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Too Small to Succeed or Ownership Structure to Thrive?

Two recent federal banking agency reports show very different pictures of the banking environment for community banks.  In “Too Small to Succeed? – Community Banks in a New Regulatory Environment,” the Federal Reserve Bank of Dallas lays out the “apparent” rising regulatory burden confronting banks today.  In contract, “Financial Performance and Management Structure of Small, Closely Held Banks,” published in the FDIC Quarterly, provides an empirical analysis of the success of closely held community banks in the FDIC Kansas City, Dallas and Chicago regions.

Lots of Community Banks Remain

As a reminder (which often seems forgotten in these discussions), the U.S. banking industry is still full of community banks.  As of December 31, 2015 (the latest data available), there were 6,182 insured depository institutions in the United States (banks and thrifts, exclusive of credit unions).  Only 107 of those institutions had more than $10 billion in assets; 595 institutions had between $1 and $10 billion, 3,792 had between $100 million and $1 billion, and 1,688 had less than $100 million in assets.  (That’s not to say there isn’t significant concentration; the 110 institutions over $10 billion in assets hold over 81% of the assets in the industry.)

As indicated by the otherwise down-beat Federal Reserve paper, community banks (measured as having less than $10 billion in this analysis) have still maintained 55% of all small-business loans and 75% of all agricultural loans (and banks under $1 billion in total assets still provide 54% of all agricultural loans).  As pointed out by the Federal Reserve paper, community banks accounted for 64% of the $4.6 trillion of total banking assets in 1992, but accounted for only 19% of $15.9 trillion of banking assets in 2015.  While we have certainly had consolidation (both fewer banks, and larger banks), the community bank’s aggregate market ownership has, based on the Federal Reserve’s percentages and totals, actually gone up slightly from $2.9 trillion to $3.0 trillion.

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The Economist Frames the Argument Against Excessive Bank Regulation (somewhat unintentionally)

On March 26, 2016, The Economist published an article entitled “The Problem with Profits.” That article discussed the high profitability of U.S. firms and why that seemingly positive fact is actually harmful to the overall economy, mainly because those profits are not being distributed for spending by shareholders or reinvested in business growth. As a result, the economy shrinks as resources flow to these firms and remain on their balance sheets. The focus of the article was a call for increased competition, but we believe we should focus on other conclusions.

While the article gives a tip of the cap to the impact of regulation generally and bank regulation specifically, banks represent the poster child for the negative impacts of limiting the ability of domestic firms to reinvest, an impact that is not directly reflected on balance sheets or income statements.

Since the onset of “new and improved” regulation stemming from Dodd-Frank and other regulatory reforms, we are seeing are clients use their resources to

  • hold capital on their balance sheets, in some cases to protect against the anticipated negative impacts of an imaginary doomsday scenario;
  • retain “high quality liquid assets;”
  • invest in extraordinary compliance expertise and management systems; and
  • fill buckets left empty from reduced interchange fees, the impact of stress testing, and higher costs to originate mortgage loans, among other things.

As an industry, we frequently point to decreased lending to small businesses and increased consolidation as the evils of increased regulation. In our view, however, the dampening of reinvestment initiatives is much more significant for the industry and for the economy in general.

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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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Walt Moeling Selected as Lifetime Achiever

March 30, 2016

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Atlanta Senior Counsel Walter Moeling has been selected as a Lifetime Achievement Award recipient by The Fulton County Daily Report. Moeling received the honor for his considerable contributions to the legal profession in Georgia.

For nearly 50 years, Moeling has been with Bryan Cave and its predecessor firm in Atlanta, Powell Goldstein. Moeling has counseled financial institutions on corporate governance matters, operational and regulatory issues, capital and acquisition strategies, board disputes and dissident shareholders, as well as other strategic decisions.

He has been recognized by Who’s Who in America. He has been ranked since 1998 in Best Lawyers, including as Best Lawyers’ 2015 Atlanta Financial Services Regulation Law “Lawyer of the Year” and as one of the top 10 lawyers in the state. He also has been featured annually in Chambers USA since 2003.

