The Financial Stability Oversight Council has adopted a final rule that went into effect on May 11, 2012 describing the framework that the Council intends to use to determine whether a non-bank financial company is systemically important to the US financial system and whose failure could pose a threat to the U.S. financial stability. The consequences of being designated a systemically important company is that the Federal Reserve is given the authority to impose risk based capital requirements, leverage limits, liquidity requirements, resolution plans, concentration limits, a contingent capital requirement; enhanced public disclosures; short-term debt limits; and overall risk management requirements.
The Council adopted a three-stage process for making its determination. The first stage is designed to narrow the universe of non-bank financial companies by establishing certain size or other quantitative thresholds. The second stage applies the analytic framework (i) size, (ii) interconnectedness, (iii) substitutability, (iv) leverage, (v) liquidity risk and maturity mismatch, and (vi) existing regulatory scrutiny to determine whether company could pose a risk to U.S. financial stability. The third stage will utilize qualitative and quantitative information obtained directly from the companies through the Office of Financial Research.
On Tuesday, May 22, 2012, Atlanta partners Jim McAlpin and Rob Klingler will be presenting at Porter Keadle Moore’s CFO Peer Group meeting.
Jim will present “Risk Management from a Legal Perspective.”
The regulators are raising the bar for enterprise risk management at community banks. Bank boards and senior management need to be thinking of how to satisfy these requirements within the context of the limited resources that community banks can deploy. One more area of focus is being added to an already crowded Board agenda.
Rob will present “The Impact of the Jobs Act on Community Banks.”
In a time of ever increasing regulation, Congress has passed the Jobs Act, a significant piece of deregulation of the federal securities laws. Public and private offerings are both impacted, and likely to be permanently changed. Capital is still hard to raise, but at least a few obstacles have been relaxed.
Please click here for more information or to register for the event.
We are pleased to announce that Dan Wheeler has joined the international law firm Bryan Cave LLP as a partner in the firm’s San Francisco offices. He will practice with the firm’s Banking Client Service Group.
“Having Dan join us as another West Coast member of our team complements the breadth of our nationwide banking practice and our ability to serve our clients’ needs,” added Kathryn Knudson, leader of Bryan Cave’s Financial Institutions Industry Practice Team. “Our team represents more than 300 financial institutions and is consistently ranked among the leading deal making banking practices in the U.S., so Dan’s experience and client base will be a welcome expansion of our practice on the West Coast.”
“Dan’s scope of practice will be invaluable in serving and strengthening our relationships with financial institutions throughout the Bay Area and beyond,” said Lee Marshall, managing partner of Bryan Cave’s San Francisco offices. “We are excited to welcome him to our firm and we look forward to adding his perspective and insight to our team.”
On May 14, 2012, the Federal Reserve, FDIC and the OCC released a joint statement confirming that that banking organizations with total consolidated assets of $10 billion and under will not be required to conduct formal stress tests. Management of many smaller banking organizations had been concerned that the stress testing required of larger banks would “trickle down” in an informal sense to smaller banks. With this regulatory statement, that concern is alleviated, at least in the official sense.
We continue to believe that the heightened (or perhaps renewed) emphasis on risk management by the regulators will affect banks of all sizes. It is likely that regulators, directors, and shareholders of all banks will want to confirm that management has identified the key risk factors affecting the institution and that the board has established the institution’s tolerance for accepting those risks and implemented any appropriate mitigants.
We recommend that banks of all sizes, even the smallest community banks, undertake an enterprise risk management analysis to identify the key risks facing the institution. The board of the institution, as a subpart of its strategic planning function, should review those risks and establish the institution’s risk tolerance with respect to each category of risk (many consultants will capture this analysis in a “risk appetite statement”). Establishing and understanding those risk tolerances will form a roadmap for setting and executing the institution’s strategic initiatives. In implementing this analysis, some institutions may undertake some level of stress testing with respect to certain risks.
This risk management analysis is a natural adjunct to the self examination process used we recommend using in preparing for a regulatory exam (see our prior “Self Exam” post). While the self exam process is typically more focused on the bank’s current position and past performance and this risk management analysis is more forward-looking, both processes require an introspective review. Senior regulators have repeatedly confirmed to us (and we have seen in practice) that where banks take the initiative in implementing credible risk management programs and other pre-examination preparation, the examiners are much more likely to defer to the judgment of management and the board of the bank – with the result being a much better interaction with regulators (who, in an ideal scenario, can be a partner in the risk identification process).
On May 3, the Treasury Department announced (via blog post) its intentions with regard to the 343 banks that remain in the TARP Capital Purchase Program. Specifically, Treasury identified three approaches: (1) allow repayments over the next 12-18 months; (2) limited restructurings in the context of mergers or capital raises; and (3) auctioned sales of the TARP securities, either for individual banks or in pools. These intentions are flexible and sufficiently vague to allow Treasury to moderate from these plans, particularly if political pressures necessitate. However, they also provide a road map (at least a current road map) of the path that Treasury anticipates using.
