ings associations have converted to the stock form of ownership, in the process raising $16 billion in new capital.

As these numbers suggest, a principal benefit of an institution converting from the mutual to the stock form is raising capital, a result that can otherwise be difficult for mutuals to achieve. Mutual associations can increase their equity base only from retained earnings. This can be a lengthy process.

Often, a mutual-to-stock conversion by a healthy institution results in a quick appreciation in the value of the stock. This makes the transaction attractive to the institution's insiders because of the opportunity for those insiders to realize a profit, often a substantial profit, on the stock they purchase in the conversion transaction. This aspect of the transaction has recently drawn a great deal of attention. It is, as I will shortly discuss, one of the focal points of CTS regulation. I believe it would be useful to begin, however, with an overview of the mutual-to-stock conversion process. The decision to convert a mutual institution is typically initiated by the institution's board of directors. The institution's directors adopt a plan of conversion, file an application, and notify the institution's account holders.

The conversion application, filed with the regulator, usually includes a plan of conversion, a copy of the proxy statement to be sent to account holders, and an offering circular registering the conversion stock. In addition, the institution is generally required to provide some form of valuation of the conversion stock.

If the conversion application receives regulatory approval, the plan of conversion is usually submitted to a vote at a special meeting of account holders. In most cases, a majority of the total outstanding votes of account holders is required to approve the plan. Account holders may vote in person or by proxy.

In the conversion process, priorities and incentives are typically established with respect to the purchase of conversion stock. Priority purchase rights may be extended to account holders, the institution's officers and directors, employee stock benefit plans, and to members of the general public residing in the communities where the association has offices.

I would like to now give a brief history of the Federal conversion rules.

Prior to 1948, all savings associations operated as mutual associations. When Congress authorized savings associations to convert from mutuals to the stock form in 1948, concerns were immediately raised regarding conversions and the distribution of the net worth of the mutual institution among potential owners of the new stock. As a result, the Federal Home Loan Bank Board and Congress imposed various moratoria on conversions and only a small number of conversions were actually completed. In an effort to address these concerns, the Federal Home Loan Bank Board proposed conversion regulations in 1973. Both the Bank Board and the Congress held hearings on the regulations and the need for legislation in this area. Following these hearings, the Bank Board issued regulations in 1974.

It was generally believed that the new regulations adequately addressed the problems arising from conversion windfalls. As a re

sult, Congress allowed its conversion moratorium to expire on June 30, 1974. This regulation continues in effect today.

The conversion from a mutual form of ownership to stock ownership creates several concerns. In a mutual-to-stock conversion, the mutual's insiders, its directors and managers, 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 will benefit from the stock's appreciation in the aftermarket.

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 mutual conversion there are no "typically motivated" sellers. The market 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. To receive OTS approval, an institution must meet the following conditions: (a) Specific subscription priorities must be established that give first priority, after any tax-qualified ESOP purchases, to savings account holders with the institution at least 90 days prior to the date of adoption of the plan of conversion. Only then may a priority be established for management and employee stock purchases.

(b) Purchases by officers and directors in the aggregate are limited to between 25 percent and 35 percent of the total conversion stock offering, depending on the asset size of the institution.

(c) 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. The appraisal is reviewed by the OTS to ensure there is adequate data to support the estimated pro forma market value, for conformity with appraisal methodology and documentation standards, and to verify the appraiser's experience and independence.

The OTS conversion regulations, which are comprehensive in scope and govern all aspects of the conversion process, set forth specific and detailed standards that have been consistently imposed without exception as regulatory requirements in conversion standards over the years. These key regulatory controls are consistent with our understanding of the purpose and objectives of congressional intent in allowing the mutual-to-stock conversion moratorium to expire in 1974.

Mr. Chairman, the nature of mutual-to-stock conversions and the dynamics of the marketplace make it difficult to write regulations in this area. In administering the Conversion Program, the OTS continuously reviews the need for further changes to its rules. OTS has revised the conversion regulations several times since 1974 and remains open to any suggestions for further improvements to its rules.

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 OTSsupervised mutuals, they are presumably appropriate for other mutual institutions that convert.

A number of States do follow closely the Federal conversion rules. Some, however, do not. Differences in those States that do not follow the Federal rules primarily involve: The rights of mutual account holders to purchase conversion stock; the amount of conversion stock that institution insiders may purchase; the amount of stock incentives that may be given to management; and the valuation of the conversion stock.

The 1989 FIRREA legislation provided the authority for a SAIFinsured savings association to become a State savings bank. Increasingly, mutual institutions that are choosing to convert to stock form find it advantageous to do so under State rules. Over the past several years, the number of OTS-supervised mutual institutions that have changed to State savings bank charters has increased dramatically.

For example, 51 North Carolina mutual institutions recently removed themselves from OTS jurisdiction in favor of North Carolina's State savings bank charter. Of these, nearly half subsequently undertook a conversion to stock form. During the same time, only two North Carolina mutuals supervised by the OTS undertook similar conversions. Similar patterns exist in Pennsylvania, Wisconsin, and New Jersey.

Of course, differences in Federal and State conversion standards are not the only incentives for OTS-supervised thrifts to change charters. Institutions changing charters can save on supervisory expenses. OTS-supervised thrifts are required to hold stock in the Federal Home Loan Bank System. Thrifts that change to State savings banks may redeem their Federal Home Loan Bank stock.

