Why Should Credit Unions Care?

Read Part 1 here.

Mergers of sound well run credit unions are a fact of life in the cooperative system.  So why should the $2.1 billion mega-merger of Schools Financial and the $16.1 billion SchoolsFirst be an issue?

I believe the circumstances and specifics of this merger highlight in ways that smaller combinations do not, the threat these transactions represent to an independent system of cooperative financial institutions in the American economy.

Credit unions have a federal and many  state income tax exemptions because they are supposed to be creating an alternative to the purely for-profit practices of other consumer options. Cooperatives are designed around certain premises including self-help, self-finance and self-governance.  Member-owners are loyal, over and above the economic benefits, because the institution belongs to them and  future member-owners.

Once these fundamental facts are debased by agents who pay lip service to principles but act from personal and institutional self-interest, then the boundary lines between for-profit and coops is blurred, if not lost.

Factual Basis Missing From Merger Process

While not entirely unique, the size of the SchoolsFirst merger dramatizes the failures of the current merger process to disclose and to protect members interests.  A few of the critical omissions are:

• The failure to mention any aspect of the approximate $540 million wealth transfer;
• The absence of any description of the significant losses to the community in terms of business relationships, the setting of local lending and investment priorities and the consequent reduction in civic leadership;
• The complete lack of any specific product, service or fee comparisons and changes that would be coming-whether gains and losses;
• The conflicts with the senior management and the board negotiating their own ongoing roles and compensation versus the absence of any commitments for continuing or new services, programs and products from which the members would benefit;
• The lack of any disclosure of alternatives considered and, if evaluated, why this merger was the option chosen.

These significant information gaps and subsequent post-merger announcements suggest a pattern of deception.

Given the public record and limited details provided, it is hard not to conclude that this combination is motivated more by the personal ambitions of two CEO’s and their boards, not from promoting the best interests of School Financials’ members.

Members Given 49 Days to Decide a Charter Cancellation

Today a new charter takes years, volumes of paperwork, financial  projections, organizers’ resumes,  and millions of donated capital to open the doors of a de novo credit union.  It seems contradictory, even absurd, that a CEO and board should ask members to give up a charter in less than 60 days from the public notice of October 23 to the December 12 final vote.  The timing prohibits any meaningful discussion.  Surely the process to surrender a charter granted and successfully managed since 1933 should warrant greater member dialogue and public scrutiny.

Lessons Learned

As other CEO’s and boards read about mergers similar to SchoolsFirst, these examples incentivizes behavior that contradicts both faithful stewardship and the priority of members’ wellbeing. Consultants now openly solicit engagements to show how CEO’s can enhance their benefits from mergers. Credit unions market their willingness to bargain with CEO’s where “like seeks like” to facilitate the sale of their leadership responsibilities.

Boards begin to feel  they must play the same game to protect their options or to preempt competitive intrusions in their markets.

The consequence is that instead of creating a cadre of cooperative leaders driving innovation for member benefit, the system is spawning a capitalistic, robber-baron CEO style that elevates institutional growth over member value.

These self-serving mergers  promote a stunted view of what cooperative leadership and collaboration looks like.  They adopt a simplistic view of success and a Neanderthal’s approach to change.

Cooperative growth opportunities are not being enhanced.   Rather myriad options for future innovation are shut down and the industry becomes more heavily concentrated in a small percentage of large institutions.  Industry risk becomes more concentrated.

The system does not grow its reach through mergers; it only reduces the diversity of credit union institutional models.  During the past decade the number of credit unions declined by 2,400 (virtually all by mergers) and shares grew at only  5.7%, an annual rate characteristic of a mature, if not stagnant, system.

The moral capital that the cooperative system created over the past century is being squandered by short term behaviors from executives unwilling to pursue long term member value creation.

The Arguments Back

1. Everybody does it. Wrong, not everybody.  And if that were true, we should have had a much more public and active bidding process for not only this merger, but all mergers.  Instead CEO’s selectively seek  the best option for themselves, privately discuss the potential, and then negotiate in secret with the board’s blessing or indifference.
2. The regulator approved this. Therefore, it must be all right.   Correct, NCUA and state regulators routinely sign off on actions even when shown that they violate any objective test of member benefit or due process.   The fact that the regulator can be, and often is incorrect or unknowing in its actions, does not mean an action is proper.

