Rule 506 of Regulation D provides a widely-used safe harbor from the registration requirements of the Securities Act of 1933 for qualifying private offerings. Under current Rule 506, neither the issuer nor any person acting on the issuer’s behalf may offer or sell securities by any form of “general solicitation or general advertising,” and securities sold pursuant to Rule 506 may only be sold to “accredited investors” or persons who, either alone or with a representative, have sufficient knowledge and experience in financial and business matters to make them capable of evaluating the merits and risks of a prospective investment.

The Advisory Committee is of the view that the restrictions on general solicitation and advertising prevent many privately held small businesses and smaller public companies from gaining sufficient access to capital sources and thereby materially limit their ability to raise capital through private offerings. The Advisory Committee noted that the investor protections afforded by the existing restrictions on general solicitation and general advertising are not necessary in private offerings where the securities are sold solely to accredited investors. Because the concepts of general solicitation and advertising are vague, the prohibition increases compliance and diligence costs for issuers of securities who seek to avoid potential activities that might be deemed to constitute general solicitation or advertising and thereby destroy the availability of the Rule 506 safe harbor.

The Advisory Committee’s recommendations are not binding. Modification to the current requirements would require either SEC approval or the enactment of legislation. In November 2011, the U.S. House of Representatives passed legislation that would permit general solicitation in Rule 506 offerings so long as all of the purchasers are accredited investors.

The SEC established the Advisory Committee in September 2011 to provide a formal mechanism through which the SEC can receive advice and recommendations specifically related to privately held small businesses and publicly traded companies with less than $250 million in public market capitalization.

For more information on this topic or other proposals affecting emerging companies, please contact any of the attorneys listed below or a member of the Bryan Cave’s Financial Institutions Client Service Group.

Eliot W. Robinson, Atlanta
(404) 572-6785
eliot.robinson@bryancave.com

Katherine M. Koops, Atlanta
(404) 572-6819
katherine.koops@bryancave.com

Robert D. Klingler, Atlanta
(404) 572-6810
robert.klingler@bryancave.com

Rob Endicot, St. Louis
(314) 259-2447
rob.endicott@bryancave.com

Brendan Johnson, St. Louis
(314) 259-2438
brendan.johnson@bryancave.com

Todd Kaye, St. Louis
(314) 259-2194
todd.kaye@bryancave.com

Rich Plumridge, Denver
(303) 866-0583
rich.plumridge@bryancave.com

Mark Weakley, Boulder
(303) 417-8549
mark.weakley@bryancave.com

Brett Souza, Irvine
(949) 223-7119
brett.souza@bryancave.com

]]> http://bankbryancave.com/2012/01/sec-advisory-committee-recommends-relaxing-restrictions-on-solicitation-and-advertising-in-private-offerings/feed/ 0 http://bankbryancave.com/2011/10/potential-securities-relief-on-the-horizon/ http://bankbryancave.com/2011/10/potential-securities-relief-on-the-horizon/#comments Thu, 27 Oct 2011 13:45:01 +0000 Rob Klingler http://bankbryancave.com/?p=7807 While any relief still has a long (and uncertain) path before it would be effective, on October 26, 2011, the House Financial Services Committee approved four bills (with bipartisan support) that would remove regulatory federal securities law obstacles to capital formation.

H.R. 1965 would, for banks and bank holding companies, raise the SEC registration threshold to 2,000 shareholders and the deregistration threshold to 1,200 shareholders.

H.R. 2167, the “Private Company Flexibility and Growth Act,” would raise the SEC registration threshold for all companies to 1,000 shareholders and would exclude accredited investors and certain employees from the definition of “held of record” for registration purposes.

H.R. 2940, the “Access to Capital for Job Creators Act,” would permit general solicitation and general advertising for private offerings conducted under Rule 506, so long as all purchasers were accredited investors.

H.R. 2930, the “Entrepreneur Access to Capital Act,” would permit companies to conduct “crowd source” capital raises under a new exemption under the federal securities laws.  The proposed exemption would permit offerings of up to $5 million in which each investor contributed no more than the lesser of $10,000 and 10 percent of the investor’s annual income.  Any investors purchasing under this exemption would be excluded from the number of investors “held of record” for purposes of SEC registration.