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Crossroads: Banking and Fintech Conference in Atlanta 4/20-4/21

We are pleased to announce that we are co-hosting a conference with Banks Street Partners and TTV Capital that will take a new look at the opportunities that exist for the banking community within the evolving Fintech landscape.

The agenda features prominent industry speakers regularly quoted in the media as foremost experts in the banking and fintech arenas. The morning keynote will be given by Chris Nichols, Chief Strategy Officer for CenterState Bank. Chris Nichols is an active bank investor, entrepreneur and lover of quantified banking. He currently serves on the Editorial Advisory Board of Banking Exchange and is co-founder of Wall&Main, Inc. a leading platform for crowdfunding. Prior to joining CenterState, Chris was CEO of the capital markets arm of Pacific Coast Bankers’ Bank and is the former author of the Banc Investment Daily.

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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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Loan Sale and Loan Participation Lessons Learned From the Recession, Part 2

(Note: Part 1 is available here.)

One of the problem areas that came up during the recession was the accounting treatment for loan participations and loan sales. The difficulty arose from the fact that FASB changed the guidance for how to recognize a “true sale” several times over the last decade and not all banks realized that their form documents needed to be changed to reflect those changes. The current guidance is now found in Accounting Standards Codification Topic 860 “Transfer and Servicing” (formerly FAS 166 “Accounting for Transfers of Financial Assets”) which itself was an update of FAS 140 “Accounting Transfers and Servicing of Financial Assets and Extinguishments of Liabilities.

If we go back ten years ago, there were several different variations on how loan participations divided distributions from loan payments among the parties. Pro rata is perhaps the most common but it was also typical to see both LIFO (last in first out) and FIFO (first in first out) arrangements. The older accounting treatment allowed an institution using any these different distribution models to be treat the transaction as a true sale, thus removing the asset from its books. The accounting treatment today is dramatically different. Under ASC 860, neither LIFO nor FIFO participations transferred on or after the beginning of a bank’s first annual reporting period that began after November 15, 2009 qualify for sale accounting and must instead be reported as secured borrowings.

Many banks actually used preprinted loan participation forms where one simply checks the block showing whether distributions were shared pro rata, LIFO, or FIFO and continued to use such forms after the FAS change. This resulted in interesting situations where pieces of the same loans can receive differing accounting treatments. For example, assume that Bank A originated a $1 million loan on June 1, 2009 and sold 50% of it on a LIFO basis to Bank B on the same date. Assuming that it meets all of the tests necessary to move an asset off of its books then Bank A can treat that as a true sale. If Bank A later sells another 10% of the loan to Bank C on March 1, 2010, also on a LIFO basis, that transfer will not be treated as a true sale and must be accounted as a secured loan by Bank C to Bank A.

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How to Get the Most out of Annual Board Reviews

There has never been a more challenging time to be a bank director. The combination of today’s hugely competitive banking market, increased regulatory burden and rapid technological developments have raised the bar for director oversight and performance. In response, an increasing number of community banks have begun to assess the performance of directors on an annual basis.

Evaluation of board performance is done in many ways, and ranges from an assessment by the board of its performance as a whole to peer-to-peer evaluation of individual directors. Public company boards are increasingly being encouraged by institutional investors and proxy advisory firms to conduct meaningful assessments of individual director performance. The pace of turnover and change on most bank boards is slow, and more often the result of mandatory retirement age limits than focus by the board on individual director performance. This may be untenable, however, as the pace of external change affecting financial institutions often greatly exceeds the pace of changes on the bank’s board.

While some institutions prefer a more ad hoc approach to assessing the strengths and weaknesses of the board and its directors, we suggest that a more formal approach, perhaps in advance of your board’s annual strategic planning sessions, can be a powerful tool. These assessments can improve communication between management and the board, identify new skills that may not be possessed by the current directors, and encourage engagement by all directors. If used correctly, these assessments often provide valuable information that can focus the board’s strategic plan and help shape future conversations on board and management succession.

