The Dodd-Frank Wall Street Reform and Consumer Protection Act codified a form of the Transaction Account Guarantee (TAG) program initiated by the FDIC that extended unlimited deposit insurance coverage to certain no- or low-interest transaction accounts. Under the Dodd-Frank version, which expires on December 31, 2012, there is no cap on FDIC insurance for “noninterest-bearing transaction accounts.” As we have explained, qualifying accounts must meet the statutory definition and cannot have even the potential to be paid interest. Congress modified this definition at the end of 2010 in order to extend coverage for IOLTA accounts (which may pay interest).
The industry is beginning to draw attention to the statutory expiration of this unlimited coverage. As originally initiated by the FDIC in 2008, the program was intended to stabilize large deposits in a time of crisis within the financial system. The Dodd-Frank extension of TAG was completely paid for by financial institutions under the general deposit insurance assessment framework. Community banks have arguably benefitted the most from the unlimited coverage provisions because the corporate, non-profit, and government depositors holding most of the affected accounts may have more concerns (real or imagined) about the continued solvency of small banks than of big banks. Without the guarantee, smaller banks may have to rely more on pricing in order to retain these depositors, potentially exposing the insurance fund to greater risk.
By one industry estimate, more than half of all TAG account balances (over $500 billion) are already held by just 19 banks over $100 billion in assets. According to the FDIC, more than three-quarters ($191.2 billion) of Q4 2011 growth in domestic deposits was attributable to account balances subject to the guarantee. The 10 largest insured banks accounted for 73.6 percent ($140.7 billion) of the growth in these balances during this period. As of December 31, 2011, the average institution with less than $1 billion in assets had 15 covered accounts worth an average of $713,000. Although liquidity is generally less of a concern than it was in 2008, these large depositors are more likely to seek loans and otherwise bank with institutions holding their TAG-size accounts.
The questions, then, are whether the industry and its regulators are unified around this issue and whether legislators will have the stomach to extend the program in an environment where initiatives seens to benefit banks are politically sensitive. The original FDIC manifestation was optional, with participating banks paying for the coverage. Although the Dodd-Frank version is universal, again, banks have picked up the tab through the assessment process. Nonetheless, it is always possible that an extension of the program will be marred as a boon to banks and a burden to taxpayers.
Notwithstanding the position of former Chairman Sheila Bair and some currently within the agency that the program should only be further extended by Congress, the FDIC stands at the center of the issue and could always extend the program administratively. FDIC’s 2008 program was authorized under the FDI Act by a determination by the Secretary of the Treasury in consultation with the FDIC and the Federal Reserve that conditions of ”systemic risk” justified an exception to the least-cost-resolution requirements of the Act. It was extended by the FDIC in 2009 as a continued response to this finding, although at that time the agency also cited as “additional authority” more general statutory language relating to its mission. We believe there is footing for a similar, transitional extension of the program under this broader authority. In fact, when the FDIC extended the program in 2010 through the end of that year, it reserved the right to extend the program through 2011 without additional rulemaking. This was ultimately not necessary in light of Dodd-Frank, and we think an additional regulatory extension is unlikely to occur here without significant advocacy for it. The Independent Community Bankers of America and the American Bankers Association, for their part, have recently outlined their views on the issue.
Meanwhile, examiners are beginning to ask how banks are planning for the expiration of the program. Many institutions are balancing this expiration with Dodd-Frank’s repeal of the prohibition on the payment of interest on business checking accounts (and by extension Regulation Q). Challenging as this may be in a time of regulatory uncertainty, these considerations should also be evaluated along with Regulation D’s reserve requirements (where restructured accounts may become demand deposits).
On February 29, 2012, FinCEN released an advance notice of proposed rulemaking on customer due diligence and beneficial owners, proposing to make a customer due diligence obligation explicit for ALL customers (to “clarify, consolidate and harmonize” the federal banking agencies’ expectations) and extending the requirement to collect (and possibly verify) beneficial owner information for most or all customers as well.