Treasury invested a total of $245 billion under the TARP bank programs, and has already recovered $264 billion through repayments and other income. This represents a $19 billion positive return, without providing any value to the remaining investments. Every additional dollar recovered is an additional return for the US taxpayers.
Of the 364 remaining investments, Treasury notes that most are smaller, community banks. Treasury is careful to point out that these banks have just as much desire to repay TARP, but have generally found it harder to raise funds from private investors in the capital markets and have often been particularly hard hit by troubled real estate loans.
Notably, Treasury now indicates that it intends to continue to hold the TARP securities of those banks that Treasury believes will have the ability to repay over the next 12 to 18 months. This could suggest that those banks that Treasury believes could obtain regulatory approval to repay will not be provided the opportunity, at least in the short term, to participate in a public auction (and therefore repurchase their securities at a discount to par value). The Treasury also indicates that they will communicate “regularly” with the group of banks that they think can repay over the next 12 to 18 months and will share with them Treasury’s “expectations” for repayment. Treasury has expressly indicated that its expectations regarding which banks will be able to repay may change over time.
Many financial institutions, particularly community banks, have enhanced the experience level of their boards by adding a director who is a banker or serves on the board of another financial institution. In general, utilizing a director who has current experience with another financial institution is a great way to add valuable perspective to a variety of issues that the board may encounter. In addition, as private equity funds made substantial investments in financial institutions, they often bargained for guaranteed board seats. The individuals selected by private equity firms as board representatives often serve on a number of different bank boards. As market conditions have led to increased bank failures, however, a problem has resurfaced that may cause some financial institutions to take a closer look at nominating directors who also serve other financial institutions: cross-guarantee liability to the FDIC.
The concept of cross-guarantee liability was added to the Federal Deposit Insurance Act by the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (FIRREA). The pertinent provision states that any insured depository institution shall be liable for any loss incurred by the FDIC in connection with:
- the default (failure) of a “commonly controlled” insured depository institution; or
- open bank assistance provided to a “commonly controlled” institution that is in danger of failure.
This means that if two banks are “commonly controlled” and one of them fails, the other bank can be held liable to the FDIC for the amount of its losses or estimated losses in connection with the failure. As many of us see each Friday, the amounts of these estimated losses are often quite high. In fact, the FDIC’s estimated losses for 2011 bank failures were approximately 20 percent of total failed bank assets for the year. Accordingly, the prospect of cross-guarantee liability can be a tremendous financial issue for the surviving bank.
Bryan Cave is a proud sponsor and speaker for the 2012 NBPCA Annual Congress, the Power of Prepaid.
The Power of Prepaid
June 3-6, 2012
Gaylord National Hotel & Conference Center
Washington, D.C.
Bryan Cave Partner Judith Rinearson will be speaking on a panel on the second day about Scaling for Growth: Keeping up to Date and up to Speed as your Portfolio Grows in Size and Scope. The full conference brochure can be downloaded here.
The United States Court of Appeals for the 11th Circuit rendered an important decision on March 5, 2012, addressing the enforceability of binding arbitration provisions in consumer deposit agreements. The case began when Lawrence and Pamela Hough brought suit against Regions Bank for allegedly violating federal and state law by collecting overdraft charges under its deposit agreement. The deposit agreement contained an arbitration provision and Regions moved to compel arbitration. The federal district court hearing the case denied the motion to compel on the ground that the arbitration clause was substantively unconscionable because it contained a class action waiver. Regions appealed the decision to the 11th Circuit Court of Appeals and the appellate court vacated the ruling and sent it back to the trial court in light of a recent United States Supreme Court which held that the Federal Arbitration Act preempted a California’s judicial rule regarding the unconscionability of class arbitration waivers in consumer contracts. This time around the district court found other reasons to deny Regions’ motion to compel arbitration, holding that the arbitration clause was substantively unconscionable under Georgia law because it believed that a provision granting Regions the unilateral right to recover its expenses for arbitration allocated disproportionately to the Houghs the risks of error and loss inherent in dispute resolution.