Comparable attempts to raise the SEC registration threshold and otherwise alleviate the regulatory burden associated with capital raises have failed to gain traction over the last several years.  We will continue to monitor the progress of these bills, but will also continue to advise existing public banks and bank holding companies on potential means to deregister from the SEC and “go private.”

As recognized by the Federal Reserve, “the SBLF Subordinated Securities, like the CPP Subordinated Securities, are issued to Treasury as part of a nationwide program to provide capital to eligible banking organizations that are in generally sound financial condition in order to increase the capital available for lending to small businesses, thereby mitigating the ongoing effects of the financial crisis on small business and promoting financial stability.” The Federal Reserve also acknowledged that “the SBLF Subordinated Securities are in terms and substance substantially equivalent to the CPP Subordinated Securities.”

Not withstanding these goals and similarities, the SBLF Subordinated Securities will only be eligible for Tier 2 capital treatment, as required by the Collins Amendment portion of the Dodd-Frank Act. Notwithstanding the Tier 2 treatment, as a result of the Small Bank Holding Company Policy Statement, small bank holding companies (less than $500 million in consolidated assets) can still downstream the SBLF funds as Tier 1 capital into their subsidiary bank(s). By adopting this rule, the Federal Reserve confirmed that a Sub S or Mutual BHC that otherwise qualifies for the small banking holding company policy statement will not have to treat the SBLF funds as “debt” for purposes of complying with the policy statement (which limits the ability to pay dividends if the debt to equity exceeds certain ratios.

For Sub S or Mutual bank holding companies with more than $500 million in consolidated assets, it’s very difficult to rationalize why they would seek to convert their CPP Subordinated Securities (Tier 1) into SBLF Subordinated Securities (Tier 2). For all other groups of institutions, the capital treatment between TARP and SBLF either remains the same or is functionally irrelevant due to the Small Bank Holding Company Policy Statement.

As a side note, it’s now been 600 days since President Obama first floated the idea of providing additional capital to community banks to spur lending for community banks, 502 days since President Obama included the idea in his State of the Union Address (to a standing ovation from both sides of the aisles), and 174 days since the Treasury released the SBLF term sheet and application. We are not aware of any SBLF fundings, much less approvals. So much for “mitigating the ongoing effects of the financial crisis on small business and promoting financial stability.”

I am also a parent of a child with special needs. I just say that because I’m testing to see if related articles works by scanning similar terms. See also: I am the parent of a child with special needs. Should I give money to a relative to care for my child with special needs after my death instead of giving the money directly to my child?

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Your expressed desires to your relative about the money create only a moral obligation on your relative and are not legally binding obligations that can be enforced. Further, if the relative dies, divorces or has financial problems, your child’s lifestyle could be negatively affected. Specifically, in a divorce, your child’s monies may be considered part of the marital property and part or all may be awarded to your relative’s spouse. If the relative dies, the money passes into the relative’s estate and goes to his or her beneficiaries or heirs, which might not be your child. Also, if your relative has to declare bankruptcy, creditors could put a lien on your child’s monies.

• Preemption standard for national banks and federal thrifts is altered
• Codification of the requirement that a bank holding company act as a “source of strength” for any subsidiary that is a depository institution
• Federal Reserve is authorized to issue orders and regulations relating to the capital requirements of holding companies
• Heightened capital requirements for interstate acquisitions
• New restrictions on insider asset sales and lending
• Truth in Lending Act exemption threshold for certain credit transactions and consumer leases is increased from $25,000 to $50,000 (i.e., TILA coverage is increased)
• Repeal of Regulation Q and the underlying statute (permitting payment of interest on demand deposit accounts)
• Increase in next-day availability requirement for deposit items not themselves subject to next-day availability under the Expedited Funds Availability Act from first $100 to first $200
• Required credit score disclosure under the Fair Credit Reporting Act where adverse action is based in whole or part on a consumer report

We will continue to follow rulemaking and enforcement of the Act and provide updates linked to our dedicated Dodd-Frank page.  Regulators (and Barney Frank) are celebrating the law’s milestone today by testifying before the U.S. Senate on how the Act has improved supervision.  Stay tuned.