So what are the key considerations in designing an effective board evaluation process? Let’s look at some points of emphasis:

  • Think big picture. Ask the board as a whole to consider the skill sets needed for the board to be effective in today’s environment. For example, does the board have a director with a solid understanding of technology and its impact on the financial services industry? Are there any board members with compliance experience in a regulated industry? Does the board have depth in any areas such as financial literacy, in order to provide successors to committee chairs when needed? Do you have any directors who graduated from high school after 1985?
  • Develop a matrix. Determine the gaps in your board’s needs by first writing down all of the skill sets required for an effective board, and then chart which of those needs are filled by current directors. Then discuss which of the missing attributes are most important to fill first. In particular, consider whether demographic changes in your market will make recruiting a diverse and/or female candidate a priority.
  • Determine the best approach to assessment. Engaging in an exercise of skills assessment will often focus a board on which gaps must be filled. It can also focus a board on the need to assess individual board member performance. Many boards are not prepared to launch into a full peer evaluation process, and a self-assessment approach can be a good initial step. Prepare a self-assessment form that touches upon the aspects of being an effective director, such as engagement, preparedness, level of contribution and knowledge of the bank’s business and industry. Then, have each director complete the self-assessment, with a follow-up meeting scheduled with the chair of the governance committee and lead independent director for a conversation about board performance. These conversations are often the most impactful part of the assessment process.
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Loan Sale and Loan Participation Lessons Learned From the Recession, Part 1

Watching loan participation activity over the last decade has been like watching the progression of a car on a roller coaster. The early to mid-2000’s showed the car heading ever upward and then in 2008-09 it hurtled downwards at breakneck speed. The last several years have shown a resurgence as the car begins climbing slowly back up the track. Not surprisingly, the FDIC has taken notice of that trend and issued a Financial Institution Letter on Effective Risk Management Practices for Purchased Loans and Purchased Loan Participations in November of 2015.

The reasons why lenders want to sell either loan participations or whole loans and others want to purchase them remain the same today as they were a decade ago. Sellers may have loan to one borrower issues that a loan participation may cure, they may be seeking to reduce overall exposure to a particular borrower or industry or they may find that providing loan product for other institutions is a profitable venture as it may generate gains on sale as well as servicing income depending on how the sale is structured. Buyers are looking to broaden their geographic and industry diversity in order to better manage the overall credit risk inherent in their portfolio and it may be more cost-effective to source loans from another lender than trying to originate them yourself. Another, more recent development, has been the purchase of loans from peer-to-peer non-bank lenders who operate on a national basis.

When the US economy hit the skids in the 2007-2010 time frame with its corresponding bank failures, it became clear that in many situations loan participations had not generated the expected benefits. There were several reasons for this, the most significant being that simply obtaining geographic diversity of ADC loans still left a lender susceptible to outsized losses when that segment of the economy ground to a halt. Too many community banks failed to realize that true diversity in a loan portfolio means that ADC can only be a portion of the entire portfolio, not the entire portfolio, even if you have geographic diversity. The perceived reduction in risk was therefore illusory.

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Rinearson Identifies How US is Behind in FinTech Innovation

London and New York Partner Judith Rinearson authored a “Bankthink” opinion piece posted on the front page of American Banker  on Dec. 28 regarding differences in how the payments industry is perceived and supported in the U.S. and Europe.

“My biggest surprise after moving to London in September is how far the U.S. has to catch up to the United Kingdom and other European Union countries in the fintech and payments innovation race. Compared with their U.S. counterparts, U.K. and EU regulators are really trying to encourage payment innovation through licensing regimes. One thoughtful and pragmatic step taken by the U.K.’s payments regulator, the Financial Conduct Authority, was to ask industry for its input on appropriate policy. But the U.K. and EU’s bigger advantage is how their ‘e-money’ and payment service licensing processes work compared with U.S. state money transmitter laws.”

Click here to read her full article.

Rinearson is leader of Bryan Cave’s global Prepaid & Emerging Payments Team and has recently been named co-chair of the firm’s new Fintech Team.

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