UNCERTAINTIES, VALUE AND THE PARTICIPATION OF U.S. INSTITUTIONS

LATIN FINANCE in conjunction with EL FINANCIERO Mexico

Capital Markets Workshop

June 20-21, 1991, Hotel Nikko, Mexico

UNCERTAINTIES, VALUE AND THE PARTICIPATION OF U.S. INSTITUTIONS

By Bruce Claugus, Esq. Claugus and Mitchell, LLP. New York

The issues of valuation and the resolution of commercial uncertainties are related concerns. Value is obviously a function of the surrounding uncertainties. Two basic uncertainties are generated by participants in the U.S. capital markets. Will U.S. institutions, particularly U.S. commercial banks, participate as investors in the dis-incorporation of Mexican commercial banks? If not as investors, will these U.S. institutions participate as lenders in the dis-incorporation?

Bruce Claugus said: "If you believe the financial press, there are too many economic and legal problems to overcome for U.S. banks to participate. The economic problems are well known and include the recent and unpleasant experiences of U.S.. banks in Latin America, reserve requirements, the recessionary state of the U.S. economy, and capital inadequacy. The legal problems include the pending U.S. regulatory agenda, statutory limitations on ownership of disincorporated entities by U.S. banks and the uncertain configuration of the coming North American Free Trade Agreement. At first impression these are serious problems; however, they depend heavily on an incomplete, static view of current circumstances. A complete analysis, considering favorable underlying economic and legal fundamentals and trends, gives a different impression. "

Claugus mentioned: "A concentration on unpleasant experiences of the immediate past overlooks historic realities. Mexico was politically and economically conservative and stable for decades prior to the administrations of Sres. Echeverria and Lopez Portillo. For thirty years before these administrations took office inflation averaged 3.8%; debt was only 8.8% of gross domestic product; and output grew at an average of 6.7%. Clearly, the two administrations mentioned were aberrations, particularly when compared to the restabilizing policies of Sres. de la Madrid and Salinas. There is no persuasive reason to believe Mexico can not cure itself and return to its former stability and rate of growth."

Problems of reserves and capital adequacy assume the recession will continue in the U.S. Some progress on these problems had been made before the onset of the most recent recession and, in any case, the recession is already showing signs of ending. These problems should be resolved by growth in the U.S. economy.

Bruce Claugus stated that the regulatory agenda in the U.S. will remain full. Important changes in regulation will be made, increasing the ability of commercial banks to underwrite securities, sell insurance, and engage in interstate branch banking. The structure and interrelationship of the regulatory bodies will also be materially changed.


Much is made of the barrier posed by the limitation of individual foreign interests to 5% or, possibly, 10%. This limitation is illusory. First, for the economic reasons mentioned above, 5% may be as much as is prudent for a U.S. commercial bank investor. it is enough of an interest for the investor to participate meaningfully in the positive economic developments in Mexico and to gain experience in new areas. It also is an affordable interest and one for which an unfavorable outcome would not be ruinous -- as a large portfolio of junk bonds has proved to be. In addition, it is quite clear that the limitation on the size of U.S. interests is temporary. The Free Trade Agreement is certain to come about and, through the Protocol of Accession, is certain to liberalize existing Mexican constraints on ownership. In fact, the concept of "national treatment", which is the central theme of the Agreement, will require that U..S. banks in Mexico enjoy the same rights as do Mexican banks in the U.S., that is, complete freedom of lawful ownership, including 100% ownership. The only real question is over what length of time will the Protocol of Accession phase in these freedoms? In this scenario, a U.S. commercial bank could take a small, initial interest now, gain experience in the Mexican market, make reasoned judgments about the quality of this experience and, if the experience justifies the step, incrementally increase the size of its interest toward control over the life of the Protocol. The economic sense of this approach is especially sound since the Free Trade Agreement is expected to add significant power to the Mexican economy, particularly in the northern states, and the U.S. investor could test and benefit from this effect.

Claugus also told that an argument raised against this approach is that U.S. banks should remain independent and establish their own branches as soon as it is permitted. This argument overlooks two important problems. First, if there is no apparent interest in the Mexican market made manifest by investments in Mexican banking, there may be limited political pressure for an aggressive Protocol and withholding investment will be selfdefeating. Second, it is not clear that starting a new, U.S. bank or branch in Mexico is so easy.

In the foregoing context, it may be that the Mexican government has crafted a very elegant opportunity for U.S. banks. Without causing political difficulties, an affordable, expansible vehicle has been provided which permits a smooth, incremental exposure to the Mexican economy, universal banking and unitary, functional regulation. The impending Free Trade Agreement reinforces the value of this vehicle by expanding the scope of permissible interests as it expands the Mexican economy.


Bruce Claugus said that this analysis would seem to resolve the uncertainty of U.S. participation in favor of investment and add value to the banks now being disincorporated. It would also seem to reduce the prospect of U.S. participation by means of new, start up enterprises which would reduce the value of the banks being auctioned. So, where are the U.S. banks? With the possible exception of American Express, which is not really interested in a bank for the sake of banking, the financial press claims U.S. banks are not interested. Relatively little interest seems to be coming from Europe either. European banks may, in fact, not be interested. The Free Trade Agreement will place them at a significant disadvantage relative to U.S. banks since they will lack a free trade basis for expanding their position. They will have to depend on new, special purpose legislation which may or may not be enacted. For U.S. banks, there may be more interest than meets the eye. It may be deliberately hidden; it may emerge in the form of buy-outs sometime after disincorporation; it may be latent, but it should be there.

