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FDIC Examinations and Cyberattack Risk

FDIC bank examinations generally include a focus on the information technology (“IT”) systems of banks with a particular focus on information security. The federal banking agencies issued implementing Interagency Guidelines Establishing Information Security Standards (Interagency Guidelines) in 2001. In 2005, the FDIC developed the Information Technology—Risk Management Program (IT-RMP), based largely on the Interagency Guidelines, as a risk-based approach for conducting IT examinations at FDIC-supervised banks. The FDIC also uses work programs developed by the Federal Financial Institutions Examination Council (FFIEC) to conduct IT examinations of third party service providers (“TSPs”).

The FDIC Office of the Inspector General recently issued a report evaluating the FDIC’s capabilities regarding its approach to evaluating bank risk to cyberattacks. The FDIC’s supervisory approach to cyberattack risks involves conducting IT examinations at FDIC-supervised banks and their TSPs; staffing IT examinations with sufficient, technically qualified staff; sharing information about incidents and cyber risks with regulators and authorities; and providing guidance to institutions. The OIG report determined that the FDIC examination work focuses on security controls at a broad program level that, if operating effectively, help institutions protect against and respond to cyberattacks. The program-level controls include risk assessment, information security, audit, business continuity, and vendor management. The OIG noted, however, that the work programs do not explicitly address cyberattack risk.

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Ownership Succession for Family-Owned Banks: Building the Right Estate Plan

For a number of community banks, the management and ownership of the institution is truly a family affair. For banks that are primarily controlled by a single investor or family, these concentrated ownership structures can also bring about significant bank regulatory issues upon a transfer of shares to the next generation.

Unfortunately, these regulatory issues do not just apply to families or individuals that own more than 50 percent of a financial institution or its parent holding company. Due to certain presumptions under the Bank Holding Company Act and the Change in Bank Control Act, estate plans relating to the ownership of as little as 5 percent of the voting stock of a financial institution may be subject to regulatory scrutiny under certain circumstances. Under these statutes, “control” of a financial institution is deemed to occur if an individual or family group owns or votes 25 percent or more of the institution’s outstanding shares. These statutes also provide that a “presumption of control” may arise from the ownership of as little as 5 percent to 10 percent of the outstanding shares of a financial institution, which could also give rise to regulatory filings and approvals.

Upon a transfer of shares, regulators can require a number of actions, depending on the facts and circumstances surrounding the transfer. For transfers between individuals, regulatory notice of the change in ownership is typically required, and, depending on the size of the ownership position, the regulators may also conduct a thorough background check and vetting process for those receiving shares. In circumstances where trusts or other entities are used, regulators will consider whether the entities will be considered bank holding companies, which can involve a review of related entities that also own the institution’s stock. For some family-owned institutions, not considering these regulatory matters as part of the estate plan has forced survivors to pursue a rapid sale of a portion of their controlling interest or the bank as a whole following the death of a significant shareholder.

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HVCRE Update – New Interagency FAQ

As previously mentioned, the federal banking regulators have been working on a FAQ on the topic. The interagency FAQ was published on April 6, 2015. While there were no surprises in what was published there were a number of takeaways from the FAQ that lenders need to keep in mind and I have added those to my previous list of FAQ. Under Basel III, as a general rule, a lender applies a 100% risk weighting to all corporate exposures, including bonds and loans. There are various exceptions to that rule, one of which involves what is referred to as “High Volatility Commercial Real Estate” (“HVCRE”) loans. Simply put, acquisition, development and construction loans are viewed as a more risky subset of commercial real estate loans and are assigned a risk weighting of 150%.