As in its financial management of credit union’s cooperative resources, the NCUA board’s oversight of mergers is squandering an inheritance that it does not value nor understand.

Instead of honoring the unique member-owner design and being the architects of a cooperative system, the NCUA board sees itself as just another banking regulator.

The NCUA’s merger process undermines any meaningful democratic choice for member owners; in fact, it promotes corruption by endorsing the self-interest of the initiators of these transactions.

Member voting is nothing more than a sham. A merger proposal has never been turned down by members.   This democratic fig leaf can no longer hide the naked ambition that animates these events.

The NCUA board lacks any respect for the member-owner cooperative system.  It does not grasp how credit unions differ from other financial institutions.   Even when given detailed examples of improper and self-serving mergers, the agency at the highest levels is unable to see the mistakes of its own making.

In sum, two wrongs do not make a right.

3. I agree but these mergers are just the “way the world works.” This argument  reminds me a line from the play, Just Call me God.  In it the character observes, “The one thing I know about power is that the good never seek it.”

But the reality of the cooperative model is that one is not asked to stand alone.  The whole model depends on the realization that each credit union member, board and CEO is part of a whole.   That together, we uniquely contribute to a greater good.

We succeed not by acquiring but by collaborating, learning and then helping each other.

Similarly, this distortion of the cooperative system, will be ended when leaders say enough is enough.   Just as happened in the conversion from coops to mutuals and then to for-profit charters in the 1990’s.

Next Steps:

This SchoolsFirst merger is a prime example of how the community’s future is jeopardized when an individual’s ambitions or a credit union’s claim of superior capability is given priority over cooperative value and design.

It poses the question whether the cooperative system can correct its own excesses.  Will the future evolution just be a relentless pattern of bigger buying out the smaller?

This merger exposes multiple institutional failures within the cooperative system including: individual credit unions with leaders converting cooperative design to commercial ends; regulators who grasp neither purpose nor practice when faced with challenges; and,  fellow travelers trying to earn a living seeking the next big wave to take them to shore.

These factors suggest that  change may have to come from outside the system should credit unions be unable to learn from their own experience.   The fourth estate is always looking for aberrant behaviors; competitors seek examples of cooperative hypocrisy; and congress protects the public interest by highlighting the other party’s administrative failures.

The Action Called For

However, this charade of mergers ends or is transformed so members actually received the benefit they created, this is an important moment for those aspiring to future cooperative leadership.

A participant once caught in a similar historical dilemma commented: “I didn’t do anything wrong; But I didn’t do anything right.”   The difference is courage. Do believers in the specialness of cooperatives still exist?

 

Note: As background for this article, please see previous posts: How Can This Merger in the Members’ Best interests and What Credit Unions Can Learn from Bank Purchases

Largest Ever “Special Credit Union Dividend” of $540 Million Paid to Members on January 1, 2020

In a December 26 release to the credit union press, Schools Financial CU announced it was paying its members a special pre-merger dividend of $4 million before it completed combining with SchoolsFirst FCU on January 1, 2020.

What the announcement omitted was that the January 1, 2020 merger will also transfer over $540 million of the reserves and net worth of Schools Financial members to the Board and members of SchoolsFirst FCU.

Each Financial Schools member’s pro rata share of this transfer is  $3,420 versus the token $26 they were given upon approval of the merger.

This is the largest wealth transfer by the members of one credit union to another credit union’s control. The use and disposition of over a half billion dollars of common wealth created by the former member-owners of Schools Financial CU since 1933 is no longer theirs to determine.

How the $540 Million Wealth Transfer Occurs

In this merger of two sound, well-run credit unions, the terms called for the entire equity of Schools Financial CU to be transferred at par. The estimated year-end net worth based on the credit union’s announced 2019 ROA of 1.73% is $270 million. This becomes “equity acquired in a merger” and is added directly to the net worth of SchoolsFirst FCU.

In addition, under the accounting standards codification for “business combinations,” Schools Financials’ merged assets and liabilities assumed by SchoolsFirst are recorded at their fair values. To simplify the numerous calculations, prior year end audits certify that the assets of Schools Financial when “fairly presented” exceed the liabilities by the amount of the net worth, which would be the estimated $270 million reserves at December 31, 2019.

This excess of assets over liabilities acquired is recognized as income on the books of SchoolsFirst FCU. It is called a “bargain purchase gain” or “negative goodwill.”