Perhaps a question equal in importance to concern about the simple existence of interest is who could be interested and do you want to arouse this interest? Part of the problem is focus. Most of the attention thus far has focused on the U.S. money center banks. There may be more logical prospects as U.S. investors. Bruce Claugus said that there are more than 13,000 banks in the U.S. If a combination of comparably sized institutions is preferred to a combination with a U.S. giant, there could be between five hundred and a thousand viable prospective investors. Filtering this many prospects may be impossible; however, if synergies are sought, then the task becomes somewhat more simple. For example, Banca Cremi is known for its expertise in the mining industry. There are a number of U.S. banks in the west and southwest with like expertise. An investment by one of these U.S. banks would seem to make a lot of sense, though it is now too late. It might not be too late for Banco del Centro (Bancen) which has the same expertise, as well as expertise in agricultural lending. Properly stimulated, U.S. banks could be very interested, particularly if, in addition to the other advantages, there exists the opportunity to reinforce current lines of business.


Assuming you want or are willing to accept a U.S. bank as an investor, thought must be given to provisions in the format of the investment that the U.S. investor will want for its protection. These same protections will also come into play if the ownership interest of the U.S. investor grows and protection is needed by the remaining interests against their U.S. investor. There may be approaches to this problem under U.S. law but, because of the predominantly Mexican content of the problem, Mexican law will control and reshape these approaches into hybrid solutions. Developing the desired level of protection will vary from case to case and a comprehensive solution can not be presented in the abstract. Some basic ideas can be suggested, however.

Claugus said "From the outset a U.S. investor will require some representation on the board of directors of the bank. The right of a minority to have board representation can easily be accomplished through a charter or by-law provision allowing a particular shareholder or class of shareholders the right to elect a specified number of directors. other, more complex methods include the use of a charter or by-law provision providing for a system of cumulative voting in the election of directors. Under a system of cumulative voting, the number of shares held by a shareholder is multiplied by the number of directors to be elected to obtain the number of votes the shareholder is entitled to cast. The shareholder may cast all of such votes for a single candidate or distribute the total as the shareholder may determine. More often the same objective can be achieved by allocating places on the board through voting and shareholders agreements among shareholders. It might be agreed, for example, that C shares can elect a specified number of directors."


A minority shareholder also may desire a more direct voice and direct participation in the affairs of the corporation. This may be achieved by the use of a charter or bylaw provision requiring unanimity or concurrence of a high percentage of voting shares for action by the shareholders or directors. For example, the requirement of a supermajority vote could be used in cases where fundamental corporate changes are being considered or in certain other designated corporate matters. An alternative to supermajority vote requirement is to provide shares with weighted votes; certain shareholders may be given weighted votes of greater value than provided other shareholders. For example, class C shares could have 3-1/3 times the weight of A and B shares. A supermajority quorum requirement in the charter or bylaws also may be used. Such a provision would require fixing high attendance requirements for quorums at meeting of shareholders or directors for the transaction of business generally or designated kinds of business. Other devices include the use of class voting for directors, voting trusts, and irrevocable proxies. All of these methods can be used individually or in combination. Another safeguard against the erosion of proportionate voting power and proportionate interests in corporate earnings and corporate assets is the use of a charter clause providing preemptive rights for shareholders.

Obviously, a U.S. bank should require greater rights to inspect corporate books and records. The bank probably would expect an unqualified right at all times to examine all corporate books, contracts, accounts, correspondence, memoranda and other records of the acquired bank and to copy those documents and records.

The issue of whether U.S. banks will participate as lenders in the disincorporation of the Mexican banks raises different structural issues, but depends on the same economic fundamentals. If the Mexican economy has been restabilized and if the Free Trade Agreement will be adopted soon, the underlying foundation for the new banks should be encouraging. The analysis then turns to the banks themselves with the economic review proceeding on a case by case basis. At this stage some banks will obviously fare better than others. Based on current indications, the acquisition of the largest banks should be readily bankable provided that the loans are secured, typically by the stock of the acquisition, at ratios of not less than 2:1. In the same vein, convertible debentures could be used in anticipation of an investment by the lender. certain of the smaller banks could be partially financed in this manner provided they are strong performers. Banorte, Bancen, and Banorie might be examples.


A third, interesting, albeit more complex approach, could be undertaken if the investors are able to tolerate intense documentation, not only as between the group of investors and the lender, but also as among the members of the group. This third approach might be required in more difficult credit situations and, in very simple terms amounts to a receivables financing based on receivables generated by various members of the group. The privatization.of the Cananea copper properties was entirely accomplished in this manner and this same structure has been applied in a wide variety of similar transactions. The technique is often used where there is a perceived need to limit country risk to production and exportation.

Returning now to the original problem of uncertainties and value, it may be that little additional certainty has been developed regarding whether or not U.S. banks will stay at home or participate as investor s in disincorporated institutions or in their own, new enterprises. There are clear and convincing reasons to believe they should invest in the banks being auctioned. Whether they will respond to these reasons and who will respond remains unclear. Somewhat more certainty exists regarding whether U.S. banks will lend into acquisitions. In some cases it is known that they will on the basis of a rather simple structure. In difficult cases intense documentation will be required at all levels of the transaction. In between these extremes the structure will vary widely, but in all but the most difficult situations, U.S. commercial financing should be possible.