Information for the meeting of the Chamber of Deputies of the Parliament of the Czech Republic to discuss the development of the situation in Union banka

Information on the development of the situation in Union banka

1. Basic information about the bank

on banka, a.s., has its registered office in Ostrava, 30. dubna street, building no. 635. The bank's commercial network comprises 91 outlets (11 branches, 56 consultancies and 24 sub-branches) located throughout the Czech Republic. The largest concentration of outlets, however, is in South Moravia (17) and the Moravian-Silesian region (10).

of 31 January 2003, the bank's total assets amounted to approximately CZK 20.8 billion, i.e. 0.83 percent of the total assets of the banking sector. The bank's assets consist chiefly of amounts due from clients of approximately CZK 13.8 billion (1.52 percent of loans in the banking sector). On the liabilities side, client deposits amount to approximately CZK 16.6 billion (1.15 percent of total deposits in the banking sector). Of this volume, insured deposits amounted to approximately CZK 16.48 billion and the compensation to be paid would amount to approximately CZK 12. 8 billion. The deposits of private individuals make up 85 percent of the total volume of deposits. The bank has approximately 250,000 clients.

bank's authorised capital amounted to CZK 2.25 billion, although the bank recorded an unpaid loss for previous periods of approximately CZK 0.88 billion.

The bank's major shareholders are Union Group, a.s. (75.36 percent) and Invesmart B.V. (22.6 percent). Invesmart B.V. also has a 60 percent holding in Union Group, a.s.

At present, the bank's board of directors is as follows: Roman Mentlík (Chairman), Štefan Veselovský and Michal Gaube. The bank's supervisory board is made up of the following: Paolo Catalfamo (Chairman), Paul de Sury, Hana Jeníková, Ivana Růžičková and Marco Bertolin.

2. Establishment of the bank

Union banka (the 'bank" or 'UB") was established in 1991 as a small, regional bank with the aim of assisting in the restructuring of the Ostrava region. The bank was closely involved with large companies, primarily from the North Moravian region: by 1993 large industrial concerns from the region such as Severomoravská plynárenská, Vítkovice a Nová huť had increased their shareholding in the bank. In order to serve the bank's most important clients, business centres were gradually opened in Prague, Brno and Olomouc as well as other locations throughout the Czech Republic.

At the end of 1995 the bank's shareholders established a company (formerly Facium and from 1996 Union Group) that became the owner of the bank's shares in their place. The original shareholders of the bank then owned holdings in this company. The reason given for this transaction was that it would act as a 'defence against a hostile takeover" by one of the newly-created predatory financial groups.

3. Takeover and integration of other banks.

At the turn of 1993-1994, banking supervision conducted an investigation in the small Czech banks in order to ascertain their situation. For most of the banks the results of the investigation were very unfavourable, although Union banka received a relatively positive assessment.

In 1996, when the crisis in the sub-sector of small Czech banks reached a peak, the CNB, taking into account the relatively positive results recorded by Union banka at that time, agreed to the bank's plans for expansion. These consisted inter alia of the takeover and integration of some of the problem banks. In 1996, memoranda of understanding were concluded between the CNB and Union banka and Union Group concerning a solution to the situation of Bankovní dum Skala, a.s. (BDS), Evrobanka, a.s. (EVBA) and Ekoagrobanka, a.s. (EAGB). As part of the solution, Union banka took over a holding in the problem banks and subsequently their assets and liabilities by means of contracts of sale of the company or a part thereof. In accordance with the aforesaid memoranda, the CNB participated in cleaning the balance sheets of the individual banks of bad loans so that integration should not have a disproportionate effect on the bank's performance. Union banka and its shareholders covered the remaining part of the loss assets and the payment of operating costs relating to integration.

In 1998, the bank also decided to take over Foresbank, a.s. (FORE), which at that time was included in the government's Stabilisation Programme. By taking over FORE, Union banka acquired the two largest pension funds in the Czech Republic (Podnikatelský penzijní fond and Vojenský otevřený penzijní fond - the 'VOPF", both funds later merging under the name VOPF) and the service of customs workplaces, the acquisition of which Union banka considered important for the further development of the Union Group.

The integration process was the object of increased attention on the part of the CNB. It held a number of meetings with the bank's management and conducted a partial inspection in the second quarter of 1997, followed by a full inspection at the end of the year. The CNB required the bank to remedy the shortcomings ascertained, in particular with regard to the insufficient creation of provisions for its own assets and those it had assumed. The bank also faced the problem of insufficient yield rates, due mainly to the high operating costs linked to the ongoing integration of the banks it had taken over, a process that was not proceeding according to Union banka's original plans.