FinCen’s advance notice of proposed rulemaking (ANPRM), seeks public comment on a range of questions regarding the development of a customer due diligence (CDD) regulation that would “(i) codify, clarify, consolidate, and strengthen existing CDD regulatory requirements and supervisory expectations, and (ii) establish a categorical requirement for financial institutions to identify beneficial ownership of their accountholders, subject to risk-based verification and pursuant to an alternative definition of beneficial ownership.” Comments received in response to the ANPRM will likely be influential in FinCEN’s development of a more formal and detailed proposed rule on the topic.
FinCEN is initially considering a CDD rule to cover banks, broker dealers, mutual funds, futures commission merchants, and introducing brokers in commodities, and thus the ANPRM is focused on those institutions. The scope of the ANPRM, however, includes all industries subject to FinCEN’s anti-money laundering (AML) program requirements. FinCEN believes that a CDD rule may be appropriate for all financial institutions under its purview and will consider extending a CDD rule to other types of institutions in the future. Thus, FinCEN is specifically requesting comments from all other financial institutions covered by FinCEN regulations as well, including providers of prepaid access and other types of money services businesses (MSBs), insurance companies, casinos, non-bank mortgage lenders and originators, and dealers in precious metals, stones and jewels.
Over the last several months, we have become aware of a number of changes to various regulator’s frequently asked questions. These changes are frequently made without any public announcement, and, in some cases, without any notation that the FAQ’s have been modified at all. Frequently, banks are made only made aware of the change when they (a) aren’t aware of the initial FAQ, and (b) subsequently ask the question and are directed to the FAQ.
On November 1, 2011, the FDIC updated its Frequently Asked Questions regarding the “High-Rate Area” exception to the market rate caps for less than well-capitalized institutions. Previously, institutions relying on a “high-rate area” designation had to re-apply every calendar year to maintain the designation. However, late in 2011, the FDIC determined that institutions that had received a high-rate determination from the FDIC would no longer be required to submit an annual high-rate determination request. Instead, the high-rate area designation will automatically renew until and unless the FDIC notifies the institution that it is no longer operating in a high-rate area. In light of continued historically low interest rates, the current national rate caps have not proven to generally be difficult for banks to comply with, but this modification (if it isn’t changed again) could provide welcome relief if/when rates rise.
On February 16, 2011, the Treasury updated its Frequently Asked Questions regarding the Capital Purchase Program changes under the American Recovery and Reinvestment Act of 2009. Without acknowledging any change to the FAQ, Treasury reduced the minimum repurchase amount to the greater of (i) 5% of the issue price of the preferred and (ii) $100,000.00 in principal amount. Previously, Treasury required institutions seeking to repurchase their TARP investment to repurchase at least 25% of the principal investment.
Ten years ago, Bank Secrecy Act (BSA)/anti-money laundering (AML) compliance was one of the biggest areas of concern for banks and their regulators. Following September 11 and the heightened regulatory focus on BSA matters, most banks found it necessary to expend significant resources to enhance or even rebuild their BSA/AML programs.
In the past few years, bank regulators have had to focus on other matters, including residential and commercial loan concentrations, adequate capitalization, and even bank failures. Banks also wisely have focused on these matters during these difficult economic times.
It is important, however, that these other matters do not push BSA/AML compliance aside. This article summarizes some of the top BSA-related issues that the Board of Directors of every bank should keep in mind.
Best Practices for the Board
It is easy in difficult financial times for the Board and management to push aside compliance matters, including BSA/AML compliance. Compliance matters can seem less important when one is worried about the bank’s very survival.
Nevertheless, compliance continues to be important. It is critical that the Board stay informed, devote adequate resources to compliance, and set the proper tone for compliance within the organization.
The following are four best practices for Boards of Directors.
1. Require Periodic and Thorough BSA Reports
One of the most important things for the Board to understand about the BSA and AML requirements is that the Board is expected to stay abreast of the institution’s progress and what is working and not working. That means that the Board needs to receive at least annual BSA/AML training, and also needs to receive regular reports on BSA/AML compliance matters from its BSA officer, including on suspicious activity report (SAR) filings and trends.
Georgia Governor Nathan Deal recently signed into law HB 683, a bill that reforms the way in which banks and other corporations may respond to a garnishment summons. Under the new law, banks may now use their own employees to respond to a garnishment summons and are no longer required to hire an attorney for this task.