In Georgia, new consideration is not required to execute new non-competes, so employers are in a good position to strengthen their competitive protections under the revised statute, but action is required as only new agreements will enjoy the benefits of the new law.  The new law also governs restrictive covenants between distributors and manufacturers, lessors and lessees, partnerships and partners, franchisors and franchisees, sellers and purchasers of a business or a commercial enterprise, and two or more employers.

In-Term Covenants Generally

The bill codifies many aspects of the law in this area that had developed in the Georgia courts.  This includes the presumption that any restriction within an agreement that operates during the term of the underlying employment or business relationship is not unreasonable because it lacks any specific limitation on the scope of activity, duration, or geographic area as long as it promotes or protects the purpose of the agreement or deters any potential conflict of interest.

In addition, the following presumptions also apply to in-term covenants:

• Duration - A restricted time period equal to or measured by the duration of the parties’ business relationship is presumed reasonable.
• Geographic scope - A restriction which covers the areas in which the employer does business at any time during parties’ commercial relationship, even if not known at the time of entry into the restrictive covenant, is reasonable as long as the total restricted distance is also reasonable and/or the covenant contains a list of particular competitors that the restricted party may not contact for a limited period of time.
• Scope of competition - The scope of competition restricted is presumptively measured by the business of the employer or other person or entity in whose favor the restrictive covenant is given.

Post-Termination Covenants

Enforcement of contracts that restrict competition after the term of employment shall not be permitted against any employee who does not, in the course of his or her employment:

• regularly solicit for the employer customers or prospective customers;
• regularly engage in making sales or obtaining orders or contracts for products or services to be performed by others;
• perform the duties of a “key employee” or of a professional; or
• perform the duties of supervision and hiring/firing as a manager

This prohibition is not a major limitation on post-employment non-competes as most employees for which an employer desires to avoid competing with engage in one or more of these activity categories.  In the case of a post-employment covenant entered into prior to termination, any “good faith estimate” of the activities, products, and services or geographic areas that may be applicable at the time of termination will satisfy any provision of the new statute requiring a description of such activities, products, and services or geographic areas, as will any description that provides “fair notice of the maximum reasonable scope of the restraint . . . even if the description is generalized or could possibly be stated more narrowly to exclude extraneous matters.”

Through provisions that codify other aspects of Georgia case law, the following types of restrictive covenants are presumed reasonable in time under the new statute:

• Post-employment covenants – 2 years (measured from the date of termination of business relationship)
• Distributor, dealer, franchisee, lessee of real or personal property, or licensee of a trademark, trade dress, or service mark covenants – 3 years (measured from the date of the termination of the business relationship)
• Sale of business covenants – 5 years or the period of time during which payments are being made to the seller (measured from the date of termination or disposition of interest)

Non-Solicitation Agreements and NDAs

In non-solicitation covenants, express reference to geographic area or types of products or services considered to be competitive will not be required.  Courts will instead look to whether the employee had “material contact” with the prospective customers during his or her employment for the purpose of providing products or services that are competitive to the employer’s business.  This is a very broad term under the new statute.

As noted above, under the new law, NDAs need not contain any limit on the period of time for which a party may agree to maintain information as confidential or as a trade secret, or any limit on the geographic area within which such information must be kept confidential or as a trade secret, for so long as the information or material remains so.  The law permits restrictive covenants as to information that constitutes a trade secret as well as other information about the business of an employer disclosed to or of which the employee became aware as a result of his or her employment, has value to the employer, and is not generally known to the employer’s competitors.

Burden of Proof and Applicable Law In Light of the New Statute

Finally, under the revised Georgia statute, the person or entity seeking to enforce a restrictive covenant must plead and prove the existence of a “legitimate business interest” justifying the covenant.  This is also a very broad term and includes, among other things, trade secrets and other valuable confidential information, substantial relationships with customers or vendors, customer goodwill, and extraordinary or specialized training.  If the party seeking enforcement establishes prima facie evidence that the restraint is in compliance with the provisions of the statute authorizing it, then any person opposing enforcement has the burden of establishing that the specified restraint does not comply with such requirements or that such covenant is unreasonable.