HVCRE is defined to include credit facility that, prior to conversion to permanent financing, finances or has financed the acquisition, development, or construction (ADC) of real property, unless the facility finances:

  1. One- to four-family residential properties;
  2. Real property that would qualify as a community development investment;
  3. agricultural land; or
  4. Commercial real estate projects in which:
    • The loan-to-value ratio is less than or equal to the applicable regulator’s maximum amount (i.e., 80% for many commercial bank transactions);
    • The borrower has contributed capital to the project in the form of cash or unencumbered readily marketable assets (or has paid development expenses out-of-pocket) of at least 15 percent of the real estate’s appraised ‘‘as completed’’ value; and
    • The borrower contributed the amount of capital before the lender advances funds under the credit facility, and the capital contributed by the borrower, or internally generated by the project, is contractually required to remain in the project throughout the life of the project.
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Congress Makes Capital Requirements Easier for Small Banks

Author’s Note: On April 9, 2015, the Federal Reserve adopted a final rule to implement the changes discussed below.  The final rule will be effective 30 days after publication in the Federal Register.

For many years, bankers have asked the question, “What size is the right size at which to sell a small community bank?”  Some offer concrete asset size thresholds, while others offer more qualitative standards. We have always believed the best answer is “whatever size allows an acquirer’s profits and capital costs to deliver a better return than yours can.” While that answer is typically greeted with a scratch of the head, a recent change in law impacts the answer to that question for smaller companies. Given a proposed regulatory change by the Federal Reserve, a growing number of small bank holding companies will soon have lower cost of capital funding options that are not available to larger organizations.

President Obama recently signed into law an act meant to enhance “the ability of community financial institutions to foster economic growth and serve their communities, boost small businesses, and increase individual savings.” The new law directs the Board of Governors of the Federal Reserve System to amend its Small Bank Holding Company Policy Statement by increasing the policy’s consolidated assets threshold from $500 million to $1 billion and to include savings and loan holding companies of the same size. By design, more community banks will qualify for the advantages of being deemed a small bank holding company.

The Federal Reserve created the “small bank holding company” designation in 1980 when it published its Policy Statement for Assessing Financial Factors in the Formation of Small One-Bank Holding Companies Pursuant to the Bank Holding Company Act. The policy statement acknowledged the difficulty of transferring ownership in a small bank, and also acknowledged that the Federal Reserve historically had allowed certain institutions to form “small one-bank holding companies” with debt levels higher than otherwise would be permitted for larger or multibank holding companies. The first version of the policy statement had a number of criteria for what constituted a small bank holding company, most importantly that the holding company’s subsidiary bank have “total assets of approximately $150 million or less.” The asset threshold has been revised on several occasions, most recently in 2006 to the current level of $500 million in consolidated assets.

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Has Your Georgia Non-Compete been Rendered Invalid?

Can Inclusion Of A Boilerplate Duty Of Loyalty Provision
Invalidate Your Covenant Not To Compete?

The Early v. MiMedx Decision

On February 10, 2015, the Georgia Court of Appeals held in Early v. MiMedx Grp, Inc., that a provision in a consulting agreement requiring an employee to devote her full working time to the performance of her duties for the employer was not a loyalty clause but, instead, constituted an illegal restraint on trade. In and of itself, the decision in Early is interesting and will undoubtedly affect how employers draft their duty of loyalty provisions. Perhaps a less obvious consequence of this decision, however, is that by reading a loyalty clause as a restrictive covenant, the Court has now placed employers in jeopardy of having their
otherwise valid, and properly tailored, restrictive covenants invalidated if they are contained in an agreement signed prior to May 11, 2011.

Sometime in January 2011, MiMedx Group, Inc. (“MiMedx”), a developer and manufacturer of patent protected bio-material based production, began discussing a potential business relationship with Ms.
Ryanne Early.  As part of these discussions the parties entered into a Mutual Confidentiality and Nondisclosure Agreement (the “Nondisclosure Agreement”) which “prohibit[ed] Early from disclosing trade secrets and confidential information, which might be revealed to her during negotiations with MiMedx.” Shortly thereafter MiMidex and Ms. Early entered into a Consulting Agreement, whereby Ms. Early’s company ISE Professional Testing and Consulting Services (“ISE”) agreed to provide certain consulting services to MiMidex (the “Consulting Agreement”).

