equity base only from retained earnings, and this can be a lengthy process.

In the last several years, mutual-to-stock conversions by healthy institutions have resulted in quick appreciations in the price of the stock. This makes the transaction attractive to the institution's insiders because of the opportunity to realize a profit, often a substantial profit, on any stock purchased by insiders in the conversion transaction. It is one of the focal points of OTS regulation.

The conversion from mutual-to-stock ownership creates several concerns. In a mutual-to-stock conversion, the mutual's insiders, its officers and directors, are the parties who initiate and set the terms for the sale of the stock. But they are also potential purchasers of the stock. They, like any purchasers, are motivated to buy low in order to maximize the stock's value to them in the aftermarket.

The account holders, who have an ownership interest in the mutual institution, are also potential stock purchasers. As such, they too benefit from the stock's appreciation in the after-market. Thus, when a mutual institution converts to stock form, the transaction is one-sided. There are typically motivated buyers for the stock, but in a conversion there are no typically motivated sellers. The market thus does not exert discipline over the transaction. The usual tension between seller and buyer is lacking. It is this absence of market discipline that is most troublesome and creates the potential for abuse.

OTS regulations are designed to counteract this tendency by imposing limits or controls on insiders' activities in connection with mutual-to-stock conversions. OTS conversion regulations, which govern all aspects of the conversion process, set forth specific and detailed standards that have been consistently imposed in conversion transactions over the years. To receive OTS approval, an institution must meet the following conditions: eligible savings account holders have first priority in purchasing stock after any tax-qualified ESOP purchases. Descending priorities then go to remaining account holders, management, and employee stock purchases, local community members, and finally other members of the public.

Purchases by officers and directors in the aggregate are limited to between 25 and 35 percent of the total conversion stock offering, depending on the asset size of the converting institution. Management compensation claims are subject to review and approval by the OTS.

The conversion stock must be sold at a price equal to the estimated pro forma market value of the converting institution's stock based on an independent valuation. Proxy materials to be furnished to account holders must comply with the disclosure requirements of the Federal securities laws and specific OTS thrift disclosure requirements.

The conversion application must include a business plan which describes the institution's intended use of the conversion proceeds. Mr. Chairman, the nature of mutual-to-stock conversions and the dynamics of the marketplace make it difficult to write regulations in this area. OTS has revised its conversion regulations several times since 1974 and remains open to any suggestions for further improvements.

Despite the complexity of this area, we continue to believe that minimum regulatory standards in the conversion area are desirable to curb the potential for abuse inherent in the skewed economic incentives in mutual-to-stock conversions. If such conversion standards are appropriate for OTS-supervised mutuals, they are presumably appropriate for other mutual institutions that convert.

In your letter of invitation, you asked about the effectiveness of the appraisal process in insuring the conversion stock is priced at a fair market value. Determining the market value of an institution is more of an art than a science. In our experience, the initial appraisals filed with the agency are frequently rejected as too conservative-in other words, too low-an estimate of the fair market value of the converting institution. OTS staff estimate that in recent years approximately three-quarters of all appraisals are initially rejected by the OTS because they are undervalued.

Because a conversion lacks the traditional willing buyer, willing seller tension that generally produces a fair market sales price, the appraisal is critical to achieving this result. The tendency on the part of the appraiser, however, is to undervalue the institution so as to avoid harming the buyers, the party whose interest predominates in the conversion, because they are the only recognizable party in the transaction. The seller, the institution itself, can only be heard through the voices of its management, who are usually buyers of the conversion stock and who retain the appraiser to value the institution.

Due to the nature of these relationships, the role of the regulator in the appraisal process is to exert discipline on the appraiser to estimate more accurately the true value of the institution upon completion of the conversion. Ultimately, the agency must be satisfied that the valuation range for the stock that is established by the appraiser is acceptable.

You also asked, in your letter, that we address the issue of merger conversions. These transactions raise unique issues not involved in other types of conversions, including the adequacy of the consideration paid by an acquirer, the treatment of mutual account holders in the distribution of conversion stock, whether mutual account holders should be able to purchase conversion stock at a discount, and the appropriateness of management compensation arrangements and stock incentive packages offered by an acquirer to coax the mutual management into the conversion.

