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.
Modern entertainment, whether it be books or movies, oftentimes grapple with the issues of “who are you?” As a story line develops the audience is kept guessing as characters turn out to have different motivations or identities than what they were first perceived to have. Political thrillers oftentimes involve agents of shadowy groups behind which the true masterminds operate. How much effort will it take to reach the truth? FinCEN has recently come out with some proposed guidance that addresses this issue in the context of the legal entities that financial institutions do business with.
In a proposed rulemaking published in late July, FinCEN proposed a new regulatory requirement to identify beneficial owners of legal entity customers. Going forward, the essential elements of customer due diligence will include: (i) identifying and verifying the identity of customers; (ii) identifying and verifying the identity of beneficial owners of legal entity customers (i.e., the natural persons who own or control legal entities); (iii) understanding the nature and purpose of customer relationships; and (iv) conducting ongoing monitoring to maintain and update customer information and to identify and report suspicious transactions.
The first element is already something which financial institutions address as part of their customer identification program (“CIP”). The second element is the subject of the proposed rulemaking. In order to identify the beneficial owner, a covered financial institution must obtain a certification from the individual opening the account on behalf of the legal entity customer (at the time of account opening). The certification form requires the individual opening the account on behalf of a legal entity customer to identify the beneficial owner(s) of the legal entity customer by providing the beneficial owner’s name, date of birth, address and social security number (for U.S. persons). Significantly, the rule also requires financial institutions to verify the identity of the individuals identified as beneficial owners on the certification form. The procedures for verification are to be identical to the procedures applicable to an individual opening an account under the existing CIP rules.
The proposed definition of “beneficial owner” includes two independent prongs: an ownership prong (clause (1)) and a control prong (clause (2)). A covered financial institution must identify each individual under the ownership prong (i.e., each individual who owns 25 percent or more of the equity interests), in addition to one individual for the control prong (i.e., any individual with significant managerial control). If no individual owns 25 percent or more of the equity interests, then the financial institution may identify a beneficial owner under the control prong only. If appropriate, the same individual(s) may be identified under both criteria.
Revised Guidance on Third Party Payment Processors
The FDIC issued a “clarification” on July 28 to the effect that banks had gone overboard in their reaction to the FDIC’s expressed concerns about third party payment processors. The pressure the banks have been subjected to is related to “Operation Choke Point” where the Justice Department, with the assistance of the federal bank regulators, have attempted to block of the flow of funding to certain businesses such as payday lenders by attacking the ability of third party payment processors who deal with the targeted businesses to maintain deposit accounts with commercial banks. The expressed regulatory reason for this was that banks were exposed to undue reputational risk by assisting such companies to stay in business. While the ability of some of the underlying companies to operate across state lines is currently being litigated by various parties across the US including local cities, the FTC and the New York Attorney General, the businesses for the most part conduct businesses where they are located.
Operation Choke Point has received a great deal of publicity, particularly since it seeks to cut off funding to businesses whose operations are not illegal. The rub being that regardless of what you believe the merits of payday lending to be, once an agency of the federal government decides to put the squeeze on one line of commercial business, what stops them from picking on other lines business. In other words, why do they get to pick and choose who the winners and losers might be and isn’t there some risk that politics can raise its ugly head in the process.
The FDIC and the OCC published Guidance in November of 2013 where they define Reputation Risk as:
Reputation risk is the risk arising from negative public opinion. Deposit advance products are receiving significant levels of negative news coverage and public scrutiny. This increased scrutiny includes reports of high fees and customers taking out multiple advances to cover prior advances and everyday expenses. Engaging in practices that are perceived to be unfair or detrimental to the customer can cause a bank to lose community support and business.
