or somehow otherwise make it public.

And the problem with that is that attorneys are not independent public accountants. Independent public accountants by definition are independent. Their job is to report information to the investing public. Attorneys have an attorney-client relationship with their clients and one of confidentiality. And that issue of confidentiality requires that attorneys not make public information that they’ve gained through that confidential relationship. So that’s still a big area of debate.

There’s this retaliation prohibition that goes along with the whistleblower protection I talked about earlier that creates up to ten years imprisonment for violations of a variety of different federal offenses.

An area that has created some issue among a lot of our community bank clients is this issue with respect to the prohibition on non-audit services. If you have an independent auditor, if you’re a reporting company, you can’t use them for your internal audit and a list of other type of services.

For those companies that are already running into this issue, the immediate impact is they’ve seen an increase in cost for their external audit. Whether audit firms use the promise or the potential of getting these other services to encourage them to bid low on the external audit, or whether there truly was some efficiency by having the same firm used as your internal and external auditor, I'm not sure.

But the bottom line is that the cost of external audits is going up, in part in response to this.

And the big question right now is whether the regulators are going to impose the same requirement on non-reporting banks and bank holding companies. There’s a lot of discussion ongoing about that.

There’s also a prohibition in the act on employment of auditor personnel that you ought to be familiar with, if you are not.

Then finally, the other issue that’s affecting the accounting firms is this audit partner rotation question. It requires that you rotate off the audit partner every five years if it’s a public company. This is also a question that’s being debated as to whether that ought to be made applicable to non-reporting companies in terms of whether the federal regulators will require that.

WRAPUP and Q&A

With that, I guess as I said, the overall discussion that I've tried to talk about really has been your strategic planning process.

I wanted to talk about maybe one practical suggestion you might want to think about. I know there’s been a lot of literature out recently about whether if you have a CEO who’s also chairman of the board and therefore controls the agenda of the board, whether that should be separated. I'm not sure I'm a strong advocate of that. I haven’t in a community bank context seen a lot of abuse with respect to that issue. But there is one thing that I do advocate, and that is having executive sessions where at the end of a board meeting anybody that’s employed by the bank, including the CEO, leaves so that there can be a candid discussion among the independent directors about any issues that are on their mind.

I often get sort of an initial kind of knee-jerk reaction against it from CEOs—no, I don’t want to do that. But quite frankly, we think it’s really kind of a positive for everybody. Because if you don’t have that, what tends to happen is you have sidebar conversations that take place and these issues tend to fester and, you know, get to a level that they don’t need to be if you had this practice in place.

What we recommend, quite frankly, is during this executive session you rotate from month to month who’s the chair of that executive session. That way if you have an issue that you need to talk with the CEO about, the person who goes and talks to him about it just happens to be the person who is the chair of that session that month. So there’s nothing that’s attributed to that person personally. It’s, you know, an entire board issue. And by and large, if you have those kind of sessions, what we find is that issues get addressed earlier on before they become big problems and they get solved earlier on. And if you don’t have those kind of programs in place they can _ problems that might not otherwise be brought to management’s attention _ become big problems.

So with that I'm going to stop and let you ask any questions and I'll attempt to answer. Yes?

AUDIENCE MEMBER: At the very beginning you talked about the role of [off mic – not audible enough to transcribe]

JOE HEMKER: Okay. That’s a good question. First of all, the courts don’t really distinguish between what size your organization is in terms of the legal standards that apply. But the courts have, you know, formerly stated that your duties as directors are not to provide a short-term return to your shareholders. It is your long-term strategic plan that is important. And in developing your long-term strategic plan you're entitled to consider other constituencies. And certainly if you’re a community bank, other constituencies include what impact it would be to your community bank customers if you were to sell to some big organization that’s no longer going to service your community. And while, as a legal matter there really isn’t a distinction between a shareholder of one corporation versus a shareholder of another corporation, people clearly buy in the community banks with an expectation that they’re going to be part of an organization that’s going to have as its focus the customers, both in the short-term and the long-term.

