In Who’s Best Interest – Credit Union Conversion
Credit Union Conversion
There is rift in the banking industry between the proponents of non profit credit unions and the proponents of for profit banks and mutual savings banks. In the past decade this divide has become even larger with the conversion of credit unions to mutual savings banks (MSB). Much of this debate is about whether management of the credit union is putting the members’ best interest first, or if they are only converting to line their pockets (Gilpatrick, August 2005).
Conversion has been an option for credit unions since 1998 with enactment of the Credit Union Membership Access Act (Causey, 2003). According to Gilpatrick (September 2005) of Credit Union Magazine, “a handful (26 as of fall 2005) of America’s 9,000 credit unions, took the strategic path less traveled and converted to mutual savings banks.” Only .29% of all credit unions have converted to MSB’s. Even though the numbers are small, the National Credit Union Administration (NCUA) is worried about this trend. Jim Dahl of the Michigan Credit Union League declared “We all know that credit unions are in a period of major transition…,all of us need to think about the interests of the entire credit union movement, and not just our own individual credit unions” (MCUL CUcorp, 2006). Before delving into the heated debate over conversion, a general understanding of the credit union/banking relationship will be discussed. Second, the current market conditions will be identified to show the rational both credit unions and mutual savings banks have about choosing their respective charter. Third, the positives and negatives of conversion will be addressed to help inform others about the conversion of credit unions to mutual savings banks.
As defined by NCUA,
“A federal credit union is a nonprofit, cooperative financial institution owned and run by its’ members. Organized to serve, democratically controlled credit unions provide their members with a safe place to save and borrow at reasonable rates. Members pool their funds to make loans to one-another. The volunteer board that runs each credit union is elected by the members. Not for profit, not for charity, but for service is a credit union motto.” [Italicsleft from original source] (National Credit Union Administration)
The CEO of Pentagon FCU, Frank Pollack (2006), states “Credit unions serve three constituencies: members, the institution itself, and employees. Members are the focus of a credit union.” Pollack goes on to say after conversion “the board of directors must take into account a fourth constituency: stockholders. This group would bring capital stock to the institution and expect to be rewarded for doing so.”
Banks/thrifts on the other hand are a for profit financial institution owned by stockholders and/or members. As with most other for profit businesses, their primary responsibility is to provide a return to the shareholders. Banks provide the same level of services credit unions offer and are also a safe place to save and borrow money, but the average rates at banks are slightly worse than the average credit union rates (Hanson, 2006).
For decades, banks and credit unions haven’t been the best of friends. This split has grown in recent years with the growth in credit union membership resulting from lenient new membership requirements and business lending (Gilpatrick, 2003). Both banks and credit unions are looking for growth, which means they are competing for the same customers. With credit unions doing many of the traditional banking services including mortgage, consumer, business, and investing, the line between credit unions and banks has been blurred.
The current banking environment is very competitive for new business. Conversion of a credit union to a mutual savings bank may seem advantageous due to regulation limitations on credit union activities. Credit Unions have government imposed regulations as to how much business lending, how much capital (reserves) you keep, and how and where your members are affiliated with you at membership opening. These limitations are much more severe for a credit union than for a bank. In fact, a bank does not limit its’ membership as credit unions do and banks have to the ability to raise additional (secondary) capital through issuing and selling shares while credit unions are completely limited to their primary capital from earnings.
Credit unions do have significant benefits in the current market. They are not taxed. This means all their income goes back into the credit union, while about 40% of a bank’s income goes to the government. Lisa Hochgraf (2006) from Credit Union Management affirms “President Bush’s budget estimates that the CU tax exemption cost the U.S. Treasury $1.29 billion in 2005.” Hochgraf also points out that $1.29 billion can go a long way “…to advance their philosophy of service.” Michael Vadala, president /CEO of The Summit Federal Credit Union notes, “Absent the tax-exempt structure, it would be really difficult to be a credit union” (Hochgraf, 2006).
With the tax exemption noted above, credit unions have a huge benefit in offering lower fees and better rates than banks. Hochgraf points to a recent study from University of Wisconsin-Whitewater. The survey of 175 financial institutions nationwide found that “…CU’s constantly provide better rates on both savings accounts and loans than their bank counterparts” (Hochgraf, 2006).
As of the past decade, credit unions have also been able to expand their member base to include larger community emphasis areas and more employee groups. Even though their potential membership base has expanded,it is not totally open to whoever walks in the doors like that of a bank.