The merger of two stable credit unions creates a wealth transfer similar to a credit union which makes a “whole bank purchase.” Unlike a bank purchase however, none of the shareholders’ equity is paid to the member-owners whose loyalty and patronage created the wealth. Nor is there any additional amount, that is a “premium” over book value, offered as would be expected in a purchase of a sound bank.

The Duties of Credit Union Directors

The fiduciary duties of credit union directors, established by NCUA rule and standard legal practice, are summarized in the following article:

https://cusomag.com/2019/12/05/board-member-liability-in-an-age-of-litigation-part-1-duties-and-case-studies/

The five key legal concepts relating to director responsibility and liability are excerpted in part below:

1. 1. Business Judgment Rule

The business judgment rule dictates that a court must presume a director based his or her decision on an informed and honest belief that the decision was in the best interests of the institution and members… To receive the business judgment rule’s presumptive protection, directors must inform themselves of all material information and then act with care.

1. 2. Duty of Care

Fiduciary duty of due care requires directors to use that amount of care which ordinarily careful and prudent persons would use in similar circumstances and consider all material information reasonably available when making business decisions.

1. 3. Duty of Loyalty

This duty forbids corporate directors from using their position of trust to further their own private interest (i.e. “self-dealing”)… Additionally, directors are required to act in an “adversarial and arms-length manner” when negotiating transactions between the corporation and the director.

1. 4. Duty of Good Faith

Breach of the duty of good faith occurs if the directors consciously and intentionally disregard their responsibilities, adopting a “we don’t care about the risks” attitude concerning a material decision. Moreover, deliberate indifference and inaction in the face of a duty to act epitomizes bad faith.

1. 5. Waste

Waste is defined as a director irrationally squandering asset. To prove waste, the plaintiff must establish that an exchange was so one-sided that no businessperson of ordinary, sound judgment could conclude that the credit union received compensation.

I believe each of these standards is relevant when assessing this transaction.

What the Members of Schools Financial Were Told About the Merger

The primary document provided members was an October 23, 2019 letter to members from the Board Chair. NCUA did not post the financials referred to in the letter so it is not clear how the financial combination was presented, or even if it would have been understood by a member if received.

The Chair’s letter states the merger was a result of a mid-2017 board decision to refocus the credit union’s “efforts upon educators on a state-wide basis.” One public announcement since that mid-2017 date was on January 22, 2019 in which the two credit unions in a joint press statement announced their intent to merge. The Chairman’s announcement of the member vote in October was the implementation of this January decision.

The letter to members is very general in its justifications. The most specific language was two pages of detail about the potential increase of compensation to be received by the CEO ($8 million of the total $9 million described) and five most senior managers as a result of the merger.

The letter did not state:

• That the credit union’s accumulated wealth of over half a billion dollars would be transferred to another credit union’s control and use;
• That the credit union’s resources would now be controlled by a board of directors for which no information was provided and is located over 400 miles from Schools Financial primary service area;
• That the operating control of the credit union’s assets and shares would now be under the control of a management team about which no information was provided and which, like the board, is over 400 miles removed from the Sacramento membership;
• Any immediate changes of rates on savings or loans that would occur as a result of the merger;
• Any information about ongoing roles negotiated for Schools Financial’s Board of Directors;
• Any commitments relating to products and services provided by Schools Financial that are not offered by SchoolsFirst such as Banking for Everyone Savings, business accounts or the shared branching outlets-“each to be evaluated to determine whether to continue or discontinue them after the merger;”
• Any impact on Schools Financial’s field of membership granted by the State of California which according to the September 5300 Call Report covered up to 4 million potential members.

The members were urged to give up their independent charter and the direct control of their credit union’s resources and all future decisions in return for general promises of “improved financial benefits” and “to gain economies of scale to be able to compete with larger financial services companies.”

On this latter point about the benefits of scale, in the year-end special dividend announcement by Schools Financial, the full year’s ROA of 1.73% would be approximately double the industry average and .60 basis points higher than SchoolsFirst FCU which is eight times the size of the Sacramento based credit union.

