United States: Conversion Merger — An Emerging Strategy For Small Mutual Associations?

Last Updated: January 5 2016
Article by John J. Spidi

Wells Financial Corp., a small bank holding company located in Wells, Minn., recently completed its acquisition of St James Federal Savings and Loan Association, a mutual savings association located in St. James, Minn., in a rare transaction known as a "conversion merger." In the past 20 years, there have been seven non-supervisory conversion mergers undertaken and successfully completed, two of which, including Wells, occurred in June and July of this year.

While back-to-back conversion mergers may not signal a trend, they do perhaps represent a new strategy for small mutual thrift institutions and their stockholder-owned bank counterparts. What may spark increased interest in this type of transaction, however, is the relief obtained by Wells from regulations that would normally require the acquiring bank to undertake some very expensive post-transaction listing and reporting requirements. For non-reporting bank holding company acquirers, this relief greatly reduces the post-transaction costs and burdens of the conversion merger.

As the name implies, a conversion merger is really two transactions. The first is the conversion to the stock form of organization of a mutual savings institution. Simultaneously with the completion of the stock conversion, the converted savings institution merges with a stockholderowned financial institution. As part of the conversion, the stockholder-owned bank offers shares of its stock in a subscription offering with first priority to purchase the shares given to the depositors and borrowers of the converting mutual association. Typically, the stock of the acquirer is offered at a 5% to 15% discount to the market price of the acquirer's stock, with the amount of the discount subject to negotiation between the converting mutual association and the acquirer. Shares not sold in the subscription offering are simultaneously offered to members of the general public in the communities served by the parties to the transaction.

"Historically, small mutual institutions have been happy to be independent, member-owned, community banks with limited access to the capital markets, relying primarily on retained earnings for capital and growth. However, given the higher operating costs and growing regulatory compliance burden on community banks, scale increasingly matters and so does access to capital for growth. "

One reason why conversion mergers are relatively rare transactions is that they have been viewed with skepticism by federal banking regulators, which since 1994 have imposed significant regulatory hurdles and limitations on these transactions. There exist no federal banking regulations specific to a conversion merger; however, the regulators have broadly applied the federal mutual-to-stock conversion regulations to conversion mergers and have instituted certain policy limitations regarding eligibility to undertake a conversion merger.

Historically, small mutual institutions have been happy to be independent, member-owned, community banks with limited access to the capital markets, relying primarily on retained earnings for capital and growth. However, given the higher operating costs and growing regulatory compliance burden on community banks, scale increasingly matters and so does access to capital for growth. As a consequence of these pressures, small mutual banks are reconsidering their independence and are instead looking for a new growth strategy that does not rely exclusively on retained earnings. Indeed, these are the reasons given by St. James for its decision to merge with Wells. In the other recently completed conversion merger, Commonwealth Bank FSB, the merging mutual bank cited its reasons for combining with a bigger bank: limited options continuing as a stand-alone entity, growth and earnings pressure, high operating expenses as a stand-alone entity due to its small size and limited earning capacity, and the increasing complexity of regulatory compliance. Thus, an exit strategy for small mutual banks may be emerging.

The benefits of a conversion merger to the acquiring stock bank are obvious: increase market presence through a low-cost acquisition and simultaneously raise capital. The benefits of a conversion merger to the mutual bank are less obvious but still exist: achieve scale through a business combination with a larger bank with greater earnings and capital to support the increasing regulatory burden and higher operating costs; customers of the mutual bank obtain access to a greater array of products and services; the owners of the mutual bank (depositors and borrowers) have the opportunity to become stockholders of the resulting bank; and directors, officers and employees of the mutual bank, to some extent, get positions with the resulting bank. In essence, the franchise survives as part of a larger organization. In addition, to the extent that the members of the mutual bank purchase stock in the conversion merger, they benefit immediately by being able to purchase the acquirer's stock at a discount, and they could also achieve capital appreciation through stock repurchases, dividends on the stock and ultimately a take-out premium on the sale or merger of the resulting bank.

"Because these transactions are reviewed and approved by the regulators on a case-by-case basis, it is possible to imagine that the regulators will expand the scope of mutual banks that are eligible to undertake a conversion merger by, for example, allowing mutual banks with greater than $35 million in total assets to do a conversion merger."

If there is a trend developing on this emerging strategy for small mutual institutions, it will almost surely be fueled by the flexibility shown by the regulators in the Wells/St. James conversion merger. Wells Financial Corp. was formed in 1995 as part of the mutual-to-stock conversion of Wells Federal Bank, its wholly owned subsidiary. In February 2005, Wells went to great effort and expense to terminate the registration of its common stock with, and thereby stopped reporting to, the SEC by completing a modified Dutch auction issuer tender offer and a 1-for-100 share reverse stock split. By terminating its registration with the SEC, Wells achieved significant savings in legal and accounting costs related to being a public company registered with the SEC. In pre-filing conferences with the regulators relating to the conversion merger with St. James, Wells was able to obtain relief from compliance with several provisions of the mutual-to-stock conversion regulations that, to our knowledge, had not been previously granted in any conversion transaction. For example, after completing the transaction, Wells was not required to register with the SEC for a minimum of three years; list its stock on the Nasdaq Stock Market; downstream 50% of the proceeds from the stock offering to its subsidiary bank; or wait one year before it can commence stock repurchases. This relief translates into substantial posttransaction expense savings and cost reductions in terms of Nasdaq listing fees, attorney fees and accounting fees, as well as employee time, expense and distraction from the main business of banking. Absent this relief, Wells likely would not have proceeded with the transaction.

Because there are no hard and fast regulations applicable to conversion merger transactions, federal banking regulators can be flexible with the elements of the mutual-to-stock conversion regulations and policy limits that are imposed on such transactions, as evidenced in the Wells/St. James conversion merger. Because these transactions are reviewed and approved by the regulators on a case-by-case basis, it is possible to imagine that the regulators will expand the scope of mutual banks that are eligible to undertake a conversion merger by, for example, allowing mutual banks with greater than $35 million in total assets to do a conversion merger. Given the flexibility the regulators displayed in the Wells transaction, and the fact that these transactions are handled by the regulators on a case-by-case basis, small mutual institutions with more than $35 million in total assets should give consideration to a conversion merger as one of their potential strategies to survive in the increasingly difficult environment for small banks. If indeed banking regulators continue to be flexible with mutual banks and open up conversion mergers to larger mutual banks, this emerging strategic trend should continue to accelerate.

Previously published by SNL Financial LC

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