Editor’s Note: The following is excerpted from a comment letter by Chip Filson to NCUA regarding its proposed rules around CU mergers (12 CFR Parts 701, 708a, and 708b), which among other things requires greater disclosures to members as part of the merger process. Filson is Chairman Emeritus of Callahan & Associates and former president of NCUA’s Central Liquidity Facility and Office of Examinations. The complete letter can be found in CUToday.info’s The Gov here.
By Chip Filson
We support NCUA’s proposed rule especially the areas of improved transparency, greater opportunity for member to member communications and the expanded time for notice and deliberation.
One area that needs greater clarity however is NCUA’s role in the overseeing the merger process. Today that oversight is largely ministerial (were forms properly completed?), review of the latest call reports and the most recent examinations. In the limited cases where we have reviewed the merger file, there appears to be limited documentation of any effort to review the assertions of the merging credit union, its due diligence, or even the necessity for giving up its independent operations.
NCUA’s proposals to require greater transparency, including a 24-month look-back of board minutes for merger-related items, will improve the opportunity for merger review.
However, if the new rule is merely a more detailed roadmap for the forms and disclosures necessary for regulatory approval, then individuals who want to game the system for advantage will continue to do so at the member-owners’ expense.
We believe that NCUA’s oversight role should continue to include reviewing the requirement that CEOs and directors have indeed fulfilled their fiduciary responsibility in this irreversible decision to surrender their credit union charter.
Today NCUA will only grant a new charter after years of effort, pages of documentation, commitments for funding and even then, often still further limit potential services through a letter of understanding if a charter is granted. This statement is not to critique NCUA’s difficult chartering process, but rather to emphasize the extraordinary value of an existing, operating credit union charter. It’s “replacement value” would easily cost in the millions of dollars.
50 Years of History Gone in 10 Days?
Under the existing regulation that “license” can be surrendered with a minimum of 10 day’s board notice to the members –even though most charters have been active for fifty years or longer.
Moreover, the merger “option” can be manipulated by both boards and NCUA personnel to “solve a problem.” Credit unions report that NCUA “encourages” mergers as a solution to worrying financial trends, CEO retirement and/or turnover, or other factors, such as a lack of board involvement. These mergers decisions promoted either examiner direction, or by CEO and board intent to shed responsibilities, are frequently listed factors motivating merger.
Both parties in these transactions, NCUA examiners and disinterested boards, have a responsibility to members to seek new leadership from within the credit union or the membership at large before the option of giving up the charter is considered a reasonable choice.
We believe the fiduciary responsibility of a board should be reasserted in the new rule. NCUA has issued a number of statements on the directors’ duties, two of which are cited in the case study below.
However, we believe that for this fiduciary responsibility to have effect, it should be explicitly stated as part of the merger review process. Specifically, in any proposed merger where the continuing credit union is booking a gain through “negative good will” then the burden of fiduciary disclosure should be accordingly more substantive. Giving away members’ collective ownership, especially in the situation of a sound, well-run credit union as described below, should always be subject to increased scrutiny.
(As an example), the merger of Belvoir FCU into Pentagon FCU in early 2016 seemed to come out of nowhere, at least to members and movement stakeholders who weren’t the senior managers receiving golden parachutes for handing over seven decades of building goodwill and cooperative capital.
It took months of asking and Freedom of Information (FOIA) filings to pry loose what really happened. Here’s the story, a cautionary tale why more transparency is desperately needed, something the NCUA is now proposing to add to the merger process.
The Source of the $41 Million
The February 2016 Special Membership Meeting Notice sent by Belvoir FCU’s board chair announcing the credit union’s intent to merge with PenFed included a combined statement of the two credit unions’ financial condition as of June 2015. The merger adjustments included an entry for “negative goodwill” totaling $40.7 million which would be added to PenFed’s balance sheet when the combination was completed.
This amount was the total of Belvoir’s book capital plus additional gains from the estimated market value of its assets and liabilities. This is what Belvoir FCU members paid PenFed to have PenFed take control of their credit union in this so-called “voluntary” merger.
Unlike the sale of a bank, where the owners are paid for their ownership plus estimates of future earnings value (real goodwill), the 27,458 Belvoir members at March 31, 2016, instead paid an average of $1,482 to join PenFed. This happened despite the fact that joining PenFed was always an option for any Belvoir member merely by purchasing one redeemable share.
PenFed recognized this negative goodwill (or extraordinary gain) as “non-operating income” in 2016. It was used to pay PenFed’s operating expenses, support the dividend and to add to retained earnings. Without this extraordinary income, PenFed’s ROA would have been $41 million lower, or 69 basis points versus the reported 89 basis points. Even with this one-time revenue item, PenFed’s gain in net income over 2015 was only $22.2 million, meaning a portion of the $41 million income was used to enhance PenFed’s dividends.
How Did Such a One-Sided Deal Go Down?
How could such a transfer of member wealth from a sound, successful credit union with a 70-year operating history occur? What did the board tell its members? Was the NCUA involved? Are there lessons for other credit unions from this transaction?