With attorneys and staff worldwide, Bryan Cave attorneys are often quoted in the news. Recent mentions of Financial Institutions group attorneys include:
Jerry Blanchard in the Atlanta Journal-Constitution
Atlanta Partner Jerry Blanchard was quoted July 18 by The Atlanta Journal-Constitution on reasons behind the shrinking number of banks in Georgia. The state, which led the nation in bank failures stemming from the real estate bust, has seen an increase in the number of banks being bought up at a rate of about one a month as healthy banks grow through the acquisition of other healthy banks. Blanchard said the question on many bankers’ minds is, “Can you survive the recovery? It’s hard to make money.” Click here to read the full article.
Rob Klingler in American Banker
Atlanta Partner Robert Klingler was quoted July 1 by American Banker concerning the trend among trust-preferred creditors of telling deadbeat banks that they must negotiate repayment or be forced into liquidation. Trapeza Capital Management filed legal documents recently to force FMB Bancshares in Lakeland, Ga., into involuntary bankruptcy. Trapeza, which manages a collateralized-debt obligation containing FMB’s trust-preferred securities, said in its filing that it is owed $13.6 million in unpaid debt and interest. FMB is the second lender to face involuntary bankruptcy over unpaid trust-preferred dividends. “Involuntary bankruptcies send a clear signal that doing nothing does not appear to be a good strategy,” Klingler said. “When you’re in default and tell your creditors you can’t do anything, you’re asking for an involuntary bankruptcy.”
Walt Moeling in SNL Financial
Atlanta attorney Walt Moeling was quoted July 10 by SNL Financial regarding the increase in bank M&A in Georgia this year. These recent transactions are simply logical, said Moeling, who noted that acquirers today have excess capital and outstanding commitments to put those funds to work, and they often are looking to rationalize fragmented franchises. Moeling agreed buyers are becoming more assertive and attributed some of the increased confidence to the fact that potential sellers are sitting on firmer ground. “They’re picking up a much smaller amount of problem assets and so there is a willingness to be a little more aggressive in doing acquisitions and again that’s only logical,” he said.
We are receiving quite a few calls regarding the recent activity surrounding trust preferred securities, including voluntary and involuntary bankruptcies, restructurings, acquisition opportunities, and potential personal liability of directors. Given this level of interest, Bryan Cave attorneys will be presenting at the Georgia Bankers Association Trust Preferred Town Hall Meeting in Macon, Georgia on August 6, 2014. A flyer and agenda for the event is linked here, and you can register by clicking here. The town hall format of the event will allow for interaction with the presenters and with the other attendees. We will share ideas that will benefit those who are looking for alternatives to work out their trust preferred obligations, those who hold trust preferred securities, and those looking to better understand the landscape to take advantage of opportunities. We hope you will join us for this unique opportunity.
On July 21, 2014, the FDIC issued a Financial Institutions Letter (FIL) on the impact of the capital conservation buffer restrictions under Basel III on S Corporation banks. The guidance essentially states that, even though Basel III restricts an S Corporation bank’s ability to pay tax distributions if it does not maintain the full capital conservation buffer, the FDIC will generally approve requests to pay tax distributions if no significant safety and soundness are present. The succinct guidance probably raises more questions than answers. Among those questions are the following.
- Would a bank that does not meet the capital conservation buffer requirements ever really be 1 or 2 rated and experiencing no adverse trends?
- Does the FDIC believe Obamacare and the related net investment income tax will be repealed? What about state income taxes? The factor limiting the dividend request to 40% may ignore what is actually required to allow shareholders to fund their tax liabilities.
- What is an “aggressive growth strategy?” Is it the same as an intentional growth strategy?
- If your institution is a national bank, a Fed member bank, or a bank holding company with more than $500 million in consolidated assets, will the Fed and the OCC follow suit and issue similar guidance?
At the end of the analysis, the guidance is probably similar to the current capital rule stating that 1 rated institutions may have a leverage ratio as low as 3.0% and still be considered “adequately capitalized.” That rule has little practical impact in that it is awfully hard to find an institution with a 3.0% leverage ratio that is 1 rated. Similarly, we believe any institution that meets the guidelines set forth in the FIL would almost certainly have no need to make this request. Indeed, the FIL itself seems to acknowledge that fact.
