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Senate-passed Regulatory Reform Offers Real Benefits to Depository Institutions under $10 Billion in Assets

On March 14, 2018, the Senate passed, 67-31, the Economic Growth, Regulatory Relief and Consumer Protection Act, or S. 2155.  While it may lack a catchy name, its substance is of potentially great importance to community banks.

The following summary focuses on the impact of the bill for depository institutions with less than $10 billion in consolidated assets.  The bill would also have some significant impacts on larger institutions, which could, in turn, affect smaller banks… either as a result of competition or, perhaps more likely, through a re-ignition of larger bank merger and acquisition activity.  However, we thought it was useful to focus on the over 5,000 banks in the United States that have less than $10 billion in assets.

Community Bank Leverage Ratio

Section 201 of the bill requires the federal banking regulators to promulgate new regulations which would provide a “community bank leverage ratio” for depository institutions with consolidated assets of less than $10 billion.

The bill calls for the regulators to adopt a threshold for the community bank leverage ratio of between 8% and 10%.  Institutions under $10 billion in assets that meet such community bank leverage ratio will automatically be deemed to be well-capitalized.  However, the bill does provide that the regulators will retain the flexibility to determine that a depository institution (or class of depository institutions) may not qualify for the “community bank leverage ratio” test based on the institution’s risk profile.

The bill provides that the community bank leverage ratio will be calculated based on the ratio of the institution’s tangible equity capital divided by the average total consolidated assets.  For institutions meeting this community bank leverage ratio, risk-weighting analysis and compliance would become irrelevant from a capital compliance perspective.

Volcker Rule Relief

Section 203 of the bill provides an exemption from the Volcker Rule for institutions that are less than $10 billion and whose total trading assets and liabilities are not more than 5% of total consolidated assets.  The exemption provides complete relief from the Volcker Rule by exempting such depository institutions from the definition of “banking entity” for purposes of the Volcker Rule.

Accordingly, depository institutions with less than $10 billion in assets (unless they have significant trading assets and liabilities) will not be subject to either the proprietary trading or covered fund prohibitions of the Volcker Rule.

While few such institutions historically undertook proprietary trading, the relief from the compliance burdens is still a welcome one.  It will also re-open the ability depository institutions (and their holding companies) to invest in private equity funds, including fintech funds.  While such investments would still need to be confirmed to be permissible investments under the chartering authority of the institution (or done at a holding company level), these types of investments can be financially and strategically attractive.

Expansion of Small Bank Holding Company Policy Statement

Section 207 of the bill calls upon the federal banking regulators to, within 180 days of passage, raise the asset threshold under the Small Bank Holding Company Policy Statement from $1 billion to $3 billion.

Institutions qualifying for treatment under the Policy Statement are not subject to consolidated capital requirements at the holding company level; instead, regulatory capital ratios only apply at the subsidiary bank level. This rule allows small bank holding companies to use non-equity funding, such as holding company loans or subordinated debt, to finance growth.

Small bank holding companies can also consider the use of leverage to fund share repurchases and otherwise provide liquidity to shareholders to satisfy shareholder needs and remain independent. One of the biggest drivers of sales of our clients is a lack of liquidity to offer shareholders who may want to make a different investment choice. Through an increased ability to add leverage, affected companies can consider passing this increased liquidity to shareholders through share repurchases or increased dividends.

Of course, each board should consider its practical ability to deploy the additional funding generated from taking on leverage, as interest costs can drain profitability if the proceeds from the debt are not deployed in a profitable manner. However, the ability to generate the same income at the bank level with a lower capital base at the holding company level should prove favorable even without additional growth.  This expansion of the small bank holding company policy statement would significantly increase the ability of community banks to obtain significant efficiencies of scale while still providing enhanced returns to its equity holders.

Institutions engaged in significant nonbanking activities, that conduct significant off-balance sheet activities, or have a material amount of debt or equity securities outstanding that are registered with the SEC would remain ineligible for treatment under the Policy Statement, and the regulators would be able to exclude any institution for supervisory purposes.

HVCRE Modifications

Section 214 of the bill would specify that federal banking regulators may not impose higher capital standards on High Volatility Commercial Real Estate (HVCRE) exposures unless they are for acquisition, development or construction (ADC), and it clarifies what constitutes ADC status. The HVCRE ADC treatment would not apply to one-to-four-family residences, agricultural land, community development investments or existing income-producing real estate secured by a mortgage, or to any loans made prior to Jan. 1, 2015.