This statute seeks to overrule a 2011 Georgia Supreme Court decision which held that corporations must use a Georgia-licensed attorney to answer garnishments, and that non-lawyer employees who responded to garnishments on behalf of their employers were engaging in the unauthorized practice of law.
If you decide to utilize non-attorney personnel to answer garnishments, as permitted by the new statute, you should keep in mind the following issues:
- The new law only permits non-lawyers to file answers to garnishment summons. If a traverse is filed in response to the answer, an attorney is then required to represent the bank. A traverse is a statement filed by a plaintiff in response to the answer, claiming that the answer is untrue or insufficient. Once a traverse is filed, the bank then must then hire an attorney to represent it further in the case.
A recent bench trial in the Cobb county Superior Court pitting a real estate developer David Pearson and several related entities against Delta Community Credit Union (“DCCU”) resulted in Pearson being awarded a lender liability judgment in the amount of $75 million. A copy of the Final Order and Judgment is available online here. Pearson initially obtained credit from Delta Community Credit Union in early 2009 when one of his entities (“Gettysburg”) refinanced a $2,025,000 loan on an office park located in Cobb County, Georgia. DCCU obtained an appraisal showing a value of $4,800,000.
Following the Gettysburg loan, Pearson sought additional financing in the form of a $30 million credit facility for the purpose of buying distressed real estate in Florida and metropolitan Atlanta (the “Master Credit Facility”). The Master Credit Facility was set up in conjunction with a formula referred to as the “Pearson Matrix” that required a certain loan to value ratio and first lien position for any real estate acquisition that Pearson might use the funding for. In addition to the Master Credit Facility, DCCU also extended a line of credit (the “LOC”) that eventually grew to $9,900,000 secured by existing real property pledged by Pearson’s affiliates.
Pearson attempted to utilize the Mater Credit Facility to purchase a number of properties in Florida. At the same time he was trying to acquire that portfolio he was also seeking to purchase the note on a project in Florida called Nature Walk for $8.1 million. Nature Walk fronts on Highway 395, less than a mile from the beach, and is adjacent to the Watercolors Project, Sea Grove Community, and the community of Seaside. He hoped to free up availability under the LOC to purchase Nature Walk by moving the other unrelated properties into the Master Credit Facility.
During the time that Pearson was looking to purchase Nature Walk, DCCU became very concerned about the quality of the appraisals previously obtained on the Georgia and Florida properties the secured both the Gettysburg loan as well as the LOC. On February 10, 2010, DCCU informed Pearson that all of the valuations for both the Georgia and Florida Properties had been rejected by an independent third-party reviewer. The reasons for the third-party reviewers’ rejections of the appraisals included: (1) USPAP violations for failure to reconcile sales of the subject property for the prior three years; (2) improper application of valuation methodologies; (3) insufficient adjustments to sales and rent comparables; (4) improper selections of sales and rent comparables; (5) insufficient accounting for current market conditions; (6) errors in proper zoning identification and reporting; (7) lack of historical operating data; (8) errors in vacancy rate calculations; and (9) errors and omissions regarding statistics and absorption data. Pearson was also informed that DCCU would be engaging new appraisers to reappraise the properties and that once completed, these appraisals would also be submitted for independent third-party review.
The relationship between Pearson and DCCU deteriorated with the result that Pearson was never able to consummate the Nature Walk transaction. DCCU declared Pearson to be in default for various reasons including the fact that Pearson used almost $5 million of the loan proceeds to invest in the stock market instead of purchasing real property. Pearson eventually brought suit against DCCU seeking damages for the alleged breach of contract. The trial itself was a bench trial conducted over 14 days. The court for the most part resolved disagreements over the competing factual claims of the parties in favor of Pearson. Although the opinion is 131 pages long one can get the sense of where things are headed in just the first few pages of the opinion when you read the following references:
- the court refers to Pearson as a “successful real estate developer” who used “conservative” investment strategies,
- DCCU is a $4 billion dollar institution and one of the largest credit unions in the nation,
- Pearson negotiated a “unique and advantageous loan commitment” with DCCU,
- Because Pearson was looking to buy deeply discounted properties it was anticipated an “unrealized gain would be created at the time of purchase” that would capitalize on the unprecedented “deleveraging” that began in late 2008.