As noted, the new law applies to restrictive covenants entered into on or after May 11, 2011.  Because of a prior constitutional challenge to the statute, agreements executed prior to November 3, 2010, are subject to the old law, as in all likelihood are covenants dated between November 3, 2010, and May 10, 2011, inclusive.

A unique feature of this transaction is a valuation adjustment that utilizes a stock escrow arrangement.   Some of the purchased shares will revert from the new investors to the legacy shareholders if the existing loan portfolio performs better than the investors have projected.

As a result of the recapitalization, the Company is among the best capitalized financial institutions, among those with over $1 billion in assets, in Georgia. The Company’s Total Risk-Based Capital Ratio stands at over 24%.  The Company anticipates that its wholly owned subsidiary bank, The Brand Banking Company, will use proceeds from the recapitalization to enhance its current offerings and expand into new banking services.

Bryan Cave LLP represented the Company in the recapitalization and has significant experience in dealing with capital improvement alternatives and the regulatory issues surrounding those alternatives.  B.T. Atkinson in Bryan Cave’s Charlotte office, and Walt Moeling and Dustin Hall in Bryan Cave’s Atlanta office led the team working on the transaction.

Our key takeaway from this effort is the need to be patient on recapitalization transactions for bank holding companies.  The parties were in discussions with the staff of the Federal Reserve for approximately one year, and six months elapsed between the signing of the definitive investment agreements and the initial closing.   In light of the complexity and uniqueness of this transaction these timeframes were very good.

We commend both the Federal Reserve Bank of Atlanta and the Federal Reserve System Board of Governors for being open to creative approaches to solving some of the more difficult obstacles to recapitalizations of community bank holding companies.  But parties interested in pursuing transactions of this type need to be prepared for multiple rounds of questions and comments regarding the terms of the transaction, the investors, and their affiliates, and also need to be flexible as the issues are addressed.

None of the Federal Reserve System, the FDIC, the OCC, or the OTS receives appropriations from Congress. Instead, each of these Federal agencies is funded through various other sources, as described below. Thus, none of the services or responsibilities of these Federal agencies will be affected if a budget agreement is not reached.

However, many other Federal agencies may be significantly affected by a Federal government shutdown, including, notably for financial institutions, the SEC. We would recommend that institutions with on-going matters with the SEC reach out to their contact persons at the SEC to discuss their situations.

The following is from each agency’s website:

Federal Reserve: The Federal Reserve’s income is derived primarily from the interest on U.S. government securities that it has acquired through open market operations. Other sources of income are the interest on foreign currency investments held by the System; fees received for services provided to depository institutions, such as check clearing, funds transfers, and automated clearinghouse operations; and interest on loans to depository institutions (the rate on which is the so-called discount rate). After paying its expenses, the Federal Reserve turns the rest of its earnings over to the U.S. Treasury.  Source: http://www.federalreserve.gov/generalinfo/faq/faqfrs.htm.

FDIC: The FDIC receives no Congressional appropriations – it is funded by premiums that banks and thrift institutions pay for deposit insurance coverage and from earnings on investments in U.S. Treasury securities.  Source: http://www.fdic.gov/about/learn/symbol/index.html.

OCC: The OCC does not receive appropriations from Congress. Instead, the OCC’s operations are funded primarily by assessments on national banks. National banks pay for their examinations, and they pay for the OCC’s processing of their corporate applications. The OCC also receives revenue from its investment income, primarily from U.S. Treasury securities.  Source: http://www.occ.gov/about/index-about.html.

OTS: The OTS receives no appropriations from Congress; the agency’s operating budget is funded by periodic assessments to the thrift industry. Source: http://www.ots.treas.gov/?p=OTSProfile.

Increasing Supervision of Holding Companies and Their Subsidiaries

Sections 604 and 605 of the conference report broaden the supervisory powers afforded to the Federal Reserve Board to supervise the activities of holding companies and their non-bank subsidiaries.  The conference report permits the Federal Reserve to review other supervisory materials – “reports and supervisory information” – provided to regulators by the holding company or any of its subsidiaries to get a better sense of the risk profile of non-depository subsidiaries of the holding company.  In addition, the Federal Reserve is permitted to commence examinations of the holding company and its subsidiaries, with a particular focus on prudential concerns such as the safety and soundness of the institution, the overall stability of the U.S. financial system, as well as a review of the compliance of the holding company and its subsidiaries with relevant provisions of federal law.