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Basel III Treatment of DTAs and MSAs

We have heard, read and seen (and internally had) some confusion regarding the joint proposed rulemaking regarding the potential simplification of the capital rules as they relate to Mortgage Servicing Assets (MSAs) and certain Deferred Tax Assets (DTAs).

In addition to simply being complicated regulations, the regulators also have two proposed rulemakings outstanding related to these items. In August 2017, the banking regulators jointly sought public comment on proposed rules (the “Transition NPR“) that proposed to extend the treatment of MSAs and certain DTAs based on the 2017 transition period. Then, in September 2017, the banking regulators jointly sought comment on proposed rules (the “Simplification NPR“) that proposed to alter the limitations on treatment of MSAs and certain DTAs (and also addressed High Volatility Commercial Real Estate or HVCRE loans).

The Simplification NPR also addressed the interplay of the Simplification NPR and the Transition NPR. The Simplification NPR provided that the Transition NPR, if finalized, would only remain effective until such time as the Simplification NPR became effective. Accordingly, the Simplification NPR, if adopted, will ultimately control, with no transition periods for MSAs and certain DTAs following January 1, 2018.

Net Operating Loss DTAs

Importantly, neither the Transition NPR nor the Simplification NPR have any affect on the Basel III capital treatment net operating loss (NOL) DTAs. DTAs that arise from NOL and tax credit carryforwards net of any related valuation allowances and net of deferred tax liabilities must be deducted from common equity tier 1 capital. Through the end of 2017, the deduction for NOL DTAs are apportioned between common equity tier 1 capital and tier 1 capital. In 2017, 80% of the NOL DTA is deducted directly from common equity tier 1 capital, while the remaining 20% is separately deducted from additional tier 1 capital. Starting in 2018, 100% of the NOL DTA will be deducted from common equity tier 1 capital.

The end of the transition period will have the effect of lowering the common equity tier 1 capital ratio of all institutions with NOL DTAs, although the tier 1 capital and leverage ratios should remain unchanged. This impact is entirely unaffected by the adoption (or non-adoption) of the Transition NPR and/or Simplification NPR.

Similarly, other aspects of NOL DTAs are unaffected by the proposed rules. Specifically, (i) GAAP still controls the appropriateness of valuation allowances in connection with the DTA, (ii) tax laws still control the length of time over which DTAs can be carried forward, and (iii) Section 382 of the Internal Revenue Code still controls the limitation (and potential loss) of DTAs upon a change in control of the taxpayer.

Temporary Difference DTAs

Unlike Net Operating Loss DTAs, DTAs arising from temporary differences between GAAP and tax accounting, such as those associated with an allowance for loan losses and other real estate write-downs, can be included in common equity tier 1 capital, subject to certain restrictions. To the extent that such DTAs could be realized through NOL carryback if all those temporary differences were deemed to have been reversed, such DTAs are includable in their entirety in common equity tier 1 capital. Essentially, to the extent the temporary difference DTAs could be realized by carrying back against taxes already paid, then such DTAs are fully includable in capital. Carryback rules vary by jurisdiction; while federal law generally permits a bank to carry back NOLs two years, many states do not allow carrybacks.

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Counter-Cyclical Thoughts About D&O Insurance

It can be a challenge, when economic times are relatively good, to take time away from thinking about new opportunities to discuss topics like D&O insurance.  Even though I am biased, I’ll admit that, in those times, discussing the risks of potential liability and how to insure those risks can feel both a pretty unpleasant and a pretty remote thing to be discussing.  However, like all risk-related issues, it is precisely in those times when business is going well that a little bit of counter-cyclical thinking and attention can do the most good over the long haul.

As you approach your next D&O policy renewal – and particularly in the 30-60 days prior to the expiration of your current policy, there are a few things that you may want to consider.

Multi-year endorsements – what’s the catch? 

In good times, many insurers will offer packages styled as multi-year policies, usually touted as an option that allows for some premium savings and perhaps a reduced administrative burden.  However, as with all things, these advantages may come with a catch.