As part of the Consulting Agreement, Ms. Early was required to “devote her full working time (not less than forty (40) hours per week) to [the] performance of Consultant’s duties . . .” (the “full working time provision”). The Consulting Agreement was subsequently terminated and MiMidex filed a complaint against Ms. Early and her company seeking damages and specific performance under the Consulting Agreement and the Nondisclosure Agreement. Ms. Early filed a motion for judgment on the pleadings “contending . . . among other things that the full-time working provision of the Consulting Agreement was void and unenforceable as either a general or partial restraint of trade.”  The primary issue considered on appeal involved the enforceability of the full-working-time provision.

In assessing the issue, the Georgia Court of Appeals determined that the full-time-working provision required that “Early would devote any working time to MiMedx’s business, whether or not that working time was related in any way to the type of enterprise in which MiMedx is engaged.” In fact, the parties agreed that Early would be prohibited from even doing jobs such as babysitting on the weekends or working at a bookstore.  Looking to its earlier decision in Atlanta Bread Co. Intl., Inc. v. Lupton–Smith, the Court held that a provision that requires an employee to spend all her working time on the employer’s business, regardless of the type of job, is a “partial restraint of trade designed to lessen competition. ”  Accordingly, the Georgia Court of Appeals deemed the full-working-time provision “a restraint of trade, rather than a loyalty provision.”  The Court went on to find the provision unenforceable as it was not limited in time, territory or scope.

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New Rules Prohibit Discrimination On The Basis of Sexual Orientation and Gender Identity

The Department of Labor’s Office of Federal Contract Compliance Programs (OFCCP) published a Final Rule on December 9, 2014, implementing Executive Order 13672, which prohibits federal contractors and subcontractors from discriminating against individuals on the basis of sexual orientation and gender identity. In accordance with the treatment of depository institutions under Executive Order 11246, the mere existence of federal deposit insurance is sufficient for a bank to be deemed a federal contractor under Executive Order 13672, without regard to the number of employees or other contractual relationships with the federal government. The new rule will take effect April 8, 2015.

Although the new rule does NOT include new reporting and information gathering mandates or require contractors to set hiring goals, it does require federal contractors and subcontractors (and thus all insured banks) to:

  • Update Contracts.  Contractors must update the equal opportunity clause in new or modified subcontracts and purchase orders to include sexual orientation and gender identity as protected characteristics.
  • Update Job Solicitations.  Contractors must update the equal opportunity language included in all job solicitations to notify applicants that they will not be discriminated against on the basis of their sexual orientation or gender identity.
  • Ensure No Discrimination. Contractors must take steps to ensure that job applicants and employees are not discriminated against because of their sexual orientation or gender identity.
  • Post Updated Notices.  Contractors must post the new supplement to the EEO is the Law poster as soon as it is available on the OFCCP’s website.
  • Ensure No Segregation.  Contractors must ensure that facilities provided for use by their employees are not segregated on the basis of sexual orientation or gender identity.
  • Notify OFCCP/State Department.  Contractors must immediately notify the OFCCP and the State Department if they believe they cannot obtain a visa for an employee to a country in which, or with which, they do business because of the employee’s sexual orientation or gender identity.
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Forming a Game Plan for TruPS

Forming a Game Plan for TruPS

November 14, 2014

Authored by: Ken Achenbach and Michael Shumaker

For the past 15 years, trust preferred securities (TruPS) have constituted a significant percentage of the capital of many financial institutions, mostly bank holding companies.Their ubiquity, both as a source of capital and as a common investment for banks, made them a quiet constant for many financial institutions. Even in the chaos of the Great Recession, standard TruPS terms allowed for the deferral of interest payments for up to five years, easing institutions’ cash-flow burdens during those volatile times. However, with industry observers estimating that approximately $2.6 billion in deferred TruPS obligations will come due in the coming years, many institutions are now considering alternatives to avoid a potential default.