The conference report attempts to reduce the burden of additional regulatory examinations on financial institutions and regulators, with the Federal Reserve instructed to rely on reports from prior examinations by other federal or state regulators in order to get a preliminary picture of the condition of the holding company and its subsidiary.  The conference report further requires the Federal Reserve to coordinate its activities with the functional regulator of a subsidiary; for example, should the conference report be enacted, the Federal Reserve is required to consult with the OCC for its review of a national bank and to consult with the Securities Exchange Commission for its review of a securities or brokerage subsidiary.

The conference report extends Federal Reserve supervision to non-depository subsidiaries engaged in activities that could otherwise be performed by a bank subsidiary, with a primary example being mortgage lending.  These types of subsidiaries will be subjected to the same supervisory regime that currently applies to depository institutions, with the Federal Reserve acting as lead examiner, with shared or alternating regulatory supervision with a state regulator possible if the subsidiary is currently under the supervision of a state agency.  Further, should the Federal Reserve fail to conduct examinations of the non-depository subsidiary, the lead federal bank regulator for the bank holding company’s insured depository institution may recommend to the Federal Reserve that it performs the examination.  If the Federal Reserve fails to either begin an examination within 60 days of the written request or provides a written explanation of why such an examination is unnecessary, the lead federal bank regulator may conduct the examination of the non-banking subsidiary for standard prudential concerns and systemic risk, exercising so-called “back-up authority.”   The examining agency is permitted to assess the subsidiary a fee or other charge deemed necessary to cover the costs of the examination.

Should the examining regulator determine that remedial action is needed by the subsidiary and its parent holding company, it must present its findings to the Federal Reserve, which may then impose some form of enforcement action against the subsidiary.  Should the Federal Reserve choose not to act, the banking agency responsible for the examination has back-up authority to take enforcement action against the subsidiary.  Section 606 of the conference report places an additional requirement on the bank holding company to be both “well-capitalized and well-managed” in order to engage in “expanded financial activities.”  Ultimately, should the risk profile of the non-depository subsidiary raise concerns, the Federal Reserve is likely to use this new requirement as a means to encourage the holding company to raise or hold additional capital to improve its overall condition.

While the conference report encourages coordination and cooperation among all federal and state banking regulators, as well as functional regulators such as the SEC and the CFTC, the Federal Reserve has a clear invitation to expand its supervisory powers over a variety of non-depository subsidiaries of bank holding companies, and to coordinate supervision of larger, more complex financial institutions.

New Standards for Interstate Bank Mergers, Bank Acquisitions and De Novo Branching

Title VI of the conference report continues Congress’ efforts to better regulate systemic risk in the nation’s financial markets, as previously discussed regarding the Office of Financial Research and the Financial Stability Oversight Council. Section 604 of the conference report requires that the Federal Reserve consider whether “a proposed acquisition, merger or consolidation would result in greater or more concentrated risks to the stability” of the U.S. banking system as part of its evaluation of the application.  Similar considerations are made in bank merger transactions – the Federal Deposit Insurance Act is amended to include consideration of systemic risk, alongside standard concern for the “convenience and needs of the community to be served.”  In addition, a financial holding company cannot acquire a company without the prior approval of the Federal Reserve if the total consolidated assets acquired exceed $10 billion, providing another regulatory check on growth of large financial institutions.

Section 607 of the conference report tightens existing standards for approval of interstate bank mergers and the acquisition of banks by holding companies.  For holding company acquisitions of banks located outside of the company’s home state, the conference report amends the Bank Holding Company Act, which currently requires holding companies to be “adequately capitalized and adequately managed” in order to complete an acquisition, to now require that the holding company must be “well capitalized and well managed” at the time of the acquisition.  Similarly, the conference report amends the Federal Deposit Insurance Act, which currently requires that the banks be “adequately capitalized and adequately managed” in advance of the transaction, and must also “continue to be adequately capitalized and adequately managed” following the combination.  The conference report maintains the requirement that banks must be adequately capitalized and adequately managed in advance of the combination; however, Dodd-Frank amends current law such that the resulting institution “will be well capitalized and well managed.”  In other words, two institutions that are currently less than well capitalized for regulatory purposes may be allowed to merge, but in order to complete the transaction, there must be an additional capital infusion to cause the resulting institution to be well capitalized for regulatory purposes.

