Co-op crisis shows need to revise Butterfill Act

Posted on January 19, 2014 · Posted in Co-operative News

It can be very useful to revisit history to work out what went wrong and why – not least to prevent repeating past mistakes.  This is perhaps a good moment to reflect on the Butterfill Act, otherwise known as the Building Societies (Funding) and Mutual Societies (Transfers) Act 2007.  This was the legislation that enabled the Britannia Building Society to merge with Co-operative Financial Services (CFS), to create The Co-operative Bank.

 

The Act passed into law in October 2007.  It had the effect of enabling one type of mutual to acquire a different type of mutual.  I am aware of just two instances where the Act was used – the second being the acquisition of the Kent Reliance Building Society, but more of that anon.

 

I had the opportunity to interview Sir John Butterfill MP at the time his Bill was going through Parliament.  He declined to tell me which mutuals had encouraged him to press ahead with the legislation, but he gave some strong – and it turned out misleading – hints.

 

Sir John represented a Bournemouth Parliamentary seat and he told me at the time of his Bill that he was putting it forward to advance constituency interests.  One of the largest employers in Bournemouth is the Liverpool Victoria Friendly Society, branded as LV=.  But when I spoke to Liverpool Victoria, it denied it was intending to use the change in law to acquire other mutuals.  It added – with what looks in hindsight like admirable common sense – that it regarded the then financial crisis as a very bad time to make big acquisitions.

 

I would have liked to have discussed these matters now with Sir John, but he is no longer an MP, he is ex directory and his house is up for sale.  He had expected to be made a peer, however this possibility fell through when he implied to an undercover reporter both that he expected to be made a lord and that this would give him a position of influence.

 

What I have been able to learn is that the behind the scenes driving force for the Act was the Co-operative Group.  I understand that at the time the Bill was drafted, Britannia was not a specific target of the Group.  We now know that the Group and Bank were – probably at around this time – considering taking over the Norwich and Peterborough Building Society.  The Bank eventually decided that the Britannia was the best target.

 

The loss-making Britannia Building Society was then taken over by the then profitable CFS.  Though, why the chief executive of the loss-making business should become the chief executive of the combined and then profitable business was something that always seemed to me irrational.

 

The merged business was a PLC that was a subsidiary of a mutual society, the Co-operative Group.  Because of this structure, it has been unable to access an escape route from under-capitalisation that the Nationwide Building Society has been able to use.

 

It is sometimes overlooked that one of the main reasons for the financial crisis and effective demutualisation of the Co-operative Bank has been the more demanding capital requirements of the new regulator, the Prudential Regulation Authority.  The PRA is part of the Bank of England, whose new Financial Policy Committee is strongly committed to reducing systemic risk within the UK banking sector.  One of its main instruments in achieving this is to increase the capitalisation requirements for UK banks.

 

The Co-op was not the only financial mutual of reasonable size to be found wanting in terms of capital.  The same issue applied to the Nationwide Building Society, not least because the Nationwide increased its lending as it supported growth in the UK economy and made funds available for more mortgage lending.

 

Nationwide was also told by the PRA that it needed to raise extra capital.  It has achieved this by issuing a new capital instrument, core capital deferred shares or CCDSs, which only building societies are able to issue.  In addition, because Nationwide is profitable, it was able to make a commitment to increase its capital reserves from future years’ profits.  As a PLC, the Co-op Bank was unable to issue CCDSs and as it had ceased to be profitable, it was unable to pledge the use of future profits.

 

So would it have been possible to use a different legal structure to achieve the outcome of a merged Co-op/Britannia financial mutual?  A reverse merger in which the Britannia took over the Co-op but as part of the Co-op Group would not, I am told, have been achievable as the merged body would have breached building societies regulations.

 

A third option would probably have been a joint venture, in which the two bodies remained legally separate, but operationally intertwined and with shared branding.  I guess that this option, if considered, would have been regarded as too messy and with too little certainty of outcome.

 

But we should also review the other application of the Butterfill Act.  The small Kent Reliance Building Society had been over-ambitious in the boom years and became very over-exposed and vulnerable in the bust period.  Its solution was the effective acquisition of the society by the private equity firm J.C. Flowers, which had been seeking a way to enter the banking market.

 

OneSavings Bank plc was formed, trading as KRBS, in which J.C. Flowers owns 40% of the equity, with the other 60% owned by a new mutual, the Kent Reliance Provident Society.  The Provident Society is owned by the former members of the Kent Reliance Building Society.  This arrangement seems to me to be a device to use the Butterfill Act to achieve a de facto demutualisation.

 

Some building societies were unhappy with the Butterfill Act at the time it was passed.  Concerns were expressed that it would aid the use of artificial structures to demutualise and that it would enable the Co-op Group to ‘hoover up’ smaller building societies.  Perhaps those concerns should have been listened to more closely.  But any blame for failures in the Act perhaps rests with the Treasury, which was responsible for some of the Bill’s detail and regulatory aspects.

 

Ultimately, though, the lessons are as much about the business strategies of some mutuals as the framing of legislation.  Ian Snaith, who helped draft the original Butterfill Bill, comments: “The bottom line is that co-ops should probably grow organically.”

 

But Ian does believe that legislation needs to be revised to assist financial mutuals to operate in the contemporary financial market place.  “It’s a problem that you can’t use an IPS [industrial and provident society] to operate as a bank if it has withdrawable share capital and is not a credit union,” he says.

 

So we will need to conduct a thorough examination of the legislative framework – and it may be that the Butterfill Act will need to be substantially revised.  Following a crisis of this magnitude we need to face up to mistakes.