In conclusion, Mr. Chairman, mutual-to-stock conversions do provide an opportunity for an institution to raise capital. Mutual-tostock conversions, however, may also tempt an institution's insiders to engage in transactions that transfer an inappropriate amount of the institution's value to the institution's insiders.

The OTS mutual-to-stock conversion regulations 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. Some of these standards are not being applied to conversions of institutions not supervised by the OTS.

We do not believe there is a compelling reason to permit what amounts to "regulatory arbitrage" that may disadvantage depositors or their local communities. To the extent that standards are necessary to guard against abuses in the conversion process, 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 prepared statement of Mr. Fiechter can be found in the appendix.]

Chairman NEAL. Well, thank you, sir, very much.
Now we would like to hear from Mr. Hove.

STATEMENT OF ANDREW HOVE, JR., ACTING CHAIRMAN,
FEDERAL DEPOSIT INSURANCE CORPORATION

Mr. HOVE. Mr. Chairman, and members of the subcommittee, on behalf of the Federal Deposit Insurance Corporation, I appreciate this opportunity to testify regarding institutions that convert from mutual to stock ownership. We share your concern regarding the need to assure that the value in institutions that convert is fairly distributed. Depositors should be treated fairly and insiders such as management, trustees, and employees should not obtain a disproportionate share. When an acquisition by another institution is part of the conversion, depositors need to be treated fairly in relation to the interests of both the insiders and the acquiring institution.

At this point the FDIC is looking for a better understanding of this issue and we would welcome your guidance. This is clearly a public policy issue; namely, depositor fairness. We would also like to point out that many conversions, particularly those by marginally undercapitalized institutions, raise much needed capital that benefit the banks, the deposit insurance fund, and the public at large. It is important that we do not place unnecessary roadblocks to these worthwhile conversions where capital is deficient.

We at the FDIC see ourselves as guardians of depositors, so we share your concern that the conversion process may not be fair to depositors of mutual institutions. We are not sure we have clear statutory authority to completely remedy that unfairness, but the Congress can change that, if necessary. What we want to focus on is not narrow jurisdictional issues, but the public policy problem that clearly calls for attention. The problem is that under current economic and market conditions, conversion creates a windfall, and it isn't going to depositors.

were

A few years ago when many mutual institutions undercapitalized and the stock market feared for the survival of the thrift industry, the conversion rules developed by State and Federal regulators created much less of a windfall. The buyers of stock in converting institutions were often saving those institutions from failure. Absent conversion, such institutions had minimal economic value. Buyers of stock received economic value approximately equal to what they had paid. Yes, the price of the new shares tended to rise from the initial offering price, but that often happens in initial public offerings.

In today's economic and market environment, conversions are creating very significant windfalls. Well-capitalized institutions, which the market regards as having significant economic_value even before any new money goes in, are being converted. Buyers of the stock receive economic value equivalent to what they had paid, plus the value that was already there.

In some cases, officers and directors of the converting institutions are capturing that windfall. But merely writing regulations to prevent this kind of "insider abuse" will not remedy the fundamental problem, which is that depositors are not getting the windfall. If "insiders" can't benefit, it will be sophisticated investors who do,

not long-term depositors. Such depositors often lack the funds to participate in the offering, or do not want to put their savings into the stock market. Others who have the money and are able to risk it, buy the stock and get the windfall.

I have directed my staff to conduct a thorough review of the conversion process, which once worked fairly well but no longer does. Without getting into the details, we believe the conversion process should probably include the three following points.

Number one: The issuance to depositors of negotiable stock purchase rights, which they can sell in order to capture the windfall, rather than needing to put up new money.

Number two: A procedure whereby anyone, a potential acquiror or investor, who wants to purchase a depositor's rights can tender for them, subject to appropriate disclosure and procedures.

Number three: There should be an independent financial advisor who will act for depositors and on their behalf. And that financial advisor should be paid for by the institution.

Finally, as you know, the FDIC Board on January 24, 1994 approved the issuance of a 45-day request for comment on all aspects of the mutual-to-stock conversion subject. In brief, the proposed policy statement focuses on areas of potential abuse in conversion transactions: Pricing the shares; apportioning the stock subscription rights; and disclosure of information needed to make an informed investment decision. We are asking for comment on whether or not State oversight is sufficiently uniform and adequate across States to protect the interests of the public, or whether Federal oversight is necessary; whether abusive practices are prevalent or likely; and whether and why the FDIC should take action; and, whether the proposed policy statement contains enough specificity to be effective in providing worthwhile guidance. Comments are also requested as to whether mutual-to-stock conversions should be governed by an enforceable regulation, and if so, should such a regulation closely follow the existing regulation of the OTS that contains a large degree of specificity, or should it more closely resemble a guidance format as embodied in the proposed policy statement.

We look forward to working with this subcommittee and the Office of Thrift Supervision on this issue, and I would be happy to respond to questions. We are willing to participate at Congress' direction in reengineering this process.

Thank you very much.

[The prepared statement of Mr. Hove can be found in the appendix.]

Chairman NEAL. Thank you, sir, very much.

In trying to understand this, I can certainly see advantages to everyone concerned, I think, in conversions from mutual-to-stock. The institution can become stronger because it becomes better capitalized, and the problem appears to occur when there is a conversion merger, and I guess we wouldn't have paid any attention to this, except that the benefits to so-called insiders seems so, in some cases, so very high.

Now, that doesn't occur under the OTS rules. What would be wrong with just adopting OTS rules, applying OTS rules to all institutions? I mean that seems fairly simple. Is there a flaw in that?