My colleagues and I frequently meet with bank boards that have received very sobering reports from their bank’s examiners. While the directors’ responses to bad examination reports vary greatly, there is one emotion that is nearly universal: a feeling of helplessness. As a result, directors almost always express a desire to get involved in the exam process after they receive negative feedback from the examiners, whether through requesting meetings with higher-level regulators, appealing the exam findings, or fighting a proposed enforcement action. Unfortunately, those actions, particularly if taken after a final examination report is issued, seem to have little positive impact on the examination process and may even prove to be harmful to the bank.
The good news, however, is that there is a way for directors to get involved in the regulatory examination process that can have a meaningful positive impact. Discussed below is our top recommendation for directors to be involved in the examination process. We believe early, proactive involvement can positively impact the outcome of a regulatory examination and also enhance the board’s understanding of regulatory criticism.
While most directors’ first contact with examiners is at the examiners’ exit meeting with the board, we suggest director involvement earlier in the examination process. There should be one or more outside directors present at the examiners’ preliminary exit meeting with management. During this meeting, the examiners will present their preliminary findings from the examination. In addition to highlighting the engagement and availability of the bank’s directors, attending this meeting allows the directors to understand the key issues in the examination. By hearing the examiners deliver their findings first hand, the directors will have a better sense of the seriousness of the issues being identified. Finally, directors will be able to ask questions of the examiners that might not be easily asked by members of management; e.g., asking for an interpretation of a regulation.
By attending this preliminary exit meeting, directors are also able to ensure that the bank’s board has a timely understanding of the issues presented by the examiners. Members of the bank’s executive management team have a natural tendency to relay examination criticisms to the board through their own point of view. Management may fear adverse action by the board as a result of regulatory criticisms or may feel so strongly about their point of view that they tend to “water down” the comments of the examiners. By having outside directors attend the meeting, those directors can deliver an independent report of the regulatory criticisms to the board.
On January 31, 2011, the FDIC released revised guidance on payment processor relationships, spelling out with a lot more specificity its expectations for banks’ relationships with payment processors.
We have summarized below some highlights of what was added to the guidance by the FDIC, and also provide a redline showing the changes from the FDIC’s prior guidance, released in 2008. Of particular interest to many of our clients, the FDIC notes that some payment processors may target smaller community banks, based on a belief that they may be more willing to engage in higher-risk transactions in exchange for increased fee income and may lack the infrastructure to properly manage or control a third-party payment processor relationship.
Highlights of some additions to the guidance include the following (not an exhaustive list):
- Financial institutions should ensure their contractual relationships with payment processors provide them with access to necessary information in a timely manner. Agreements should also protect financial institutions by providing for immediate account closure, contract termination, or similar action, and establish adequate reserve requirements to cover anticipated chargebacks.
- Financial institutions should adequately oversee all transactions and activities that they process and appropriately manage and mitigate operational risks, BSA compliance, fraud risks, and consumer protection risks, among others. Financial institutions cannot rely solely on due diligence performed by the payment processor.
- Financial institutions that fail to adequately manage relationships may be viewed as facilitating the payment processor’s or merchant’s fraudulent or unlawful activity, and thus may be liable for such acts or practices. (Italicized portion is new.)
- Financial institutions should take reasonable steps to ensure they understand the type and level of complaints related to transactions that they process. Consumer complaints may be sent to the financial institution, as well as to the payment processor, the merchant, consumer advocacy groups, online complaint websites, or posted on blogs.
- Financial institutions should determine if there are any external investigations of or legal actions against a processor or its owners and operators, during initial and ongoing due diligence.
- Policies and procedures should outline the financial institution’s thresholds for unauthorized returns, the possible actions that can be taken against payment processors that exceed these standards, and methods for periodically reporting such activities to the financial institution’s board and senior management.
- Financial institutions should be aware of nested processing relationships, and obtain data on the nested processor and its merchant clients. Risk is significantly elevated with such relationships because nested processor and aggregator relationships may be extremely difficult to monitor and control.