In order to eliminate the effects of integration and to comply with CNB requirements the bank gradually increased its authorised capital to CZK 2.4 billion in 1999.

As a result of its takeover of FORE, Union banka also assumed FORE's liability towards Česká finanční, s.r.o. (also 'ČF") under the Stabilisation Programme. As part of the agreed solution, ČF did not get back all the funds from the FORE Stabilisation Programme and ČF deposited the payment it received from FORE with Union banka under conditions that ensured that as of the date of the originally planned end of the FORE Stabilisation Programme (18 December 2004), the deposit including interest would be equal to the amount that ČF would otherwise have received through the due conclusion of the Stabilisation Programme.

The adopted solution guaranteed a higher return on funds deposited in the FORE Stabilisation programme and limited the risks for the participants of the pension funds that would have arisen in the event of bankruptcy proceedings being launched against FORE.

Due to a different interpretation of one of the memoranda, in 1998 Union banka made additional requests for the payment of costs relating to the takeover of BDS. Arbitration proceedings led to the CNB paying Union banka approximately CZK 1.9 billion in 1999 and on 27 December 1999 a Memorandum of Settlement was concluded. This replaced all previous arrangements between the CNB and Union banka concerning the takeover of BDS and settled all rights and obligations between the CNB and UB regarding the takeover of BDS.

4. Related Party Loans

Following the takeover and integration of the small banks the Union Group financial group (the 'UG") gradually began to take form. The companies Union Trading, Union pojišťovna and Union Leasing were either established or taken over and developed. The financial group also expanded to Poland, where it became the major shareholder of Bank Przemyslowy.

During the group's expansion the bank provided loans to companies that were also shareholders of UG or personally or financially linked to some of the major shareholders (so-called related party loans, or 'RPL"). It would be reasonable to expect that UG's development was thus financed due to a lack of own funds. Funds were generally provided to companies founded with a specific purpose, the major part of whose total assets consisted of a loan provided by the bank.

In its report on the bank's closing financial statement for 1999, the auditors Deloitte&Touche, s.r.o., ('DT") stated that the bank had provided RPL of CZL 5.4 billion and drew attention to the uncertainty regarding the return on these loans with the impact on the bank's financial situation without the intervention of a strategic investor including the anticipated sale prices of some of the holdings.

The CNB has been unable to prove any direct link with the increase of the bank's capital or the acquisition of holdings (loans were generally provided for financial investments) and thus a breach of legal regulations. However, following meetings with the bank and the auditor, the CNB required the bank through its regulation of 23 June 2000 to ensure without delay that blue-chip securities from the UG portfolio should be used to provide sufficient security for RPL with the aim of improving these loans' security. The bank complied with the aforesaid regulation by entering into an agreement with UG under which revenue from the sale of UG's holdings (VOPF, Union pojišťovna, Bank Przemyslowy atd.) was to be used exclusively for the repayment of RPL.

The CNB subsequently performed an on-site inspection in the bank between 11 September and 13 October which among other things focused on RPL. On the basis of this inspection the bank was required as of 19 September 2000 by means of a CNB regulation to assess the degree of risk attached to the loans, to classify these receivables, to evaluate the security and subsequently to create the necessary provisions. The bank was further required to suspend and not to increase its loan exposure with regard to UG and to take all steps necessary to reduce the bank's loan exposure to UG. The bank, however, procrastinated with regard to compliance with the regulation. For this reason a further regulation of 10 November 2000 required the bank to classify the RPL in accordance with the CNB Regulation on the classification of receivables. As of 27 November 2000, the bank re-classified the aforesaid receivables according to the CNB requirement and announced that it had implemented both remedial measures and that the RPL would be reduced through the sale of UG's holdings.

In response to the bank's plan to sell off its holdings, the CNB in its regulation of 3 January 2001 required that the bank invest the funds from the sale of UG's holding (repayment of RPL) only in assets with zero risk value (liquid funds).

In December 2000 an agreement was entered into concerning the sale of VOPF shares in Winterthur and subsequently part of the RPL was repaid (amounting to CZK 2.2 billion). The cancellation of the Fores, a.s. (formerly Foresbank) subordinated debt meant that a further part of the RPL could be paid (CZK 311 million).

By virtue of its monitoring the CNB ascertained that in December 2000 the bank provided further loans to finance the purchase of shares in UG. This was a repeated shortcoming that led the CNB to impose a penalty of CZK 2.5 million in May 2001. The penalty was paid in June 2001.