As a result of these concerns, the OTS recently imposed a moratorium on healthy thrifts entering into these transactions. The moratorium will provide OTS staff with the opportunity to review the merits of merger conversions, including whether additional safeguards are necessary to protect the mutual target's account holders, whether further limits on management compensation and stock arrangements are needed, and the nature and amount of any such limits. The moratorium will not block the acquisition of an undercapitalized thrift by a healthy institution, nor is it intended to interfere with bank acquisitions of stock thrifts.

With respect to the OTS's views on your bill, S. 1801, we are in strong support of the application of consistent standards to all Federal and State mutual-to-stock conversions. We further believe that the specific provisions of S. 1801 related to executive compensation

are worth considering as we review our regulations. In particular, we are reviewing our ability to scale back on the management recognition program, although not to the point where we want to eliminate the incentive for management to enter into conversions. We defer to the FDIC on the specific question of whether legislation is needed in order for the FDIC to apply specific conversion standards to FDIC-supervised thrifts. We believe that we can apply most of what I think has been mentioned by Chairman Hove and what is in your bill through our current regulatory authority.

In conclusion, mutual-to-stock conversions provide an opportunity for an institution to raise capital. The thrift industry, which is still in a recovery stage, has benefitted from the infusion of capital that has occurred as a result of the conversion process. Conversions may, however, tempt an institution's insiders to engage in transactions that transfer an inappropriate amount of the institution's value to the insiders.

The OTS mutual-to-stock conversion regs reflect standards and safeguards developed over the years to counteract the lack of market discipline in the process and to respond to the potential for abuses in thrift conversions. We believe there is no compelling reason to permit what amounts to regulatory arbitrage that may disadvantage the institution, its depositors, or its local communities. To the extent that standards are necessary to guard against abuses in the conversion process, we believe these standards should be consistent. The issue is not OTS rules versus State rules, but identifying what abuses, if any, exist and applying uniform rules. Thank you.

The CHAIRMAN. Thank you very much.

I appreciate the detailed nature of your statement. I want to run through a series of questions with each of you and then we will go to Senator D'Amato.

First, Mr. Hove, let me start with you. That is, I am concerned that we are receiving some mixed messages here. Your testimony states that while the FDIC has sufficient authority to curb abuses and that is a quote-in the conversion process, you say you need additional statutory authority to reform the conversion process along the lines that you have described.

So I have got two specific questions that I want to pose and I want you to respond to for the record.

Does the FDIC possess statutory authority to prevent abuses in conversions, particularly those involving highly capitalized institutions?

Mr. HOVE. We feel we do. However, as you know, our statutory authority is limited to safety and soundness, and we are relying on safety and soundness to review those applications that are coming to us to determine whether they are appropriate.

We also are looking at the guidelines that the OTS has issued, and are looking at institutions to make certain that there are not abuses for insiders. In fact, last week we approved-I am sorry, Tuesday of this week-we approved a merger conversion for an institution that was badly in need of capital.

Now, you are asking about those highly capitalized institutions. We think we do have the authority to restrict the abuses that we

have seen in those highly capitalized institutions with the statutory authority now.

Some of the issues that we have proposed here may require statutory authority to extend those provisions.

The CHAIRMAN. Let me ask you this: Whether or not the system is overhauled entirely, I am wondering, and I need to know your view as to whether your current statutory authority is sufficient to allow the FDIC to adopt the type of specific standards that are currently present in the OTS conversion regulations.

Mr. Hove. It is our opinion that it is.

The CHAIRMAN. That is an important point.

Let me ask you, then, this as a follow-up to that. The OTS obviously has staff with very great experience in these mutual-to-stock conversions which you made reference to. In fact, going back to the Federal Home Loan Bank Board, the OTS has regulated_mutualto-stock conversions since 1948, and the FDIC has not had a great amount of experience in this area. I am wondering, in view of the priority that the administration as well as this committee has placed on regulatory consolidation, if we shouldn't consider having OTS be made the Federal regulator of mutual-to-stock conversions for both Federal and State institutions. What would you think about that?