- The more a financial institution relies on a processor for due diligence and monitoring of merchants without direct financial institution involvement and verification, the more important it is to have an independent review to ensure that the processor’s controls are sufficient and that contractual agreements between the financial institution and processor are honored.
- Board-approved policies and programs should assess the financial institution’s risk tolerance for payment processing activity, verify the legitimacy of the payment processor’s business operations, determine the character of the payment processor’s ownership, and ensure ongoing monitoring of payment processor relationships for suspicious activity, among other things. (Italicized portion is new.)
- Adequate routines and controls include sufficient staffing with the appropriate background and experience for managing third party payment processing relationships of the size and scope present at the institution, as well as strong oversight and monitoring by the board and senior management.
The Third Circuit issued a long-awaited decision in the New Jersey Abandoned Property litigation, NJ Retail Merchants Association v. Andrew Sidamon-Eristoff. The court affirmed the District Court’s decision in this important escheat case with broad implications for members of the prepaid industry.
BACKGROUND
In 2010 New Jersey passed a new abandoned property law that, if upheld, would have been devastating for gift card and prepaid card issuers doing business in New Jersey.
- First, the new law shortened the dormancy period for prepaid cards and gift cards from being not even subject to escheat, to requiring escheat after 2 years of inactivity (a shorter period than other states, and far shorter than the required 5 years validity under the CARD Act).
- Second, the new law also required prepaid card issuers to retroactively escheat all funds from inactive prepaid cards sold in the last 5 years.
- Third, the new law required sellers of prepaid cards (both open and closed loop cards) to collect the name and address of the purchaser, or at the very least, the purchaser’s zip code. Later this requirement was modified so that only collection of the purchaser’s zip code was “mandatory.”
- Fourth, if the purchasers name and address (or zip code) was not known or collected, the purchaser’s address would be deemed to be the address of the store where the card was purchased.
NOTE – The reason New Jersey wants sellers to collect purchasers’ name and address, or otherwise wants to “deem” the purchasers’ address to be in New Jersey, is because under the uniform abandoned property laws, unused funds from gift cards and other prepaid cards would be paid to the state of the last known address of the purchaser. But if the last known address of the purchaser is not known (which is the case for virtually ALL gift cards), then the unused funds are paid to the state where the card issuer is domiciled. New Jersey’s new law, deeming purchasers’ addresses to be in NJ, or otherwise requiring collection of zip code data from purchasers, was intended to make sure that more of the unused funds escheat to NJ rather than to other states where the card issuers are domiciled. Since many prepaid card issuers are domiciled in states that don’t require escheat, the imposition of NJ’s new law as initially passed, with retroactivity, could have had serious consequences for many prepaid card programs.
BOTTOM LINE
The Third Circuit’s Opinion represents both good news and bad news for the gift card and prepaid card industry. See details below.
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Doctors recommend various self exams to catch disease early, so it can be treated before it’s too late. As it turns out, a self examination can be good for the health of a bank as well. My colleagues and I recommend that our banking clients and friends undertake a regular self examination in order to identify potential internal and external challenges that the bank may face. As discussed more thoroughly below, these self examinations can also be very helpful when the bank’s doctor (your friendly regulator) comes in for a check-up.
Enlist internal audit
To initiate the self examination, the audit committee of the bank’s board of directors should charge management with preparing a report that outlines the current and projected status of the bank’s key areas of risk. Ideally, the bank’s internal audit function will take the lead in performing the examination and preparing the related report. In order to maximize the value of this report, the audit committee should direct management to deliver the report at least 60 days prior to the bank’s next scheduled regulatory exam. The self examination report, in its most basic form, should cover the areas that are the focus of the bank’s regulators: CAMELS (capital, asset quality, management, earnings, liquidity and sensitivity to market risk). The report should also address any key areas of risk identified by the directors.
Analyze your market
In addition to analyzing the typical CAMELS components and other areas of risk, a very important part of the self examination process is a market study. The report should present facts, trends and projections related to the market area in order to define the opportunities and challenges being faced by the bank’s customers. While many bank directors have a good feel for market trends, we have found that this data, when presented with specific facts and trends, can inform the board’s discussions of a variety of topics a great deal. It can also provide the bank with support for dealing with its examiners, who conduct their own market analysis prior to each examination.