Many multi-year endorsements will reserve to the insurer the discretion to assess additional premium on an annual basis within the multi-year period if the risk profile of the bank changes in a material way.  So premium savings may not ultimately be realized, depending on the facts.

Beyond this, some multi-year endorsements will actually impose additional requirements on the insured to provide notice of events that could trigger the carrier’s repricing rights or other conditions.  Those obligations may be triggered when those events occur on an intra-period basis, which can set up a potential foot-fault for an organization that does not keep those requirements front of mind (which can be a practical challenge, as if those events are happening, it is likely that there are a number of issues competing for management and the board’s attention).

Companies looking at multi-year endorsements should make sure they understand fully the terms on which the multi-year option is being provided and should have counsel or an independent broker review the specific language of the proposed multi-year endorsement itself on their behalf.  In addition, while it may be tempting to use a multi-year endorsement to try to extend the renewal horizon and to try to reduce the administrative burden that comes with the renewal process, doing so may also reduce your ability to negotiate appropriate enhancements to your policy terms over the multi-year period.

Multi-year policies may be the right fit for your institution, but they should not be viewed as a one size fits all solution.  Before heading down that road, ask yourself how much is being saved and how real those savings actually are and, perhaps just as importantly, whether avoiding a broader discussion of your coverage strategy on at least an annual basis is a good thing or not.

What about the bank has changed? 

Times of economic expansion often bring with them opportunities to explore new lines of business.  In addition, substantial recent technological innovations in the financial services industries and increasing consumer demands for technological solutions have meant that not only are new market opportunities being explored but that they are being explored in new ways.  And if that isn’t enough, there is always the ever-changing regulatory and compliance landscape to contend with.

All of these trends – as well as your decisions of where and how your institution will choose to participate (or not to participate) in them – bring with them new and different risks.  To the extent that your bank has expanded its offerings, changed its footprint or portfolio mix, or otherwise changed its policies or ways of doing business, you should think about how those changes may impact your insurance needs.  It can be easy, particularly when you have a long relationship with an incumbent carrier, for the renewal process to become somewhat rote.

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The Financial CHOICE Act and Shareholder Engagement

The Financial CHOICE Act introduced in the House this spring has largely garnered attention because of its rollback of Dodd-Frank, but the bill would also significantly change the rules governing shareholder resolutions for public companies. Currently, the restrictions are relatively modest, requiring that investors have at least $2,000 in stock or one percent of the stock at a company in order to be eligible to file resolutions. In contrast, the CHOICE Act would limit eligibility for proposing shareholder resolutions to investors that have held at least one percent of the company’s stock for a minimum of three years. This change would drastically limit who can file resolutions, given that one percent of the shares of larger companies could translate to millions or billions of dollars.

The timing of the proposed change potentially reducing shareholder engagement contrasts with recent shareholder decisions approving shareholder resolutions, as demonstrated by votes at Occidental Petroleum and ExxonMobil. Shareholder majorities at those companies, exercising their rights as owners, required Occidental and Exxon to disclose the risks climate change poses to their businesses and how the companies are preparing to respond to those risks. Although these votes were historic, they are not entirely surprising; surveys show that investors are significantly interested in the business impact of regulation and are dissatisfied with current disclosure practices when it comes to environmental and climate change risks.  Moreover, some research shows that corporations that adopt the kinds of disclosure practices demanded by shareholders are better at managing long term risk and adapt to changes more quickly.

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Do Banks Need a Holding Company?

the-bank-accountOn April 11, 2017, Bank of the Ozarks announced that it would be completing an internal corporate reorganization to eliminate its holding company.  As a result, it will continue as a publicly-traded, stand-alone depository bank, without a bank holding company.

In this episode of The Bank Account, Jonathan and I discuss the advantages and disadvantages of the bank holding company structure.  Specific topics include:

  • praise for Bank of the Ozarks innovative approach to further improve its already impressive efficiency,
  • a review of the existing landscape of holding company and non-holding company structures,
  • activities that may require a holding company,
  • size-related thresholds impacting holding company analysis,
  • charter and corporate-governance related elements to the analysis, and
  • the impact the absence of a holding company may have on merger and acquisition activity.