While it is unlikely to affect community or regional banks, Section 623 of the conference report places a further restraint on mergers and acquisitions.  Under this section, interstate bank mergers, interstate acquisitions of banks by bank holding companies, and savings and loan holding company acquisitions may not be permitted if the resulting institution controls more than 10% of the total deposits in the United States, unless the institution being acquired is deemed to be effectively insolvent by its federal regulator.

Finally, Section 613 of the conference report amends the National Bank Act and the Federal Deposit Insurance Act to largely eliminate state law provisions that can bar de novo branching for non-domestic banks.  Current law allows federal approval of an interstate de novo branch application only if a particular state expressly permits out-of-state banks to establish a de novo branch.  The conference report amends federal law to allow both national and state-chartered banks to establish a de novo branch across state lines provided a state bank chartered under the laws of that particular state would be permitted to establish the de novo branch.  So while each state is permitted to have standards for the establishment of de novo branches in its state, all banks – whether national banks, state banks chartered under the laws of another state, or domestic state banks – will now effectively follow the same branching requirements in a given state.

New Restrictions on Charter Selection and Charter Conversion

Title VI of the conference report establishes a moratorium on the granting of certain types of financial institution charters, and largely prevents the charter conversion of troubled financial institutions.

Section 603 of the conference report places a three-year moratorium on the granting of charters to credit card banks, industrial banks and trust banks.  In addition, the conference report bars a change in control of a credit card bank, an industrial bank or a trust bank if the transaction would result in a commercial firm taking control of the financial institution.

Section 612 of the conference report curtails the ability of troubled financial institutions to convert to another type of charter.  National banks, federal savings associations and state banks and savings associations are not permitted to convert to another charter at a time in which the institution is subject to or has notice of a memorandum of understanding or a formal regulatory order.  The only exception to the general prohibition is if the primary federal regulator following the conversion provides the current federal regulator with a written plan to address the regulatory concerns raised by the enforcement action.

The amended Section 171 avoids placing significant and untimely capital needs on community banks.  Although we do not expect further debate on this or any other provision of the Dodd Frank Act, the reconciled bill still needs to pass both houses of Congress and be signed by the President in order to become law.

The conference report does not modify the basic policy change proposed by Senator Collins — to subject holding companies to capital requirements at least as stringent as those applicable to banks.  As we have discussed, this shift would exclude trust preferred securities and TARP CPP Preferred Stock from holding company tier 1 capital totals.  The impact of this change cannot be understated since banks are already struggling to retire trust preferred obligations and to generally raise capital.  However, the conference committee has significantly softened the impact via grandfather provisions, blanket exemptions and transition periods.

First, Section 171(b)(5) fully exempts from the new standards: (1) securities issued to the federal government pursuant to the TARP program prior to October 4, 2010; (2) any Federal Home Loan Bank; and (3) holding companies subject to the Federal Reserve’s policy statement on small bank holding companies (generally, holding companies with less than $500 million in assets).  Importantly, the securities of any small bank holding company not otherwise exempted would become subject to heightened capital standards if its assets grew to beyond $500 million.

Second, Section 171(b)(4)(C) grandfathers securities issued before May 19, 2010 by: (1)  holding companies with less than $15 billion in assets as of December 31, 2009; and (2) by entities that were mutual holding companies as of May 19, 2010.  Pursuant to this grandfather provision, these entities will be able to continue to treat these securities as Tier 1 capital subject to existing Federal Reserve limitations through the life of the securities.

Third, Section 171(b)(4)(B) provides a phase-in for securities issued before May 19, 2010 by issuers that are not eligible for the grandfather provisions discussed above.  For these entities, securities issued prior to May 19, 2010 will become subject to the Dodd Frank Act’s heightened capital requirements over a three-year phase in beginning on January 1, 2013.   Conversely, any securities issued on or after May 19, 2010 will be immediately subject to the Act’s heightened capital standards unless otherwise exempted or grandfathered.