You can’t lose sight of the fact that you still have to deliver an acceptable rate of return so you’re going to have to compare yourselves against peers. Who are your peers? Your peers are other community banks that have similar approaches. You don’t have to compare yourself against, you know, some industrial company that, you know, might be having a multiple on earnings, you know, fifty times or something like that, if anybody has that kind of rate these days. But you compare yourself against other community banks. And since community banks do tend to have that same philosophy, that’s an appropriate way to go about addressing that issue.

AUDIENCE MEMBER: [off mic question]

JOE HEMKER: I've been involved in a lot of acquisitions of other banks, including in the late eighties and early nineties a lot of acquisitions of failed institutions, and where I saw some of the money penalties and those kinds of things implemented by regulators against bank directors, you had almost invariably directors who simply were not paying attention, did not take their responsibilities seriously. And I will tell you, even to this day, I run into situations like that. I had a situation where I got a call from a bank CEO a couple weeks ago and he was complaining to me about the chairman of his audit committee. And what his concern was, was this was a bank that has been under an MOU with the federal regulators for the last two years. They think they’re going to be coming off of it in April. The audit committee was scheduled to meet on a particular morning with their independent auditors after they completed their audit, to go over the results of the audit. The chairman of the audit committee was down here in sunny Florida. Now, they knew he was going to be because he spent six months of his year down here in Florida, which is sort of your first indicator that you might have a problem.

In any event, he was supposed to be participating by conference call. First of all they had trouble getting hold of him. When they finally got a hold of him he said, “How long is this going to take? I’ve got a tee time in ten minutes.”

Obviously that is a bank director who is not probably going to be protected by the business judgment rule should that bank deteriorate further. But, you know, those are obviously instances where regulators get fairly excited if they become aware of those kind of issues.

But I think, you know, the practical advice is, you know, be on top of the issues. Ask management for information. Don’t wait until the loan portfolios start to sour before you start asking those tough questions. If you’re already in that situation you got to be working very hard with management in terms of what’s the strategy for dealing with this, and on what basis do you think that’s going to work. You know, how does that fit into our plan? How should our plan be adjusted? Do we need to be thinking about raising additional capital to, you know, address the deficiencies that are going to occur. But again, they’re all part of this planning process that you need to be part of every day.

AUDIENCE MEMBER: Should you minute those executive sessions that you recommended?

JOE HEMKER: Okay. The question is, if you go into executive session like this, do you keep minutes of that, and who keeps the minutes and, what are the implications of that because it’s going to be part of your board minutes if you do keep minutes.

Well first of all, from a practical standpoint, you simply appoint one of the other directors as temporary secretary for that purpose just like you have appointed one of the people as chair of that portion of the meeting on a rotating basis. But yes, you would keep minutes, but the real practical reality is that most of those meetings are very short because rarely are there issues. If there are issues that are significant enough to warrant discussion with the CEO then there should be some mention in the minutes about the fact that this topic was discussed and a temporary chair was, you know, directed to have a discussion with the CEO about it.

But problems rarely develop to that level. And so the vast majority of time, there’s really nothing for that secretary to report except that they met in closed session and what time they adjourned.

AUDIENCE MEMBER: At what age of your CEO should you think about succession planning?

JOE HEMKER: I think succession planning should start the day you hire your CEO. It really starts with middle management. Who you're bringing in, what kind of qualifications you have so that those people can be brought up. As you’re going through the hiring process of your CEO you’ve got to ask some questions about what is their philosophy about bringing up the next generation of managers. It’s not a process that you can do in a day. This is something that’s an ongoing process.

So I don’t know if there’s a magic age. You know, obviously people have different philosophies about, you know, when people should retire and it varies a lot from institution to institution. So I don’t really want to do it in the context of age. I think that’s just an ongoing basis that should be part of every bank’s strategic planning process no matter--because it’s not just age. I mean, the person might get hit by a truck. You know, what do you do under those circumstances? So the strategic planning process really includes management succession, certainly at the top level. It includes director succession as well, and planning for that at all stages.

THE END