Subsequent Announcements by Both Credit Unions

After the voting and special $4 million dividend were announced, the following information has been published by the credit unions on their websites after stating the merger was overwhelmingly approved:

• The annual membership meeting of the newly enlarged SchoolsFirst FCU will be on May 19, in Tustin, CA approximately 430 miles from the location of the former office of Schools Financial CU.
• The Nominating Committee of Schools Financial met on December 5^th (one week before the December 12^th Schools Financial member meeting to vote on the merger) and nominated two of the merged credit union board members to their board: Marie B. Smith who as Chair signed the merger letter, and Theresa Matista, another current board member approving the merger. The annual meeting notice also stated: “The election will not be conducted by ballot when there is only one nominee for each position to be filled. There will be no nominations from the floor.”
• In a post-merger web announcement titled: An Exciting Time for Schools Financial Members,” Marie Smith, chair of Schools Financial stated: “I along with two other current Schools Financial CU Board Members will serve on the SchoolsFirst FCU Board of Directors. I look forward to our bright future and helping you and your family secure lasting financial security.” Apparently, the Nominating Committee didn’t get the same message for the December 5^th nomination described only two board members from Schools Financial!
• The letter also listed five potential fee reductions such as eliminating $8 incoming wire service fee. The post also reiterated the prospect of “improved savings rates and highly competitive interest rates on loans” but with no specifics.
• In another section of the web: Returning to our Roots, Schools Financial, a division of SchoolsFirst FCU announces that their FOM is “exclusively open to current or retired school employees and their immediate families,” not the open community charter followed prior to the merger.
• On the SchoolsFirst website, the FAQ about the merger includes the announcement that the credit union will open a new branch in the Sacramento area in the first half of 2020. But otherwise the credit union twice states, “most things will stay the same,” and again, “all products and services will stay the same.” One way to interpret this assurance is that the junior partner’s product and service profile will be conformed to that of the senior partner.

These after the fact disclosures illustrate the lack of transparency surrounding this $2.1 billion transaction. The assessment begun in May of 2017, triggering the joint merger press release in January 2019, which suggests the board had over two years to evaluate and to negotiate on behalf of the members. Yet the most detailed part of the letter to members concerns compensation to the CEO and senior managers, and no details of any potential benefits or losses for the membership.

Which raises the most important question, what options did the board consider and evaluate for the members’ best interest?

What Could $540 Million Endowment Contribute to the Sacramento Community

Separately from the issue of whether the board talked to or considered mergers with local credit unions such as Safe or Golden 1 to enhance the future for Schools Financial members, is whether the credit union even deliberated investing some or all of the wealth created by the members to benefit the future of the community which created this surplus.

Did the directors consider paying forward the reserves for helping the school districts and communities versus giving half a billion dollars to the control of a board and management whose primary responsibilities are rooted hundreds of miles away in a different part of the state?

What could a half billion-dollar fund do for the needs of the Sacramento educational community?

• How might it help with affordable housing options for teachers to live closer to the communities they work in?
• For scholarships to seniors from families that cannot afford to contribute to higher education expenses?
• For teacher training especially in areas that fall outside the immediate priorities such as the arts, technical and vocational skills?
• For equipment for schools that are short-changed versus wealthier districts in the allocation of funds for classroom technology or extracurricular sports?
• For educational programs for those adults striving to get a GED or other certifications?
• For pilot programs for encouraging and supporting new online educational options?
• For reducing the college debt burden to hire new graduates for teaching careers so they do not have to worry about paying off loans?
• For special grants to local community colleges and universities to underwrite innovations in educational experiences and curriculum?

With a 6% grant rate and a half billion-dollar fund, over $30 million could have been donated annually to benefit the community that created, supported, funded and made the credit union a force for good in the Sacramento area.

SchoolsFirst, the fifth largest credit union in the country, had the capital to absorb the credit union which would have allowed the credit union to transfer the wealth for the benefit of the community that created it in the first place. If the rejoinder is that the SchoolsFirst Board can now do the same work, one needs only look at the credit union’s track record to know that that is highly unlikely. For in the 2018 Annual Report, the $16 billion SchoolsFirst reports as follows: “In 2018 we partnered with local, national and global educational and credit union charities to give back in significant ways. We made more than $2 million in charitable donations including donations to local schools and colleges, Children’s Miracle Network, Hospitals, Habitat for Humanity and CUAid.”

Part II of this analysis will be posted tomorrow. It will address why credit unions should care about this wealth transfer and the circumstances which enabled it to occur.