District Circular Letters
November 21, 2001
BANKING SUPERVISION AND REGULATION:
FORWARD EQUITY TRANSACTIONS
To State Member Banks, Bank
Holding Companies, U.S. Branches
and Agencies of Foreign Banks,
and Others Concerned,
in the Twelfth Federal Reserve District
The Use of Forward Equity Transactions by Banking Organizations (SR 01-27)
Over the past several years, a number of banking organizations have engaged
in various types of forward transactions relating to the repurchase of
their common stock. In these transactions, the banking organization enters
into an arrangement with a counterparty, usually an investment bank or
another commercial bank. The counterparty purchases the banking organization's
common shares, either in the open market or directly from the institution
itself, with the agreement that the banking organization will repurchase
those shares at an agreed-upon forward price at a later date (typically
three years or less from the execution date of the agreement). These transactions
are used to "lock in" stock repurchases at price levels that
are perceived to be advantageous and also as a means of managing regulatory
capital ratios.
Banking organizations have generally continued to treat shares under
such arrangements as Tier 1 capital. However, because these transactions
can impair the permanence of the shares and typically have certain features
that are undesirable from a supervisory point of view, shares covered
by these arrangements have qualities that are inconsistent with Tier 1
capital status.
Therefore, any common stock covered by forward equity transactions entered
into after issuance of this letter will be excluded from Tier 1 capital.
Types of Forward Transactions
The two main types of forward transactions that banking organizations
have engaged in are forward equity sales transactions and forward purchase
contracts.
Forward Equity Sales Transactions
In a forward equity sales transaction, a banking organization purchases
its own common shares in the open market, generally as part of a stock
buyback program, and then issues these shares to a counterparty at a specified
price that approximates the then-current market value. Simultaneously,
the banking organization enters into a forward contract with the same
counterparty to repurchase the shares at the same price plus a premium
(the forward price).
Forward Purchase Contracts
Forward purchase contracts differ from forward equity sales transactions
in that the counterparty purchases the shares to be covered under the
contract directly in the open market. The banking organization agrees
to purchase the shares from the counterparty at a future date at the forward
price.
Settlement Methods
Forward equity sales transactions and forward purchase contracts can
generally be settled in one of three ways, typically at the option of
the banking organization:
- Gross physical settlement: The banking organization purchases all
of the shares from the counterparty for cash and retires them as treasury
stock.
- Net share settlement: The difference between the prevailing market
price and the forward price is settled in common shares. If, at settlement
date, the prevailing stock price is higher than the forward price, the
counterparty sells to third parties the number of shares necessary to
cover its costs
and remits the remaining shares to the banking organization to be retired
as treasury stock. If the prevailing stock price is lower than the forward
price, the banking organization must issue additional shares to cover
the counterparty's costs and the decline in stock price.
- Net cash settlement: The difference between the prevailing market
price and the forward price is settled in cash. If, at settlement date,
the prevailing stock price is higher than the forward price, the counterparty
sells the shares to third parties and remits cash in excess of its costs
to the banking organization. If the prevailing stock price is lower,
the banking organization must compensate the counterparty in cash for
the decline in share price plus costs.
While shares covered under such agreements retain certain characteristics
of Tier 1 capital, the shares are nonetheless under contractual agreements
that can limit their availability to absorb future losses. Specifically,
under the gross physical settlement method, the shares have the potential
to be retired in a relatively short period of time. Therefore, the forward
equity transaction impairs the permanence of those shares.
In addition, the net settlement options described above depend on the
future market price of the common stock. In a stress scenario, this could
lead to undesirable results from a supervisory point of view. For example,
if an institution has entered into a forward equity transaction and subsequently
experiences financial deterioration, it is likely that the institution's
share price would reflect this stress and would have declined to a price
lower than the forward price fixed in the agreement. In order to settle
the forward transaction, it is likely that the institution, in exercising
its flexibility to choose the settlement method, would eschew share settlement
to avoid dilution and would choose instead to settle the transaction through
an expenditure of cash. Moreover, the further the stock price declines,
the more cash the banking organization would need to settle the transaction,
resulting in a greater drain of resources for an institution that is already
distressed. Aside from the potentially negative financial effects that
could result from such a scenario, the net settlement options in these
transactions attach to a Tier 1 capital instrument what is essentially
a market value conversion feature that could weaken a stressed institution.
The Federal Reserve's examination manuals state that market-rate convertible
preferred stock must be excluded from Tier 1 capital.
The policy reasons for excluding market-rate convertible preferred apply
with equal force to common shares subject to a forward equity transaction.
Due to these concerns, the Federal Reserve has determined that shares
covered by forward equity arrangements should not be included in the Tier
1 capital of a bank holding company or a state member bank. The amount
to be excluded would be equal to the common stock, surplus, and retained
earnings associated with the shares. Banking organizations that currently
have common stock covered under forward equity transactions may continue
to treat those shares as Tier 1 capital, but shares covered by any future
forward equity transactions, other than those specified for deferred compensation
or other employee benefit plans, must be excluded, even if executed under
a currently existing master agreement.
Additional Information
All circulars and documents are available on the Internet through the
Federal Reserve Bank of San Francisco's Internet site, at http://www.frbsf.org/banking/letters.
Paper copies of the Board's notice (SR 01-27)
are available from our Corporate Services Department. To request copies
to be sent by mail, please call (415) 974-2060.
For additional information about forward equity transactions, please
contact our Banking Supervision and Regulation Department at (415) 974-2225.
FEDERAL RESERVE BANK OF SAN FRANCISCO
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