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FRB Lifts Threshold for Financial Stability Review

In its March 2017 approval of People United Financial, Inc.’s merger with Suffolk Bancorp (the “Peoples United Order”), the Federal Reserve Board eased the approval criteria for certain smaller bank merger transactions by expanding its presumption regarding proposals that do not raise material financial stability concerns and providing for approval under delegated authority for such proposals.  The Dodd-Frank Act amended Section 3 of the Bank Holding Company Act to require the Federal Reserve to consider the “extent to which a proposed acquisition, merger, or consolidation would result in greater or more concentrated risks to the stability of the United States banking or financial system.”

In a 2012 approval order, the Federal Reserve established a presumption that a proposal that involves an acquisition of less than $2 billion in assets, that results in a firm with less than $25 billion in total assets, or that represents a corporate reorganization, may be presumed not to raise material financial stability concerns absent evidence that the transaction would result in a significant increase in interconnectedness, complexity, cross-border activities, or other risks factors.  In the Peoples United Order, the Federal Reserve indicated that since establishing this presumption in 2012, its experience has been that proposals involving an acquisition of less than $10 billion in assets, or that results in a firm with less than $100 billion in total assets, generally do not create institutions that pose systemic risks and typically have not involved, or resulted in, firms with activities, structures and operations that are complex or opaque.

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Financial Stability Board Task Force Issues Recommendations on Climate Change-Related Disclosures

In January 2016, the G20’s Financial Stability Board organized a task force, chaired by Michael Bloomberg, to come up with recommendations for a uniform framework for the disclosure of financial risks and opportunities related to climate change. On December 14, the Task Force released its recommendations, which are intended to assist “all financial and non-financial organizations with public debt or equity” in figuring out what climate-related issues merit disclosure.  The report characterizes the “catastrophic economic and social consequences” of unchecked climate change as “[o]ne of the most significant, and perhaps most misunderstood, risks that organizations face today.” It notes that numerous climate-related disclosure frameworks already exist, but so far the information produced under those frameworks has been inconsistent, non-comparable and lacking the context needed for a full understanding of its importance. Because there is no standardized protocol for disclosure, the report indicates that companies face uncertainty as to what information should be disclosed, and how it should be presented to potential investors.  The recommendations, along with the extensive “implementation guidance” the Task Force released along with the report, aim to address this problem by providing a framework for disclosure that will assist companies in providing information that is “consistent, comparable, reliable and clear.”

The Task Force begins by noting that climate-related risks fall into two categories: (i) physical risks, such as those posed to coastal storms or droughts that can cause damage or disruption to the company’s facilities, infrastructure or supply chain; and (ii) transition risks, which can result from governmental efforts to reduce greenhouse gas emissions or the shift to a low carbon economy. Transition risks are further defined to include “policy and legal risks” (e.g., those posed by carbon pricing or new regulations mandating a reduction in emissions); “technology risks” (for example, where new energy-efficient technologies disrupt existing technologies –like what LED technology has done to fluorescents); “market risk” (i.e., a shift in supply or demand for products and services); and “reputational risk.”

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How Many Times Do We Have to Tell You Not to Open the Cat Video

Everyone has been in a movie theater when one of the actors approaches that door to the basement behind which strange noises are coming. They reach out to turn the knob and in unison the audience is thinking “Fool, haven’t you ever been to the movies? Don’t you know that the zombies or ghouls or some other equally disgusting creature are waiting for you behind that door. Don’t do it!” They of course open the door, blissfully unaware of the grisly fate waiting for them.

I get the same sort of feeling when I read about cybersecurity lapses at banks. Think about the following:

  • “Someone dropped a thumb drive, I think I’ll just plug it into my computer at work and see what is on it. Surely nothing bad will happen. If nothing else, I’ll give it to one of my kids, they can use it on the home computer.”
  • “My good friend, the one who sends me those emails asking me to pass them along to three of my closet friends, just sent me an email with an adorable cat video. I just love cat videos, I’ll open it on my computer at work and see what is on it. Surely nothing bad will happen. Doesn’t the FBI monitor the internet keeping us safe from bad people?”
  • “Someone from a small European country that I have never heard of has sent me an email telling me that I might be the recipient of an inheritance. I always knew I was destined for better things in life, I’ll just click on the attachment and follow the instructions. Surely nothing bad will happen.”
  • “My good customer Bob just sent me an email telling me that he is stuck in jail in South America. He needs me to wire money to post his bail. I didn’t know that Bob was traveling, I am pretty sure I just saw him in the bank a couple of days ago. I probably won’t try and call his house or wife or his cell phone to doublecheck, I’m sure his email is legitimate.”