The lower court decision was again appealed to the 11th Circuit. On appeal the Houghs argued that while the arbitration provision in the deposit agreement capped the Houghs’ costs for the arbitration proceeding at $125, another paragraph required the Houghs to reimburse Regions as a prevailing party for its costs of arbitration. The arbitration agreement permitted Regions, if it was “the prevailing party,” to obtain “reimburse[ment] for [its] costs and expenses (including reasonable attorney’s fees) … [in] arbitration” and to collect that amount by “charg[ing] [the Houghs'] account.” The district court concluded that the reimbursement provision was unconscionable because Regions had an exclusive right of setoff. The 11th Circuit disagreed, and noted that under Georgia law an arbitration provision is not unconscionable because it lacks mutuality of remedy. The district court also ruled that the arbitration clause had a degree of procedural unconscionability, but the 11th Circuit found that to be unconscionable under Georgia law, a contract must be so one-sided that “no sane man not acting under a delusion would make and that no honest man would participate in the transaction.” The court found that the arbitration clause in the Houghs’ agreement fell well short of that standard. Although the district court found it troubling that the clause was presented to the Houghs “on a take-it-or-leave-it basis with no opt-out provision,” the 11th Circuit noted that under Georgia law, an adhesion contract (i.e., one that is not truly negotiated between the parties such as a deposit agreement or a credit card agreement) is not per se unconscionable.
On March 30, 2012, Progressive Casualty Insurance Company filed an action naming as defendants the FDIC as Receiver of Omni National Bank, as well as the former officers and directors of Omni whom the FDIC had previously sued. The Complaint asserts a claim for declaratory judgment that Progressive is not obligated to cover any of the claims asserted by the FDIC against the former directors and officers in the Omni litigation. This action is significant in that it raises a number of coverage issues which former directors and officers of failed banks may see raised by their own D&O insurance carriers, and the presence or absence of D&O coverage is a critical factor considered by the FDIC in determining whether to bring an action seeking any kind of recovery.
Progressive had underwritten a director and officer liability policy for the directors and officers of Omni with a total policy limit of $10 million. The policy did not contain any exclusion which would directly exclude coverage for any action brought by a governmental or regulatory agency such as the FDIC (a so called “regulatory exclusion”). Nonetheless, apparently after having received notice of the claim by the FDIC, Progressive denied coverage on a number of separate bases, which now form the basis of the declaratory judgment lawsuit.
First, Progressive alleged that coverage for the former directors and officers of Omni was barred by the insured v. insured exclusion contained in the policy. An insured v. insured exclusion is a common feature of a directors and officers liability policy, and essentially provides that any claim brought by, on behalf of, or at the behest of any insured company or insured person under the policy against insured persons under that same policy are not covered. Progressive alleges that, because the FDIC steps into the shoes and succeeds to all the rights and privileges of the Bank, and brought the action against the directors and officers in its capacity as Receiver for the Bank, the insured v. insured exclusion is triggered and therefore no coverage is available. Whether a standard insured v. insured exclusion in fact bars coverage for an action by the FDIC against former officers and directors is an important question, and is certainly debatable.
Next, Progressive alleges that, because unpaid unrecoverable loan losses are carved out from the definition of “loss” under the policy, there is no coverage for the losses alleged in the FDIC’s complaint against the former Omni directors and officers. Progressive alleges that the FDIC’s complaint is specifically based on $24.5 million in losses that the bank suffered on over 200 loans.
On April 4, 2012, the FDIC filed an action against the former directors and officers of Cape Fear Bank, Wilmington, NC (“Cape Fear” or the “Bank”). The lawsuit was filed shortly before the expiration of the 3-year statute of limitations which commenced when the Bank was closed and placed into FDIC receivership on April 10, 2009. For a copy of the FDIC’s complaint, click here.
The FDIC’s complaint identifies two central causes of Cape Fear’s failure. First, the FDIC alleges that the D&O defendants pursued a flawed strategy of opening branch operations without consideration for the cost of new branch operations and without any plan to monitor those operations. Second, the FDIC alleges that the defendants were enticed by the real estate “bubble,” and that they aggressively pursued rapid growth through high-risk and speculative real estate lending. The defendants approved loans even where the Bank lacked sufficient capital, causing the Bank to become overly dependent on brokered deposits, which in turn severely impaired earnings. Worse yet, the defendants failed to employ basic prudent lending practices and controls. Specifically, the FDIC alleged that the defendants routinely approved loans that: (i) violated the Bank’s own loan policy and applicable lending regulations; (ii) lacked proper financial analysis or verification of the borrower’s creditworthiness; (iii) lacked a proper appraisal of the collateral; and (iv) increased CRE and ADC concentrations that had previously been criticized by regulators. To make matters even worse, the FDIC alleges, the defendants attempted to mask the Bank’s mounting capital problems by approving additional bad credits and making new advances on non-performing loans, often replenishing interest reserves that allowed borrowers to pay interest with borrowed funds. The complaint identifies 23 specific failed CRE and ADC loans that resulted in approximately $11.2 million of losses, which is the amount the FDIC seeks in damages.
One of the unique aspects to this case is the allegation that Cape Fear’s president and CEO “dominated” the board of directors and the Bank’s lending function. This unique case theory does not offer any insulation to the other directors and officers, however, as the FDIC contends that they failed to exercise their independent judgment and duties.