According to data recorded by the bank, it managed to further reduce its RPL by CZK 850 million by February 2002 through revenue from the sale of UG shares to the British investor Mr. Seddon (CNB consent to his entry in UG was not needed due to the low participation level). Information obtained during administrative proceedings with Invesmart B.V. indicates that the sale of shares to Mr. Seddon might have been financed by RPL. It was not possible, however, to confirm this as the money was routed through several companies, including some abroad.

From 9 April 2002 to 18 April 2002 the CNB conducted an on-site inspection that focused on selected loan transactions. This ascertained the need to create provision for RPL and certain other loans amounting to CZK 1.35 billion, the bank's imprudent approach with regard to certain transactions and the incorrect recording of the bank's loan exposure. After discussing the inspection results with the bank, the CNB demanded in a letter of 4 July 2002 that as a solution the bank should implement those remedial measures suggested by the bank itself, i.e. limiting loan transactions over CZK 15 million and changing the members of the board of directors.

The bank failed to meet its obligation with regard to changes in the board of directors within the prescribed time limit and consequently, as of 4 July 2002, the CNB demanded a change in the composition of the board of directors by means of a regulation. When the bank failed to comply with this regulation as well, the CNB as of 27 September 2002 demanded a change in the composition of the bank's supervisory board. A partial change in the composition of the supervisory board and board of directors was introduced at the general meeting of 30 September 2002. Only as of 20 December 2002 did the bank and UG hold extraordinary general meetings, at which new compositions for the organs of both companies were approved.

After settling the appeal proceedings to the inspection protocol, the CNB as of 2 January 2003 demanded that consequent to the results of the on-site inspection selected receivables should be re-classified and that on the basis of this classification additional provisions should be created. In response to the CNB's requirement the bank created additional provisions of CZK 1.2 billion.

5. Entry of investors

In the middle of 2000, two banks showed interest in acquiring a majority holding in UG: Raiffeisenbank a BNP-Paribas. Ultimately, both banks backed down as they were unable to obtain the required state guarantees for the quality of the bank's loan portfolio (up to approximately CZK 2.5 billion).

According to information from UG, other companies also showed interest during this period which did not require state guarantees but simply wanted to restructure UG and sell off the subsidiaries, including the bank. The Slovakian company Istrokapitál, a. s., also showed interest in the bank, although this later withdrew its application.

Due to UG's failure to bring negotiations with potential investors to a successful conclusion, UG's supervisory board decided in November 2000 to sell its individual holdings. In response to pressure from the CNB, UG entered into agreements with the bank by which the funds acquired from the sale of the UG holdings would be assigned to UB and used to repay RPL.

During the second quarter of 2001, a project was submitted to the CNB for the entry of British portfolio investors, represented by Mr. Seddon, into UG and the subsequent repayment of part of the RPL. This however did not concern the acquisition of a qualified holding in the bank and as a result the project was not taken into account in the administrative proceedings. In June 2001, agreements were concluded with this investor for the sale of UG shares amounting to CZK 1.7 billion. Part of the funds was paid in June 2001; the remaining funds were not paid.

In the fourth quarter of 2001, an Italian company represented by the Dutch company Invesmart B.V. ('Invesmart") showed interest in acquiring a qualified holding in the bank and UG. In April 2002, Invesmart submitted an application for prior approval for the acquisition of a qualified holding in the bank by means of its entry in UG. Invesmart intended to clean the bank of its bad loans and sell it to a strategic investor, as part of which it counted upon state support.

Under the Act on Banks, the CNB is obliged to make a decision on whether to grant approval on entry into a bank within three months of the launch of administrative proceedings. As Invesmart had not been able to submit all the required documents the first administrative proceedings were stopped and the second, launched upon a subsequent application, ended with the decision not to grant approval. Invesmart submitted all the required information, the scope of which is defined by generally binding legal regulations, in the third proceedings which ended 24 December 2002 with the CNB's decision to approve its acquisition of a qualified holding in Union banka.

The acquisition was to have been financed through an increase of approximately CZK 2.6 billion in Invesmart's authorised capital by its shareholders, which was confirmed by decision of the general meeting. A condition was the resolution of the České finanční receivable due from Union banka through the provision of state support for the bank. At the same time a mechanism was presented that was to ensure that the funds paid for the shares would strengthen the bank's financial situation. This consisted of taking over the RPL from the original debtors against UG and UB shares.

As of 18 November 2002, a majority holding of UG shares (approx. 60 percent) was assigned to Invesmart. Invesmart also directly acquired approximately 22.6 percent of the bank's shares. As part of the same deal, Invesmart assumed RPL liabilities of approximately CZK 2.6 billion.