A review of the public record and the FOIA file for the merger shows Belvoir’s board did not consult or request member input, but rather operated completely in secret from board approval in August 2015 until it sent out its required notice to members of the special meeting to vote on the merger. That notice although dated Feb. 24, 2016, was mailed March 11.
On February 23, 2016, the day before the date on the Chairman’s Members Meeting Notice, Belvoir issued a press release announcing its New, Modern Branch on the Fort Belvoir Base. The CEO is quoted, “We always look to bring the latest technology to our members. . .these advancements enable Belvoir Federal employees to focus on service excellence and promote greater communication between members and Member Service.” Not a mention of the merger notice signed the next day by the Chairman.
By keeping the entire plan secret except to those benefitting directly and limiting member notice to a period of just two weeks, it would have been difficult if not impossible for members to have time to analyze or learn about other options.
The member notice, while lacking specifics was clear in its recommendation: “I am pleased to inform you that we are proposing to merge Belvoir FCU into Pentagon FCU (PenFed). In today’s ever-changing economy, our Board of Directors evaluated strategic possibilities to assure you, our member, receive the full range of products and services you deserve. After considering alternatives, we determined that a merger with PenFed is in the best interest of the members.”
There is no documentation of either the board’s or managers’ due diligence in fulfillment of their fiduciary responsibility.
So, what was the driving force behind this merger?
NCUA Forces Disclosure of Payments to Senior Staff
Reinforcing this insider-arranged sale: The CEO would receive a bonus of $250,000; the CFO and COO payments of $125,000 each, upon the merger’s approval. These disclosures were added to the official notice only after the NCUA insisted they be put in the required mailing.
What was not disclosed, however, were any promises to pay other staff bonuses upon approval of the merger or employment guarantees that PenFed did disclose in subsequent mergers with other credit unions. These additional payments would be in the millions.
Seven months following the May 1, 2016, merger date the board chair of now-defunct Belvoir FCU was named to PenFed’s board.
Managing the Vote
By keeping the process secret, Belvoir’s board and senior managers were able to control the discussion and messages sent to members. Nowhere in the announcement was a comparison of rates, products, or services provided. The notice gave lists of general PenFed services and its “low loan rates” and a description of PenFed’s distribution system including its “36 worldwide branches.”
There was no description of PenFed’s business model including its “Drive to 75” ambitions ― its plan to grow from $17 billion to $75 billion in assets by 2025 ― and how PenFed’s products and services would compare with Belvoir’s five-branch, locally focused, high personal service approach.
Nowhere was there a description of what might be lost in the merger. For example, Belvoir offered member business loans, which PenFed does not offer, and which were sold prior to the merger. It offered courtesy pay and a much-broader credit underwriting approach. PenFed’s policies and business strategy are much different than Belvoir’s, which listed 189 local businesses and employee groups in its FOM.
Further there was no explanation of why PenFed which at $21 billion, or 63 times larger than Belvoir, would be able to provide better personal service. On Jan. 29, 2016, or a month prior to the merger announcement, Belvoir was named one of the best places to work in Virginia for the third consecutive year.
Even with this very one-sided, time-restricted voting process, the members voted against the merger at the required special meeting on March 30. Unfortunately, that result was overwhelmed by the ballots submitted where members relied on the notice information. For if a member trusts the credit union enough to send their money to it, why should they not believe the Board when the recommendation is to close up the shop?
What PenFed Gained
In the March 31, 2016, press release announcing the merger vote, PenFed made clear what it was gaining in this transaction:
“PenFed expands its field of membership to include the Fort Belvoir military community which . . . is home to some of the top national defense organizations. . .The largest employer in Fairfax County, Virginia, Belvoir boasts twice as many employees as the Pentagon. PenFed also gains an employee team that is dedicated to member service, five convenient branch locations, and an outstanding membership base focused on America’s national security.” In other words, PenFed bought from Belvoir management the exclusive on-base right the Defense Department grants to serve this massive, important military installation and its civilian community.
Belvoir’s board and management, while responsible for their members’ “best interests”, also transferred $41 million in collective book and market value in addition to the unique franchise opportunities described above. The members received nothing.
How did such a transaction ever get past the NCUA and its oversight of member interests and consumer rights? How could this event pass any standard of fiduciary duty by either Belvoir or PenFed’s leadership?
Making A New Rule Matter
The difficulty of a new, more transparent rule is that for those who want to game the system, the new regulation can just become a more involved roadmap. The maneuvering outlined above undermines both the values and principles that cooperatives depend upon for stewardship of common wealth.
Credit unions are designed to be an alternative to the profit-driven ambitions of other financial institutions. Member-owner interest must be the dominant consideration if credit unions want to continue to claim a special role in the marketplace.
Cooperative design depends on principled leaders. The credit union system cannot be financially prosperous and morally bankrupt.
Chip Filson is co-founder and Chairman Emeritus of Callahan & Associates