Also,banks incur additional expenses most credit unions haven’t incurred before. These added costs are the community reinvestment act (CRA) and Sarbanes Oxley (SOX). CRA is a requirement for banks to reinvest a portion of their income to the community. SOX was effective in 2004 and began to hit the pockets of banks that are publicly traded. These cost savings are “huge expenses” involved with conversion, according to Jim Blaine, president of State Employees Credit Union (Sweeney, 2005).
The limitations mentioned earlier are the driver for credit unions to convert to mutual savings banks. There are many positives and negatives that come from a credit union conversion to a mutual savings bank. The main benefits are growth, access to capital, and additional services; the main drawbacks of conversion are the tax implications and any bad press from members resisting the conversion.
By converting to a mutual savings bank, the former CU will be able to completely open up its’ membership to anyone. The public will no longer feel as if they have to be in a certain group to be eligible to join. The MSB would be able to increase deposits (the key driver of financial institutions) and in turn be able to loan more out. This would increase the MSB’s net interest income. AGE FCU former CEO, Lee Bettis, summarized the rational to convert as strictly looking toward the future. Bettis believed AGE FCU “…was confined because growth was almost impossible in the small town area we served” (Gilpatrick, August 2005).
Before a conversion, many credit unions had large capital reserves they couldn’t tap into because government regulations mandated this constraint. The regulations were put in place to limit expansion of credit unions so they would keep their focus on only their smaller member base. After conversion, this capital would be partially freed up due to less stringent restrictions on bank capital. These additional funds could be used to expand and add branches, ATM’s, or help keep rates or fees competitive. They would be able to use their non taxed reserves to help fund there taxable operations.
Mutual savings banks also have fewer restrictions on the amount of business and mortgage loans. Already with limited members, many credit unions are trying to attract more lucrative business loans. Even though these loans are more risky, the end result is generally a huge plus for the operations. Regulations also put severe limits on the proportion of business loans a credit union can have on their books, thus reducing the possibility of growing the business.
The main drawbacks of conversion are the tax implications and any bad press from members resisting the conversion. Taxes are a huge hit to the bottom line. Credit union conversion attorney Rich Schaberg stressed the following question all credit unions must answer before they convert to a mutual savings bank, “If 40 percent of our income is paid to the government, how will that benefit my members?” Schaberg further cautions “If you can’t answer the question, conversion may not be the right choice for your credit union” (Gilpatrick, September 2005). Tim Pryor, SVP/general counsel for ESL federal credit Union states “Any good CFP will tell you, though, that there is a point when you have more capital than you can effectively deploy (because of such things as investment limitation or field of membership restrictions) that a charter change does start to make sense,” he adds, “…having to pay taxes has to be weighed against the capital advantage of a bank charter” (Hochgraf, 2006).
Conversion is a very emotional issue within credit unions. There are national organizations to assist in protesting every conversion and many times a small group of credit union members become very vocal, rally others, and form their own faction to fight the conversion. A prime example is with DFCU in Michigan. The DFCU board recently withdrew its’ petition to become a mutual savings bank due to the heavy protesting by a small group of members. Just under 2,000 well organized members protested the conversion and petitioned for a special meeting to contest DFCU’s conversion (The Power of the Few, 2006). Schaberg again submits how boards must “…understand that they will be put under the microscope,” suggesting that “If a credit union is not comfortable standing up to that scrutiny, it may not have made the right decision” (Gilpatrick, September 2005).
These pros and cons of conversion must be weighed by the board before conversion. The results of the above analysis must be in line with the credit unions corporate strategy. Most results of this analysis would conclude that many credit unions have a growth strategy, but so few credit unions have converted. CUNA, NCUA, and members of credit unions will agree “…the right of member/owners (is) to exercise their democratic control of their credit unionand encourage credit unions that are considering conversions to make their decisions based solely on the best interest of their members” (Haer). This is where the board and management must decide if it is the best interest of their members to convert.
There are two enormous issues being raised about conversion; one is if the members are truly getting all the information to make an educated decision and the other is whether or not management is doing the conversion for the members’ best interest or if it is for their own best interest.
To convert from a credit union to a mutual savings bank, the majority of the board must approve and the majority of the credit union members voting must also affirm the conversion proposal(NCUA, 2005). NCUA’s Jan 05 rule 708a amendment aimed at providing members access to clear, concise, accurate, and meaningful information so they can be fully informed when they vote on a conversion (Haer). NCUA Rule 708a governs the conversion of credit unions and are summarizedbelow.
- Three required notices to credit union members. One at 90 days, 60 days, and 30 days before the conversion vote. Also, the voting ballot must be sent 30 days prior to vote.
- The credit union must provide a statement of why the credit union board is considering conversion.