One important aspect of the implementation of these capital standard changes will be left to regulatory discretion:  the specific schedule for the three-year phase-in applicable to larger holding companies.  On the other hand, the reference to the Federal Reserve’s small bank holding company policy statement freezes this agency position “as in effect on May 19, 2010.”  Even if the Fed changes the view it expresses in this statement, this pending statute would arguably preserve going forward the Section 171 exception for holding companies with less than $500 million in assets.

Section 171(b)(6) also commissions a study by the Office of the Comptroller General  on the availability of capital to insured depository institutions with total consolidated assets of $5 billion or less.  The revised Section 171 preserves the requirement that federal banking regulators to develop capital requirements that address systemic risk, including the risk associated with derivative trading and asset concentration. Incorporating a House proposal, Section 165 would authorize the Act’s Financial Stability Oversight Council to impose a 15:1 leverage ratio on banks with $50 billion or more in consolidated assets that, in the view of the Council, pose a grave threat to the financial system.

Separately, the Act’s Section 616 would specifically authorize the Federal Reserve to establish capital requirements for  bank holding companies and other companies that directly or indirectly control banks.  This section would direct the Fed to make these requirements counter-cyclical “so that the amount of capital required to be maintained by a company increases in times of economic expansion and decreases in times of economic contraction, consistent with the safety and soundness of the company.”  This concept is popular with international regulators and would in theory build reserves for financial hardship during more profitable times.  In addition, Section 616 would codify a requirement that bank holding companies as well as other companies in direct or indirect control of FDIC-insured banks act as a “source of strength” in times of financial distress.

Subchapter S and Q Sub Banks Following Notice 97-5 with Respect to Expenses Relating to Tax Exempt Income
Should Consider Filing Refund Claims

On March 17, 2010, the U.S. Court of Appeals, Seventh Circuit, reversed the U.S. Tax Court’s decision in Vainisi v. Commissioner, 132 T.C. No. 1 (2009), which held that a sub-S corporation that is a bank (or in this case a bank holding company that owned a bank that had made a qualified S subsidiary or “Q-sub” election) is required, under the provisions of Section 291 of the Internal Revenue Code of 1986, as amended, (the “Code”), to increase the amount of its taxable income by 20-percent of the amount of the bank’s interest expense that is considered attributable to certain qualified tax exempt-obligations that are owned by the sub-S bank, despite the plain language of Code Section 1363(b)(4), which provides that “section 291 shall apply if the S corporation (or any predecessor) was a C corporation for any of the 3 immediately preceding taxable years.” The bank in the Vainisi case had been a Q-sub for longer than 3 years.

The 7^th Circuit’s decision is not surprising in that the IRS’ position in the Vainisi case was clearly contrary to the plain language in the Code. The IRS, through the issuance of its Notice 97-5 and with the help of Treasury through the issuance of regulations, attempted to backstop its position by relying on, as authority for its position to disallow a portion of the Q-sub bank’s interest expense, a grant of authority from Congress in a technical corrections bill for Treasury to issue regulations prescribing rules under Code Section 1361(b)(3)(A) (not Code Section 1363(b)(4)) as to when special rules in other sections of the Code will continue to be applicable to banks that make a sub-S or Q-sub election.

The decision in the Vainisi case is well-reasoned and is solid support for a sub-S or Q-sub bank and its shareholders (regardless of whether they reside in the 7^th Circuit) to file amended returns and/or claims for refunds with respect to past returns if the sub-S or Q-sub bank followed the IRS’ position in Notice 97-5 and the Treasury regulations, and reduced their deduction for interest expense by 20% of such expense attributable to certain tax-exempt obligations owned by the bank, even though the sub-S or Q-sub bank had not been a C corporation during any of the 3 immediately preceding taxable years. The decision also provides ample support for claiming a full deduction for interest expense attributable to certain tax-exempt obligations owned by the sub-S or Q-sub bank in future taxable periods as well, at least until such time as the Code is amended by Congress to provide otherwise.

We would be happy to assist any clients with the filing of amended returns and/or claims for refund. Generally, a claim for refund must be filed within three (3) years from the time the return was filed or within two (2) years from the time the tax was paid, whichever period expires later.