If you were in the movie theater you’d be yelling out “Don’t do it!” If this were a movie you would see the green glowing blob patiently waiting to silently flow into the office computer. The blob just sits there though, waiting for the bank officer to hit that keystroke that opens the file. Now we see it watching as the person sits down at the computer and logs in, types in a password and initiates a wire transfer. The blob silently memorizes both the log in ID and the password. Weeks can go by as the suspense builds. The ominous music begins to swell in the background, we know that something is going to happen when as fast as lightning, the blob springs to life initiating wire transfers for tens of millions of dollars.

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Survey of 2015 Georgia Corporate Case Law Developments

The annual survey of decisions by state and federal courts during 2015 addressing Georgia corporate and business organization issues is now available.

This survey covers the legal principles governing Georgia businesses, their management and ownership. It catalogs decisions ruling on issues of corporate, limited liability company and partnership law, as well as transactions and litigation issues involving those entities, their governance and investments in them.

In 2015, there were a number of noteworthy decisions spanning a wide variety of corporate and business law issues. There were two significant decisions involving directors of corporations who simultaneously serve as trustees for trusts who hold a minority interest in the corporation – one dealing with liability issues, the other an insurance coverage dispute. Elsewhere, the Georgia Supreme Court issued an important opinion reaffirming the duty to read transactional documents and clarifying the circumstances under which that duty can be excused. The Supreme Court also addressed the availability of prejudgment interest in an action for specific performance of a stock purchase agreement, and the remedy of equitable partition in the context of a joint venture agreement. The Georgia Court of Appeals addressed two issues of first impression: the first dealing with a judgment creditor’s right to a charging order against an LLC member, the other dealing with an LLC’s right to recover for discomfort and annoyance in a nuisance action. The courts also dealt with interesting questions of jurisdiction and venue over corporate entities, including whether a foreign corporation or LLC with its corporate headquarters outside of Georgia can remove a tort action from the county in which it is filed to the county where its largest Georgia office is located.

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Supervisory “Concerns” with Shareholder Protection Arrangements

In December 2015 (following years of sporadic and seemingly random criticism) of shareholder protection arrangements, the Board of Governors of the Federal Reserve System issued guidance that the Federal Reserve “may” object to a shareholder protection agreement based on the facts and circumstances and the features of the particular arrangement.  Federal Reserve Supervisory Letter SR 15-15 does not require submission of such arrangements to the Federal Reserve for comment prior to implementation, but rather directs institutions considering the implementation or modification of such arrangements to “review this guidance to help ensure that supervisory concerns are addressed.”

Supervisory Letter SR 15-15 casts a long shadow, with little clarity as to the line between acceptable and unacceptable arrangements. SR 15-15 cites a wide array of potentially objectionable shareholder protection arrangements, but then indicates that supervisory staff has “in some instances” found that these arrangements would “have negative implications on a holding company’s capital or financial position, limit a holding company’s financial flexibility and capital-raising capacity, or otherwise impair a holding company’s ability to raise additional capital.”  Presumably speaking only of these particular arrangements (although not clearly so stating), SR 15-15 states “[t]hese arrangements impede the ability of a holding company to serve as a source of strength to its insured depository subsidiaries and were considered unsafe and unsound.”

SR 15-15 provides a number of examples of categories of shareholder protection arrangements that have (sometimes) raised supervisory issues.  Some of these examples are entirely consistent with past Federal Reserve precedent and are generally impermissible in bank-related investments, including price protections in offering arrangements whereby a holding company agrees to a cash payment or additional shares to the investor in the event that additional shares are issued in subsequent transactions at lower prices.  These “down-round” provisions have always been viewed by the Federal Reserve as acting as an impermissible disincentive (and potential disabling mechanism) for a holding company to raise additional capital going forward.  (In a surprising move of clarity, the Federal Reserve guidance does, by footnote, specifically indicate that preemptive rights, or the right to participate in subsequent offerings to prevent dilution of ownership, does not, in general, raise any supervisory concerns.)

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