When a lender underwrites a loan application it examines the borrower’s business and makes a decision about whether the business model is acceptable to it, whether cash flows are adequate and whether sufficient collateral exists to secure the loan. If the borrower is expanding its business operations the lender may decide whether the new operations make sense to it. Likewise, if a borrower is purchasing a major piece of equipment the lender might indicate that it does not finance certain items or it might say that it only finances such equipment on certain terms. The point is that the terms of what the lender finds acceptable will be contained in a commitment letter setting out all of the terms of the loan or in the actual loan documentation. As part of that process the lender may be a part of conversations the borrower has with various vendors such as ones selling major pieces of equipment or building major projects.
What happens if the lender decides that it wants to communicate directly with the vendor to ask questions about the product being sold? What if they have objections about the contract itself, can they express those directly to the vendor as opposed to dealing directly with the borrower? Can they request that changes be made to the contract without consulting with the borrower? Even if they can do it from a pure legal standpoint, is it a good idea? A recent case (Velocity Press v. Key Bank, N.A., 2014 WL 2959460 (CA10 2014)) would suggest that engaging in such behavior is problematic.
The lender agreed to provide a line of credit to a company in order to purchase a custom printing press from the manufacturer for $1,797,229. Under its arrangement with the manufacturer the borrower was scheduled to make several progress payments: 30% down, 30% halfway through manufacturing, 35% when the press was completed and operating on the manufacturer’s floor and the final 5% when installation of the press was finished at the borrower’s plant.
Out of the original investment of $204.9 billion in 707 institutions under the TARP CPP program, the U.S. Treasury currently only holds its original investment in 44 financial institutions representing a total outstanding investment of $422 million. In other words, the Treasury still holds its investment in about 6% of the financial institutions invested in through the CPP program, but those institutions represent only 0.2% of the amount invested. As the U.S. has already collected $225.9 billion in total TARP CPP proceeds, the ultimate disposition of the remaining 44 financial institutions will have no material impact on the $20 billion gain recognized by the U.S. Treasury through the TARP CPP program.
The 44 remaining TARP CPP investments range from $1 million to just over $50 million, with an average original investment of $9.6 million. 35 of the 44 remaining institutions have missed dividend/interest payments, with a total of $72 million in missed dividend payments (which includes $20 million in missed non-cumulative dividends that the institutions have no obligation to repay). Overall, the remaining portfolio investments have missed 11.5 quarterly dividend payments, but if you exclude the 9 institutions that remain current, the average investment has missed 14.5 quarterly dividend payments.
The Georgia Supreme Court issued its long-awaited decision in FDIC v. Loudermilk on Friday, addressing whether the FDIC’s ordinary negligence claims against former directors and officers of failed banks are precluded by the business judgment rule. There is a lot to digest in the Court’s 34-page opinion, but here are our initial thoughts.
The upshot for bank directors and officers in Georgia is that the business judgment rule is very much alive, and applies to banks to the same extent as other corporations. That itself is big news—the Georgia Supreme Court had never addressed whether the business judgment rule exists in any context, and the FDIC had argued that if the rule existed at all, it did not apply to banks because the Banking Code imposes an ordinary negligence standard of care. Much of the Court’s opinion is devoted to explaining how the business judgment rule developed as a common law principle and refuting the argument that the statute trumps the rule.
The Court explained, however, that the business judgment rule does not automatically rule out claims that sound in ordinary negligence. It distinguished claims alleging negligence in the decision-making process from claims that do no more than question the wisdom of the decision itself. A claim that a directors disregarded their duties by failing to attend meetings, for instance, could survive a motion to dismiss. A claim that the decision itself was negligent, without any allegation relating to the process leading to the decision, will not survive.
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.