Unfortunately, many of the obstacles that caused institutions to commence the deferral period have not gone away, such as an enforcement action with the Federal Reserve that limits the ability to pay dividends or interest. It is unclear if regulators will relax these restrictions for companies facing a default.

So what happens if a financial institution defaults on its TruPS obligations? It is early in the cycle, but some data points are emerging. In two cases, TruPS interests have exercised the so-called nuclear option, and have moved to push the bank holding company into involuntary bankruptcy. While these cases have not yet been resolved, the bankruptcy process could result in the liquidation or sale of the companies’ subsidiary banks. Should these potential sales result in the realization of substantial value for creditors, it is likely that we will see more bankruptcy filings in the future.

Considering the high stakes of managing a potential TruPS default, directors must be fully engaged in charting a path for their financial institutions. While there may not be any silver bullets, a sound board process incorporates many of these components:

Consider potential conflicts of interest.
In a potential TruPS default scenario, the interests of a bank holding company and its subsidiary bank may diverge, particularly if a holding company bankruptcy looms. Allegations of conflict can undercut a board’s ability to rely on the business judgment rule in the event that decisions are later challenged. Boards should be sensitive to potential conflicts, and may want to consider using committees or other structures to ensure proper independence in decision-making.

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Bankruptcy Judge Allows Involuntary Bankruptcy to Move Forward

On August 29, 2014, Judge John T. Laney, III, the Chief United States Bankruptcy Judge for the Middle District of Georgia, issued an order denying FMB Bancshares’ motion to dismiss the involuntary bankruptcy petition filed by its TruPS creditor, Trapeza CDO XII.  Among other conclusions, Judge Lacey found that the restrictions contained in FMB Bancshares’ written agreement with the Federal Reserve constituted a a restriction on the company’s ability to pay, rather than its legal duty to pay.  While detrimental to FMB Bancshares’ motion to dismiss, this conclusion should reinforce the ability of third parties to enter binding contractual arrangements with bank holding companies, which should be of great relief to those willing to lend to bank holding companies.

As reflected in the opinion and other court documents, FMB Bancshares issued $12 million in Trust Preferred Securities to Trapeza CDO XII in 2006.  Starting in March 30, 2009, FMB Bancshares elected to defer payments under its TruPS, and on March 30, 2014, FMB Bancshares exhausted the twenty consecutive quarter deferral period.  Trapeza has alleged that FMB Bancshares was non-responsive to Trapeza’s efforts to find an out-of-court solution, and declared the TruPS in default on April 7, 2014, causing an acceleration of all principal and interest.  On June 9, 2014, Trapeza filed an involuntary bankruptcy petition for FMB Bancshares, indicating that it believed an auction under Section 363 of the Bankruptcy Code would maximize its return.  On July 3, 2014, FMB Bancshares filed a motion to dismiss the bankruptcy petition, arguing (1) that Trapeza did not have the right (or standing) to institute an involuntary bankruptcy under the terms of the TruPS, (2) that FMB Bancshares was unable to pay because of its regulatory obligations with the Federal Reserve Bank of Atlanta, resulting in the debt being legally contingent, and (3) that the bankruptcy court was not the right venue for the disagreement.

In a 20-page opinion, Judge Laney succinctly rejected each of FMB Bancshares’ arguments.

With regard to Trapeza’s standing to institute the involuntary bankruptcy filing, Judge Laney found that the terms of both the Indenture and Amended Trust Agreement provided Trapeza CDO, as the the holders of the Trust Preferred Securities, with broad powers to enforce their rights against FMB Bancshares directly following the event of default (the occurrence of which was conceded by FMB Bancshares).  Specifically, both the Indenture and Amended Trust Agreement provided, following an event of default, that any holder of TruPS had a contractual right to institute a suit or proceeding directly against FMB Bancshares for enforcement of payment.  Judge Laney found that  an involuntary bankruptcy case could be properly construed as a suit for enforcement of payment, noting that bankruptcy cases in other jurisdictions reached the same conclusion.