Mr. HOVE. It seems to me that the primary regulator that has been dealing with the institution in the process, both in the case of a regular conversion and a merger conversion, is probably in the best position to negotiate the transaction, to look at the appraisals, to make a determination as to the appropriateness of the transaction and the fairness to all parties involved.

I would argue that it makes a lot of sense for the primary regulator, which in this case now is the FDIC, to have this authority over those institutions which we regulate.

The CHAIRMAN. I want to come back to the issue of your response to my second question, and that was that you felt that you did have sufficient statutory authority to adopt specific standards along the lines of what the OTS is doing.

The OTS just imposed a moratorium on merger conversions because they have raised these policy issues, and as you cite, just this week you have approved a merger conversion.

It sounds to me again like we are kind of operating on two dif ferent footings here, and I am wondering if there is some way to get to a comparable and unified policy here?

Mr. Hove. I wouldn't disagree with what Mr. Fiechter has said about his moratoriums, in that he has said that supervisory reasons would be an exception to his moratorium.

I think there are good supervisory reasons, first of all, for why you would have a merger conversion. There are also good reasons for merger conversions-because they have been good transactions. If they are not abusive, it doesn't seem to me that it makes sense to hold them up just because they happen to be a merger conversion. There could well be merger conversions that are not abusive; that are good for consolidation of the industry, and make a lot of sense. So, for that reason, I would argue against a moratorium on all merger conversions.

The CHAIRMAN. Are you holding some up now?

Mr. Hove. We now have five applications at the FDIC. One we have approved this week. Another one is a merger conversion for a supervisory institution, which, if it makes sense, we will probably approve. There are two others that are standard conversions and one other conversion that involves a mutual holding company.

The CHAIRMAN. Well, let's set aside the first one that is still in the cattle shoot and take the others. Do you think you ought to be proceeding on those until this is nailed down so there are some standards here that we are guiding by in a more specific way?

Mr. HOVE. We intend to look at these very carefully, again to apply the standards that OTS has described, to apply some of those thoughts that we have developed as we have looked at these. Again, let me emphasize that these are preliminary thoughts that we have on these conversions and that we are developing these to improve the process. We will work very carefully and very closely with the OTS to develop these so that we have consistent standards with the OTS.

The CHAIRMAN. I want to make sure that everybody is on notice, including those in the room and representatives in the room of other entities and the people at the press table that the effective date of our legislation is January 26. If this legislation is enacted, with that effective date, anything that is done after that date is subject to review, so that there is no mistake about it. I don't want to rush. I don't want to see a lot of people rush into situations that are questionable without understanding precisely the strength of the feeling here on it.

Let me just ask one other thing before yielding to Senator D'Amato.

The Shadow Financial Regulatory Committee last week proposed that half the proceeds of each mutual-to-stock conversion should go to the FDIC, in particular to the Savings Association Insurance Fund. What is your evaluation of this proposal, Mr. Hove?

Mr. HOVE. Well, it is hard to tell who this value really belongs to. But I would argue that the FDIC or the savings insurance fund or the BIF insurance fund really are not the appropriate places for that money to go. It seems to me that it belongs to someone else rather than to the FDIC. I would argue that it should not be included with the BIF or the SAIF funds.

The CHAIRMAN. Mr. Fiechter, what is your view on that?

Mr. FIECHTER. I agree with Chairman Hove. As you pointed out, Mr. Chairman, initially, I think that the thrift industry, particularly weak institutions, are in much better shape to be able to deal with problems when they are in the stock form rather than mutual form.

The last couple of years we have really had a bull market in the thrift industry. There have been lots of conversions in the mid1980's, where there is nothing like the kind of excess capital we are talking about right now. It is very likely that we could have conversions a year from now where you are not going to have that large amount of capital or where those institutions several years hence run into trouble, and if we start moving to take capital away from well-capitalized thrifts to build up the SAIF, I think we could regret that several years later.

The CHAIRMAN, Senator D'Amato.