Are any of your bank branches and offices owned by directors? That could spell trouble but it can be handled well. Here’s how.
During the mid-2000’s, it was commonplace for a bank, particularly a de novo bank, to lease some or all of their bank facilities from an entity controlled by the bank’s directors. At the time, these arrangements truly represented a “win-win” situation. The bank was able to occupy built-to-suit facilities while conserving liquidity so that cash could be deployed through making loans with attractive yields. At the same time, the directors, many of whom were real estate professionals, were able to make a sound real estate investment with the knowledge that a very stable tenant would occupy the property.
As we know, much has changed since the mid-2000’s. Vacancies in commercial properties have caused market lease rates to plummet. Similarly, market values of commercial properties have decreased substantially. Many banks have excess liquidity caused by soft loan demand, making a potential investment in fixed assets more attractive.
Because many of these leases were written with five-year initial terms, a number of banks are now weighing their options with respect to renewal, extension or renegotiation of the leases. To make matters more complex, many director-controlled entities borrowed money to construct the bank facilities. If those notes had five-year terms, they are coming up for renewal, and the lending bank may be eager to move the commercial real estate loans off of its books.
This fact presents a particularly difficult challenge for the affected directors. Banking regulations require that transactions with affiliates be made on terms at least as favorable to the bank as those terms prevailing at the time for transactions with unaffiliated parties. Most bank directors understand their duty to act in the best interests of the bank, but they are also facing personal financial exposure if the lease is not renewed on terms that allow the entity to continue to service its debt obligations. In addition, given public scrutiny of directors and officers who are perceived to have profited at the expense of the bank they serve, creating a proper process to manage these situations has never been more important.
While state law should be consulted regarding the appropriate process for analyzing and approving a transaction with an affiliate, the following best practices are helpful in reaching a fair and appropriate resolution to transactions between a bank and its affiliates.
Wear your “bank hat.” It is imperative that any director with a financial interest in the transaction focus on making the appropriate decision for the bank. Directors should understand that these transactions are likely to be heavily scrutinized by regulators and could potentially be scrutinized by shareholders.
Allow independent directors to take the lead. To the extent that two or more directors do not have financial interests in the transaction, appoint them to a committee with full authority to analyze and negotiate the renewal of the lease.
Rely on third party experts. Engage trusted third parties, such as appraisers and other real estate experts, to provide information to the board (or independent committee) regarding the bank’s alternatives. In addition, ask management to prepare a lease/buy analysis based on the bank’s existing and projected liquidity and its ability to leverage that liquidity.
Document carefully. Remember, if it is not documented, it did not happen. Be sure that all relevant considerations, discussions and reports are fully documented.
Consider all relevant factors. While an appraisal or other analysis of market lease rates is helpful, also consider the “soft” costs of failing to renew the lease, which might include:
–employee downtime related to moving;
–additional marketing expense created by advertising the move and updating existing
–reputation risk created by leaving the existing location vacant; or
–loss of branding associated with the existing location.
While a situation involving a lease of property from a director-controlled entity can be addressed using these best practices, they also can be used in analyzing a lease between the bank and its holding company. In addition, they can be helpful in renegotiating a lease with a third party or deciding to purchase facilities that the bank currently leases. Regardless of the circumstances surrounding a decision regarding the bank’s facilities, bank directors should familiarize themselves with all available alternatives in order to make the best decision for the bank.
This article was originally published on BankDirector.com.