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Extending Credit to a Bank Holding Company

Over the past several years reports of someone extending credit to a community bank holding company were similar to sightings of the Yeti in the Himalaya, you might hear about it but you never actually saw one. The number of bank failures and the consequent insolvency of many bank holding companies has led to a natural reluctance on the part of many lenders to provide such financing. The losses that many lenders suffered on such loans has raised some interesting questions about the loans were structured to begin with. The typical loan documentation for such a credit usually has traditionally had only a few financial covenants. The obligation to maintain well capitalized status for both the bank holding company and the subsidiary bank has been the primary focus on the assumption (not altogether incorrect) that maintaining a strong capital base cures many sins. Other covenants might address the ratio of non-performing loans to total capital, the ratio of the Allowance for Loan and Lease Losses to classified assets or simply the bank’s Texas ratio.

Historically, banks generally use financial covenants in loan documents as a signal to either cause the borrower to take immediate action to right the ship or to allow the lender to exit the relationship.  In theory, the “early signal” approach works in many types of businesses and industries. It has proven, however, to be problematic in the banking industry. The issue that lenders have run into is that a loan to a bank holding company is unlike any other type of loan they might make. In a nonbanking environment the lender might seek to take control of the assets and liquidate them.  At the end of the day the lender is free to liquidate assets and apply the proceeds toward the loan within a broad framework provides by general contract law and the UCC. A loan secured by a controlling interest in a bank presents a different situation.

When the subsidiary bank gets into financial distress the lender to the bank holding company can be presented with a difficult dilemma. During this past recession, it was not unusual to see banks downgraded from 2 to 5 on the CAMELS ratings in one examination cycle and to fall from being well capitalized very quickly. Thus, the early warning nature of the traditional financial covenants were of almost no assistance whatsoever to the lender. Once the subsidiary bank was considered “troubled” and prevented from making dividend payments to the holding companies, bank holding company loans quickly moved into default and in many cases had to be written off completely. Another particularly damaging element was the use by banks of  interest reserves for loans in the ADC portfolio. Interest reserves served to mask a decline in the quality of the underlying loans in that a loan may show as current on the bank’s books while in reality the real estate project has stalled.

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TruPS and Involuntary Bankruptcy

One of the most dramatic tools a lender can use in the collection of a loan is the involuntary bankruptcy case.  It is dramatic because of the implications for both the debtor and the lender who files the case. If a bankruptcy court determine that the petitioning creditor has not met the statutory requirements it may require the creditor to pay the debtor’s costs and attorneys fees in defending the petition and if the court finds that the petition was filed in bad faith it can award compensatory and punitive damages.  The consequences for the debtor are that if the creditor is successful, the debtor’s business and assets are now subject to disposition under a frameworks found in the Bankruptcy Code which may involve the appointment, at least initially,  of a bankruptcy trustee to administer the debtor’s estate.  Even if the debtor is successful in fighting off the petition it may suffer dramatic reputational risks that might affect its continued viability. Think of it then as the “nuclear” option.

This tool has now been used at least twice in connection with the enforcement by holders of Trust Preferred Securities (“TruPS”) against bank holding companies (“BHCs”). TruPS are hybrid securities that are included in regulatory tier 1 capital for BHCs and whose dividend payments are tax deductible for the issuer. In 1996 the Federal Reserve Board’s decided that TruPS could be used to meet a portion of BHCs’ tier 1 capital requirements. Following that decision many BHCs found these instruments attractive because of their tax-deductible status and because the increased leverage provided from their issuance can boost return on equity.

Smaller BHC’s typically did not bring TruPS to the market themselves, rather they were issued into a collateralized debt obligation (“CDO”) which in turn purchased TruPS from many different BHCs. According to Fitch since 2000 over 1,800 entities issued roughly $38 billion of TruPS that were purchased by CDO’s. In addition, many federally insured institutions held TruPS themselves once the banking regulators determined that TruPS were an acceptable investment.

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