- Disclose how conversion will affect the member’s voting rights.
- Disclose any economic benefit credit union management may receive.
- Disclose if the credit union intends to convert to a stock institution, or if any former unpaid directors will be paid. (NCUA, 2005)
NCUA does not formally approve any of this correspondence between the credit union and its’ members, but they can require a new vote on the conversion if they feel inadequate disclosure or misleading information has been provided (NCUA, 2005). For this reason, converting credit unions feel coerced to not say anything about the conversion unless NCUA has giving its’ blessing on any statements (Macomber & Swiontek). Ultimately, NCUA believes that if all of the conversion disclosure set forth in their rules are complied with, the member will be educated enough to make an informed decision in this complex business transaction. The National Credit Union Administration Board Chairman Johnson further comments,
“Since the enactment of the Credit Union Membership Access Act, NCUA has continued tobe concerned that many credit union members do not fully understand the effect aconversion may have on their ownership interests in the credit union and voting power in the mutual savings bank. A charter conversion is a complex andsophisticated transaction with long-term consequences that may not always be readilyapparent. NCUA believes it is of paramount importance for credit union members to be fullyinformed about this conversion so they may cast educated and meaningful votes. NCUArecognizes a credit union’s right to convert its’ charter, so long as the members who vote onthat decision have access to sufficient information to make an informed choice” (National Credit Union Administration, 2005).
In numerous conversions NCUA has exercised this option to block conversion on account of having a misinformed member base. These attempts have been unsuccessful. A prime example is the lawsuit between NCUA and Community Credit Union (CCU). CCU brought NCUA to court to reverse NCUA’s denial of the conversion as NCUA cited the “…required pros and cons of conversion weren’t clearly visible in the ballot mailings to members” (Hale & Welch, 2005). According to CCU’s lawyer Cass Weiland, “The case ultimately focused on how the letters in the mailing were folded.” The judge in the case ruled in favor of Community Credit Union and NCUA’s rejection of the conversion was not proper (Hale and Welch, 2005).
As noted above, conversion could lead to a change in the members’ voting rights. Under the credit union bylaws, each member gets one vote regardless of how many loans or deposits they have at the CU. Under a mutual savings bank, the members’ voting rights could be changed so the amount of votes is based upon what level of deposits you have with the CU. This change would make the members with less deposit balances have less power in the election of board members (Causey, 2003).
Ultimately after conversion, the credit union has become a bank. Sometimes the credit union philosophy may gradually drift away from service towards profit, while other times the philosophy remains in the veins of management after conversion. According to Lee Bettis, retired CEO of Heritage Bank of the South (formerly AGE Federal Credit Union), “Both credit union and a thrift are community oriented, member-owned organizations.” Bettis goes to say, “We always felt it was the best of both worlds –bank business with credit union philosophy” (Gilpatrick, August 2005).
The primary criticism of credit union conversion revolves around managementlining their own pockets. Elana Schor (2005) of The Hill reports “Credit union lobbyist privately question two Texas institutions business-lending levels and net worth held as capital… but neither has bumped up against the government-set growth caps.” These lobbyist are also “suggesting to some that conversion to a bank charter is more of a benefit to their boards of directors than a necessary shift to accommodate new business.” Credit Union National AssociationCEO Daniel Mica (2005) has also urged the Government Accountability Office to investigate the following: disclosures required, whether credit unions have converted from MSB’s to stock institutions, if boards of directors have fulfilled their fiduciary duties, and if statutory changes protect the interests of the credit union member. Lee Bettis, formerly of Heritage Bank, stresses “All of the decisions are like ours because there is a need for growth. The decision is being made at the best interest of the institution’s future, not any individuals.” Peter Duffy (2005) from CUNA reveals credit union management as well any member generally have an opportunity to buy secondary stock during a stock issuance at a discount below book. This gives the opportunity for all parties to make higher profits. Not all conversion stock issuances are set up this way, but some are structured this way to deliver fairness.
Unjust enrichment has been identified in the salary increases in some CEO and board of directors. Alan Theriault (2002), President of CU Financial Services concludes that conversion of credit union to a mutual bank will correct the salary imbalance between credit unions and banks. Theriault further states the cash salary gap is between 20% and 57% depending upon the size, while “…the gap in pay can be much wider at individual institutions which utilize stock.” If a mutual savings bank eventually converted to a full stock bank and had an initial public offering (IPO). Robert Fenner (2005), general counsel to NCUA states “The directors and management would share in a recognition and retention reserve equal to 4% of the IPO.” This could be millions in stock depending on the size of the IPO.