Negotiations with the Ministry of Finance on state support were held from the middle of 2002. In November 2002 it was agreed at a joint meeting attended by the Ministry of Finance, the CNB, the Office for the Protection of Economic Competition and Union banka, that Union banka would prepare a restructuring plan which would serve as the basis for the provision of state support. The bank submitted the final version of the plan as of 12 February 2003. After consideration, the Ministry of Finance informed the bank that it did not consider the plan to be a realistic point of departure from the situation in which Union banka found itself.

6. The bank's capital adequacy

According to its statements, the bank fulfils the capital adequacy indicator, which during 2002 fluctuated above the 9 percent level. However, this level was achieved through the entry of Invesmart, which assumed RPL of CZK 2.6 billion on condition that liabilities would be paid from funds acquired through an increase of its capital after receiving state support. The bank accordingly did not create provisions for the amount due from Invesmart. Following a statement by the Ministry of Finance the situation changed and it is now possible once again that Invesmart will pay the liability. The CNB thus demanded that the bank, by virtue of these facts, assess this receivable with regard to its classification and the creation of provisions in accordance with the CNB Regulation on the assessment of receivables from financial activities.

In addition to the uncertainty surrounding the amount due from Invesmart, from September 2002 the bank recorded in its financial statements an alleged loss of approximately CZK 1.75 billion on the amount due from the CNB, which it was supposed to have incurred in relation with the takeover of BDS beyond the payments already received. By recording this receivable the bank was able to create provisions for loans without affecting its capital adequacy. The receivable is now the subject of arbitration proceedings between the bank and the CNB.

7. Summary

Union banka was established and to begin with also developed as a primarily regional bank. In the second half of the nineties the bank began to expand by taking over problem banks and at the same time the Union Group was establishing and buying financial companies.

The main reason for the further development of Union banka was the provision of loans to related parties, which probably went to finance the group's expansion. The shareholders and related parties that obtained the loans were unable to repay them in the standard manner..

It has been and still is very difficult to map clearly the whole process by which the loans were provided. The bank probably provided the loans from 1997 onwards, although the CNB has never been able to obtain comprehensive documentation, despite it using every legal option available, including on-site inspections. The loans were gradually increased, prolonged, or provided to other entities. The volume of special loans gradually rose and comprised approximately one third of the bank's total portfolio. The bank recorded roughly half of these loans as standard.

In its reports, the bank's auditor Deloitte&Touche subsequently drew attention to the risks attached to these loans and stated that it was essential for the bank to find a strategic partner or to sell holdings at a price that would sufficiently cover the total receivables. In its report of 31 December 2001, which the CNB received 16 August 2002, the auditor stated that failure to organise the intervention of a strategic investor would raise real doubt about the bank's ability to continue with its activities in the foreseeable future.

The risks attached to related party loans, together with the problems in the bank's standard loan portfolio, reached a level that private investors were not willing to meet in full and as a result they made their entry into the group and the bank conditional upon state assistance.

As part of its banking supervision, the CNB regularly assessed the bank's financial situation, including by means of on-site inspections. With regard to the shortcomings ascertained, the CNB, within its legal capabilities, demanded remedial measures that would limit the risk undertaken by the bank and enforced their payment. As in the meetings with the bank's management and the representatives of the supervisory board, the CNB repeatedly demanded that risks arising primarily from the bank's loan portfolio be resolved. The responsible organs of the bank informed the CNB on a regular basis of the projects it had undertaken to resolve the risks. These consisted of the sale of the Union Group's subsidiary companies and the entry of foreign investors, including related talks with the Ministry of Finance on the matter of state support. The bank's management, which has sole responsibility for the bank's financial performance, and the shareholders thus had sufficient time to find and implement their plans to save the bank.

It was only possible however to implement the plans for the sale of holdings on a partial scale and the result of the meetings with potential investors was the takeover by Invesmart at the end of 2002. In this respect however it was not possible to find a feasible solution with regard to state support.

The bank's long-term problems led to a loss of confidence on the part of the market and the public. This was manifested in the rapid withdrawal of deposits in October 2002. After a short period of stabilisation following the entry of Invesmart, the withdrawal of deposits and rapid reduction in the bank's liquid funds occurred again in February 2003, when the bank was compelled due to reasons of solvency to close its branches. Concurrently, the CNB launched administrative proceedings for the revocation of the bank's licence. These shall provide the opportunity to perform a comprehensive assessment of the bank's financial situation as a whole.